Is It Different This Time? Part 2

“There are no guarantees, but throughout our history investors have been rewarded for long-term investing in stocks, for staying the course through short-term noise, and for being prudently diversified.” – Joni Clark.

Today the S&P 500 fell almost 4%, after being down twice that amount.  The Fear Factor is here big time.  No one knows whether stocks will fall further or will move higher in the next few months.  I believe a long-term approach is the only strategy that works and that some historical perspective is needed now.

Note that the October 13th Time magazine continues a long tradition of scary headlines and covers.  Dramatic covers sell magazines. But the media do us no favors by trying to scare us into selling and encouraging us to wait on the sidelines until economic conditions look better.   There is evidence that it always looks bleak in the middle of a financial crisis.  However, in the past, selling at that time has been a big mistake.

This article comes via Charles L. Stanley’s blog.

Breaking News: It’s Not Different This Time by Joni Clark, Chief Investment Strategist of Loring Ward, is food for thought and provides some needed historical perspective. To underscore her position, Clark cleverly displays old Time magazine covers and briefly discusses the respective article context. With the benefit of 20/20 hindsight, she shows how we survived all of the previous crises.

Here is my favorite quote:

“In an age of economic anxiety, real and rising concerns about whether free enterprise can surmount the problems of inflation, energy and productivity. The relentless daily pounding of dismal news drives deeper the public’s conviction that the economy is in a profound and morose crisis.”

Does that sound familiar to you? Well, the quote is from Time magazine’s article Capitalism: Is It Working? The cover story for April 21, 1980.

The more things change, the more they stay the same.

In a supreme understatement, Clark says, “The headlines have not been good this year.”  Well, neither were they good in the past.

But, Clark observes:

“If you’d had the courage and conviction back in the early 70s to ignore Watergate, the oil crisis, Vietnam and inflation and invested $100,000 in the S&P 500…and then if you’d taken a long-term perspective and not worried too much about the S&L crisis, the 1987 “panic,” the tech bubble and all the other speed bumps along the way, you’d now have more than $3,800,000.”

Her conclusion is the one I quote at the top of this post. It is my strong belief, as well.

Is It Different This Time? Part 1

“We cannot assume that even if the economic news gets worse that prices will decline further. It’s quite possible that prices are already reflecting investor concerns of more trouble ahead and may rise despite more gloomy business reports in days and months to come.” – Weston J. Wellington.

Scary Headlines

Lately, it seems that all we have been reading and hearing about are falling real estate values, failing national banks, global brokerage firms in dire straits, and stock prices plummeting in markets all over the world. This is no fun, no fun at all. Surely, we are in big trouble. You may believe that our current financial problems are “unprecedented.” For a different view, though, read on.

Needed Perspective

Dimensional Funds Advisors Vice President, Weston J. Wellington, offers perspective on how the current market downturn compares to past bear markets. His short, 17-minute presentation Is It Different This Time?  shows how resilient markets have really been.

Video highlights include brief discussions of past articles from Time, Newsweek, Fortune, and Business Week, which shows how past crises and bear markets were covered. What is surprising is how often the word “unprecedented” gets used.

photo credit: sorian

Coping Skills for a Bear Market

“These recent events offer a ringing endorsement of broad diversification and a consistent portfolio strategy as the best way to deal with uncertainty.” – Weston J. Wellington.

Ron Lieber writes the Your Money column for The New York Times. His beat covers everything from credit cards, student loans, frequent flier miles, paying bills online to tips on negotiating the buying of a house.

Lately, he has written two interesting columns on investing during a Bear Market.

On September 13th, he wrote Memo to the Uneasy Investor: Be Strong.

He argued against the temptation “to climb under the covers, money safely in the mattress, and hide from a world that has surely changed forever.”

He recognizes that our psychological makeup may not be suitable to successful investing.

Your natural inclination is probably to sell everything and invest in certificates of deposit or throw the proceeds in a money market fund. In fact, evolution insists on these feelings.

“We had survival mechanisms built in to avoid sitting around debating whether we should run away from the saber-toothed tiger,” Mr. Benningfield said. “That’s the fundamental problem with long-term investing. Our skills aren’t really that transferable to the challenges involved.”

But he counsels being brave and following your plan.

Investing in the middle of market gyrations isn’t just a question of controlling the urge to sell indiscriminately. It’s also about taking a close look at the contents of your portfolio and then forcing yourself to fix an asset allocation that is out of whack and to buy in sectors of the markets that are out of favor.

On September 27th Lieber delved into psychology more fully in The Financial Adviser as Hand-Holder. He interviewed “financial planners and investment advisers who got their start as psychologists or studied the field as graduate students, plus a few ringers who are adept observers of minds and money, even though they have formal training only in the latter.”

I asked them this: At this troubling moment, what’s the best way to reorient how we think about money, before we make any rash decisions about what to do with whatever we have left?

Their conclusions include “the markets will eventually recover” and “We have time on our sides.”

Managing our money is a process that unfolds over decades, not days. It’s easy to forget that, when one company after another is falling victim, week after week, and we can track their disintegration on an hourly basis.

“I think reminding people in this environment of why we’ve chosen the investment strategy that we have is a good thing for those who are a little bit antsy,” said Constance Barber, a certified financial planner with Barber Financial in Natick, Mass., who got her start as a school psychologist. “We’ve usually not set this up because it’s money that you’ll need tomorrow.”

Even if we don’t need the money right now, it doesn’t feel good to look at a retirement portfolio and find that it’s down 15 percent from its peak a year ago.

“People rely on selective memory when they’re only looking at losses from the high point that the portfolio reached,” said Victoria Collins, who has a Ph.D. in social psychology from the University of California, Berkeley and has worked as a certified financial planner for more than two decades.

This was a point echoed by many people I spoke with this week. On one hand, it’s certainly depressing to be down to $340,000 from $400,000, for instance. The basic math doesn’t help the mood either, given that after a decline of 15 percent, a portfolio needs to gain 17.6 percent just to get back to $400,000 again.

We can mimic that mindset if we choose, or we can consider what our balance was, say, a decade ago. Chances are we’ve made a lot of progress since then, if we’ve been saving all along. “There are clients who will say, ‘Yes, it’s down, but look where I started,’ ” said Ms. Barber, the former school psychologist. “ ‘I’m hanging in there, and we’ve come a long way, baby, and it’s O.K. for now.’ ”

One tricky part about the last several weeks is confronting all the headlines declaring this the worst financial crisis since the 1930s. “Most of the individuals that I find who need more handholding are the ones who’ve had some connection with the Great Depression,” says Ms. Collins, the Berkeley Ph.D., who is now an executive vice president and principal with Keller Group Investment Management in Irvine, Calif.

These people tend to be retirees, who may have had parents who told them stories about living through the 1930s or are old enough to remember it themselves. If they have little or no earning capacity now, they feel especially helpless when they see parts of their portfolios disappearing.

“I try to remind them that even they don’t need all of that portfolio today,” she said. “You’re only withdrawing a certain amount.”

Ms. Rich suggested that people reach out to someone else to discuss their situation if they don’t have a hybrid financial adviser-shrink to counsel them through the crisis. It could be a peer, a family member, a member of the clergy or staff at a senior center.

My Perspective

Bear Markets are neither unusual nor unexpected. Depending on exactly how you count, we have had 13 Bear Markets since World War II.

Repeat after me, “Bear Markets happen.” Stock prices fluctuate. Risk shows up at unexpected times.

If you cannot accept that, you might consider keeping your money in CDs. But if you follow that strategy, you have little chance of earning a decent return. In fact, after taxes and after inflation, you may achieve a negative return. Your strategy may appear to be less risky, but, in my opinion, you are fooling yourself.

Over the long term, taking on acceptable risk through a diversified portfolio of stocks, bonds, money market funds and other investments will pay off in higher returns. If you had ignored all of the Bear Markets since World War II and had kept fully invested in such a portfolio, you would be way ahead of someone who followed a very conservative approach.

For a discussion of why we should accept Bear Markets see my earlier post.

photo credit: mitchgibis

Shouting “Fire!” in the Middle of a Conflagration

Amazing! Jon Friedman of MarketWatch believes the press has been too prudent in describing the financial meltdown. In his commentary, Media shouldn’t shy away from explosive language, he accuses journalists of “hedging their bets and falling back on imprecise, sugar-coated language.” Friedman would “prefer bluntness and brutal truth.” He wants to call a meltdown a meltdown. “Bloodbath” would be even better, in his opinion.

You can call me a cockeyed optimist, but all I want to know is where has this guy been all this time? The U.S. government is proposing a $700 BILLION bailout. A number of economists have been quoted as saying that this is “the worst financial crisis since the Great Depression.” Do we really need stronger adjectives to describe the financial meltdown more clearly? I don’t think so.

I’ve been saving the front page of The Wall Street Journal all this week, I guess for posterity. Almost every day there have been large font headlines which have included the words Crisis and Failure. Depending on Congress, we may see Panic added to that any day now.

Aside from the headlines, the stories have made reference to “credit freezing,” “backstopping Money Market Mutual funds,” and “banks being afraid to lend to each other.” Do journalists really need to dramatize these events more? Once again, the answer is no.

We’ve had several large financial institutions disappearing over the last couple of months. Companies that are being bought under pressure, going bankrupt, taken over, or “saved” by the U.S. government include: AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and now, Washington Mutual. Have I left any out? Well I guess you could include Merrill Lynch on the “sick but saved” list, just without the help of the federal government.

Just today, CNN.com had an article assuring us that there would NOT be another Great Depression. Even six weeks ago, who would have imagined that such reassurances would be necessary?

So PLEEZE, don’t talk to me about the press being too “prudent and proper.”

photo credit: megananne

Bear Markets: A Necessary Evil

“Bear markets are the mechanism that serves to transfer assets from those with weak stomachs and without investment plans to those with well-thought-out plans—with the anticipation of bear markets built into the plans—and the discipline to adhere to those plans.” – Larry Swedroe.

The author of The Only Guide to a Winning Investment Strategy You’ll Ever Need: The Way Smart Money Preserves Wealth Today, Larry Swedroe always writes clearly and succinctly, and he conveys a great deal of information in a short time. 

This post is a summary of his excellent column Bear Markets: A Necessary Evil.  It is the best article I have read on investing strategy in general and during a Bear Market, in particular.

If you are a serious student of investing, I highly, highly recommend that you read the entire article, which obviously has more detail than this summary.

A necessary evil can be defined as an unpleasant necessity; something that is unpleasant or undesirable but is needed to achieve a result. An example of a necessary evil might be taxes. Investors should also view bear markets as a necessary evil.

His key point is important, but subtle:

Perhaps the most basic principle of modern financial theory is that risk and expected return are related. We know that stocks are riskier than one-month Treasury bills (which is considered the benchmark riskless instrument). Since they are riskier, the only logical explanation for investing in stocks is that they must provide a higher expected return. However, if stocks always provided higher returns than one-month Treasury bills (the expected always occurred) investing in stocks would not entail any risk—and there would be no risk premium.

Bear markets are necessary to the creation of the large equity risk premium we have experienced. Thus, if investors want stocks to provide high expected returns, bear markets, while painful to endure, should be considered a necessary evil.

Risk Premiums and Investment Discipline

“The bottom line is that the outperformance of stocks relative to Treasury bills” entails risk.

And it is a virtual certainty that the risks will show up from time to time. Unfortunately, we cannot know when, or for how long, the periods of underperformance will last, nor how severe they will be.

It is during the periods of underperformance when investor discipline is tested. Unfortunately, the evidence suggests that most investors significantly underperform both the stock market and the very mutual funds in which they invest.

The reason for the underperformance is that investors act like generals fighting the last war. They observe yesterday’s winners and jump on the bandwagon— buying high—and they observe yesterday’s losers and abandon ship—selling low.

Why most investors fail

1. Investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even the well-thought-out plans can end up in the trash heap of emotions.

2. Investors are overconfident of their ability to deal with risk when it inevitably shows up.

3. Investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate—and when the risks show up they are “forced” to sell.

The Keys to Successful Investing

1. The first key to successful investing is to have a well-thought-out plan. That plan includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable and must be built into the plan.

2. Those investors that avoid excessive risk taking are the ones most likely to be able to stay the course and avoid the buy high/sell low pattern that bedevils most investors.

3. Understand that trying to time the market is a loser’s game. A loser’s game is one that while it is possible to win, the odds of doing so are so low that it is not prudent to try.

Summary

It is difficult for most individuals to control their emotions—emotions of greed and envy in bull markets and fear and panic in bear markets.

Bear markets are a necessary evil in that their existence is the very reason that the stock market has provided the large risk premium and the high return that investors have had the opportunity to earn.

But there is another important point that investors need to understand about bear markets. Investors in the accumulation phase of their investment careers should actually view bear markets not just as a necessary evil, but also as a good thing. The reason is that bear markets provide those investors (at least those that have the discipline to adhere to their plan) with the opportunity to buy stocks at lower prices, increasing expected returns.

It is only those that are in the withdrawal phase (e.g., retirees) that should fear bear markets. The reason is that withdrawals make it more difficult to maintain the portfolio’s value over the long term. Thus, investors in the withdrawal phase have a lesser ability to take risk and should build that into their plan.

The bottom line for investors is this: If you don’t have a plan, immediately sit down and develop one. Make sure the plan anticipates bear markets and outlines what actions you will take when they occur (doing so when you are not under the stress that bear markets create).

To repeat, this entire post is a summary of Larry Swedroe’s article.

The words are his; I just happen to agree with them wholeheartedly.

Remaining Calm While Stock Prices Plummet

“If you can keep your head when all about you
Are losing theirs and blaming it on you” – Rudyard Kipling.

Based on today’s results on Wall Street, it looks like we are in for another roller coaster ride this week. Even though we emphasize long term investing, it is difficult to ignore such wild swings in stock prices.

According to a recent column in the Wall Street Journal, “The U.S. financial system last week was rocked by the biggest crisis since the 1930s — and the federal government responded with a multi-pronged intervention that is the most sweeping since the New Deal.”

We do not yet know how much the bail-out plan will ultimately cost the American taxpayer, nor do we know how it will be implemented or how it will all turn out in the end. There are, naturally, dissenters who question the plan or at least some of its ramifications, especially the issue of moral hazard. (More about that later).

That said, I would like to take a moment to recognize Brett Arends, a columnist, who counseled calm and restraint, before and during the stock market’s turmoil. Brett Arends writes R.O.I., or Return on Investment, daily for the Online Journal. On the evening of September 17th, after the Dow Jones Industrial Average had fallen by 450 points, when most people were extremely nervous, Arends put out a video called Reasons to Stay in the Market.

He advised investors not to overreact, and that after such a fall in prices, it is a better time to be buying, rather than selling.

On the morning of September 18th, before the new U.S. government intervention was announced, he followed up with a column called Ten Reasons Not to Sell Your Stocks.

“I’ve seen this sort of panic enough times to have a little perspective. I’m certainly not urging you to rush out and put all your money into the stock market. Your investments should be based on your own financial situation first, and the situation in the markets second.”

Arends added, “If you are panicking and getting ready to sell everything and hide under a rock, here are ten reasons why you shouldn’t.”

1. Oil prices just slumped.
2. Mortgage rates have tumbled.
3. A measure on Wall Street known as the “Vix” just went through the roof.
4. Uncle Sam is finally waking up and getting involved in the crisis.
5. There’s an old Wall Street saying: The time to buy is when there’s blood on the streets.
6. Even one of the most notorious bears is starting to concede some shares are reasonably valued.
7. Big money managers are bearish.
8. If you sell everything and move your money into “safe” places like cash or bonds, you will be running right smack into another risk: inflation.
9. The housing market is about to get two big doses of help.
10. America is finally getting the wake up call it needed.

I’d like to highlight and comment on a few of his “reasons.”

4. Uncle Sam is finally waking up and getting involved in the crisis.

Better late than never. If Mr. Bernanke and Mr. Paulson had taken strong, clear action a year ago, maybe some of these blow ups might have been averted, or minimized. But it’s good news that they stepped in during the AIG debacle, and it’s good news they are letting other firms swap illiquid assets for cash.

Arends wrote these comments before the big bailout proposal was announced. While it is true that the details have to be worked out and agreed upon, on the table (finally) is a comprehensive plan that aims to restore confidence and allow banks to do what they are supposed to do – raise money from investors and lend money to consumers and businesses.

As mentioned in a previous post, we have been going from one crisis to another, using a case-by-case approach that just has not worked.

5. There’s an old Wall Street saying: The time to buy is when there’s blood on the streets.

How about now? Blood isn’t just on the streets – we’re hip deep in the stuff.
There are no guarantees, but history has usually been pretty kind to those who invested after the market had plunged this far and just hung on for years. Sure, there may be plenty more bad news to come. But the collapse in share prices has already priced plenty of that in. Investors are, at long last, getting paid something for taking the risk of owning equities.

Fair enough. By the way, it was Baron Nathan Rothschild, an 18th century British financier, who has been quoted as advising, “The time to invest is when there is blood in the streets.” In other words, buy when everyone else is selling out of fear. This maxim may be easier said than acted upon.

We have definitely gone through a very rough patch, when fear was endemic. At a minimum, it is usually not a good time to sell when everyone is panicking. And after stock prices have fallen, the expected return in the future is higher, not lower.

8. If you sell everything and move your money into “safe” places like cash or bonds, you will be running right smack into another risk: inflation.

Savings account are a great place to keep ready money, but not for long term investments. They are only paying maybe 3% before tax. As for long-term Treasuries? These so-called “safe” investments are fool’s gold. They’re yielding barely 4%, again before tax. I wouldn’t buy them with counterfeit money.

In my opinion, this is a bit of an exaggeration, but I can see his point. Preserving purchasing power is just as important as preserving capital. But bonds do have a place in a properly diversified portfolio. In any event, research shows that short-term bonds have a better risk- return profile than long term bonds.

10. America is finally getting the wake up call it needed.

We’ve been living in a funny-money economy for years. Everyone from college kids to the federal government has been surviving on credit card debt and pretending it could go on forever. It was impossible to get really positive again until that came to an end. It takes a real shock for that to happen. Like this one.

Yes, we are all paying attention now, which is a good thing. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson have turned themselves into the new 21st Century version of the “Dynamic Duo,” impressing upon Democrats and Republicans the importance of working together as a team, for the good of the country.

We’ve had other financial crises in the past, so it helps to have some perspective. When you are living through a tough time, it always seems unprecedented. (This one sure does!) But we have solved serious problems before. From past experience, it is realistic to be a long term optimist.

Conclusion

I advise clients not to follow the stock market on a short term basis, but how can you not, when the evening news leads with it almost every single night? It’s as though the news consists of the stock market/credit crisis first, and then everything else. It almost makes you wish for a good old fashioned political sex scandal, just for a change of pace.

Could things get worse yet? Yes, but, then again, maybe not. If you have a diversified portfolio, based on a sensible long-term plan, stick with it. Talk to your advisor about rebalancing and possible tax loss harvesting. If you have a very concentrated position in one stock, irrespective of which stock it is, consider selling some of it and investing in a more diversified portfolio.

photo credit: Vibrant Spirit

Ignore That Bear Market Headline, Part 2

 

“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” – Warren Buffett.

The title of this post (and the previous one) is intentional. When market prices plummet, as they do from time to time, it is important to avoid panic. Do not discard your well-thought-out asset allocation and your long-range plan. And don’t even think of using the phrase, “In the long run, we are all dead.” That’s a rationalization for following your natural inclination of reacting to fear.

How do we avoid acting emotionally? Well, it helps if we have an understanding of investor psychology (especially our own) but also the perspective of market history. This post goes into each realm.

For an understanding of investor psychology, a great place to start is with Jason Zweig’s book Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich. In this book, he discusses how neuroscience, economics and psychology explain how we make good or bad investment decisions.

Zweig’s weekly column, The Intelligent Investor, published in The Wall Street Journal is always interesting, because he is insightful and brings an independent approach to the investing scene. This weekend’s article entitled Should You Fear the Ostrich Effect? may be particularly relevant. If you don’t have access to the Wall Street Journal, here’s a summary, as well as my analysis.

Zweig observes that investors pay much less attention to their portfolios when the market news is bad. The term “ostrich effect” was coined by behavioral economist George Lowenstein of Carnegie Mellon University. Lowenstein has done extensive research measuring the phenomenon.

Zweig comments that, “Turning yourself into an ostrich doesn’t make your losses go away, but it does enable you to pretend they aren’t there.”

Moreover, Zweig maintains that ostrich-like behavior isn’t all bad.

“Experiments by psychologist Paul Andreassen have shown that the more news that investors get on their holdings, the more they trade and the lower the returns they earn. When your head is stuck in the sand, you can’t open your mouth to trade.”

Absolutely! As Eugene Fama, Jr. said at a recent NAPFA meeting, “Money is like soap; the more you touch it, the less you have.”

Of course, Zweig is not recommending that you completely ignore the news and, therefore, reality, and neither am I. But, if you have a long-term approach and a well diversified portfolio, I believe that you don’t need to follow the news day after day, nor is it even recommended. It may just get you upset at the wrong time, enticing you to react inappropriately.

“When the headlines are overwhelmingly negative, as they are now, the market tends to feel riskier than it actually is. (The time to worry is when no one seems worried, not when everyone does.)”

That bears repeating. “The time to worry is when no one seems worried, not when everyone does.” That has been a favorite phrase that I frequently use with clients.

Zweig invites us to:

“Take a few moments to go back in market history and see how stocks did after other periods of despondency like 2002, 1998, 1991, 1987, 1982, 1974 and so on. If history is any guide, your inclination to act like an ostrich is a strong indication that the market is about to turn into a phoenix.”

Well, I have done what he suggested. What follows is my analysis.

While the S&P 500 had an average annual return of 11.1% from 1970 to 2007, the numbers for the year after recent market declines are much higher.

Bear Market	% Decline	Increase Next
Bottom	in S&P 500	Calendar Year
12/06/74	-45.1%	37.2%
08/12/82	-24.1%	22.5%
12/04/87	-33.5%	16.8%
10/11/90	-21.2%	30.5%
08/31/98	-19.3%	21.0%
10/09/02	-49.1%	28.7%

Source: Standard & Poor’s, cited in Simple Wealth, Inevitable Wealth, by Nick Murray and Dimensional Fund Advisors’ Matrix book.

Be Careful How You Use This Analysis

Please note that these numbers are merely illustrative, because we are using calendar years after the decline, and the declines did not end conveniently on December 31st. Still, in the calendar year following a Bear Market, the average return was 26%. This is an impressive number and makes Zweig’s point.

However, there is another caveat. We are looking back to notice what happened after a market decline. In choosing 1974 or 2002, for example, as our ending points, we are in effect doing a bit of data mining. (We are using the proverbial 20/20 hindsight.)

Recall, though, that 1973 and 1974 were both bad years. Certainly, no one could have known that in advance. So if you were thinking about this in 1973, and you saw a decline of 14.7% for that year, you might have thought that 1974 would be a pretty good year. It definitely was not — the S&P 500 declined by a further 26.5%!

Similarly, 2000, 2001, and 2002 were all down years. If you had thought in 2001 that the worst was over, you would have been spectacularly wrong! After two bad years, the S&P 500 declined a further 22.1% in 2002!

So while I acknowledge that markets tend to do very well after a spate of declines, unfortunately, we cannot know whether the bottom has been reached, at any given point in time.

Buy-and-Hold

But we do know that if you had gotten out of the market in 2002, for example, as so many people did, you would have lived to regret it. The next year, 2003, was a very good year for the S&P 500 with a gain of 28.7%.

Numbers like that reinforce our buy-and-hold philosophy. We don’t try to use “Market Timing” to decide when to get out of the market and when to get back in. It’s impossible to know when to do that. As Jane Bryant Quinn said, “The market timer’s Hall of Fame is an empty room.”

Diversifying Beyond the S&P 500

As an important aside, many indexes did much better than the S&P 500 Index in 2003.

Real Estate Investment Trusts	36.2%
International Developed Markets	39.2%
Emerging Markets Stocks	56.3%
U.S. Small Cap Stocks	57.8%

Please note that these eye-popping results came after a very difficult multi-year Bear Market. Do not expect these results to repeat in the future. And you can not invest directly in an index.

However, these results are indicative of why we recommend diversifying in many more asset classes than just the S&P 500.

“Past Performance is No Guarantee of Future Results.” The SEC makes us say it, and it happens to be true.

Finally, read the quote by Warren Buffet at the top of this post. Do you even imagine that the “Sage of Omaha” is selling today?

The Cloudy Crystal Ball, Part 4

“There will always be someone predicting disaster and someone predicting great fortune. At one time or another, each will be closer to correct than the other. But it won’t matter to you if you understand this and have invested responsibly. You have a long-term plan; stick with it.” – Peter Lynch.

A Recipe for a Beguiling Article

Creating a recipe for a column about the predictions of market gurus is an interesting task. You need people with a good track record, with different takes on which way the market is going. And most of all you need colorful language and good quotes.

As a recent example, take Jonathan Burton’s article in MarketWatch, The Four Horsemen of the Market: Heed the sobering investment advice of these veteran money managers.

Perhaps calling them “Four Horsemen” is a bit heavy on the sauce, but Burton serves up quite a dish. This particular column calls for two parts pessimism and a cup of caution. Add a dash of optimism for balance. Voila, a prediction column! And it really does not matter if the investment strategists are right about predicting the future. In a few weeks, get some new “experts” with different opinions. The recipe stays the same; only the ingredients change.

Well, if nothing else, the money managers certainly provide interesting, “insightful” analysis and very colorful quotes! But since they disagree on the best strategy, I am not sure how you could “heed” these “experts.” You would certainly get indigestion. I definitely do not recommend that you accept their market timing approach, or anyone else’s for that matter. A previous post explains why investing in the equity market should not be dependent on a prediction of the short-term direction of equity prices.

A Gaggle of Gurus

In any event, here are some of the best quotes:

Jeremy Grantham is “Officially scared.”

“The fundamentals have turned out to be worse than I had thought,” Grantham said. “My advice would be, don’t take any risk.”

“I underestimated in almost every way how badly economic and financial fundamentals would turn out,” Grantham wrote shareholders in a July letter. “Events must now be disturbing to everyone, and I for one am officially scared!”

John Hussman says, “Stay defensive.”

“The stock, bond and foreign-exchange markets continue to trade essentially on the theme that the global economy is weakening, but that the U.S. has dodged a recession,” Hussman wrote in his weekly market commentary in late August.

Investors’ consensus is mistaken, Hussman contends. He said the U.S. is mired in recession, and once investors realize that earnings expectations are overblown, stocks will take another major hit.

“The potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact,” Hussman wrote.

Bob Rodriguez is on a “Buyer’s strike”
He declined to be interviewed for the article but was described as continuing “to focus on caution and capital preservation.”

Steve Leuthold is “Pretty positive.”

Like Hussman, Leuthold is convinced that the U.S. economy is in recession. But he points out that the stock market typically bottoms around the midpoint of the downturn. By his reckoning, the economy entered recession toward the end of 2007, and the extensive valuation criteria he uses tell him there’s now light at the end of the tunnel.

“The bottom has been made,” Leuthold said. “The economy is going to start showing some positive signs sometime in the first half of 2009.”

So he’s getting in early, loading up on shares of biotechnology and alternative-energy companies in particular, and keeping a modest amount in oil drillers and natural gas producers.

Conclusion

These “experts” disagree, which is not surprising. There is no evidence that anyone can predict the course of the market. So let’s face it: No one knows whether, in the short term, the stock market will sink or soar. But we do know that the long term trend has been up for stock prices.

Judging by his recent column on how to evaluate 401(k) choices, Jonathan Burton is a very good journalist. But this “prediction” column does not serve his readers well. It fosters the mistaken belief that in order to be a successful investor you need someone to predict the future for you. That’s just not true.

It is not necessary to try to predict market prices, since a buy-and-hold approach works quite well over the long term. Now that’s a recipe for success.

It just doesn’t make for a very scintillating column.

Buy and hold is a very dull strategy. It lacks pizzazz and doesn’t inspire much admiration at cocktail parties. It has only one little advantage: It works, very profitably and very consistently. – Frank Armstrong

Ignore That Bear Market Headline, Part 1

“Without a rock-solid belief in the fundamental principles that undergird an intelligently crafted portfolio, weak-kneed investors face the likelihood of a disastrous whipsaw.” – David Swensen

Yesterday’s Los Angeles Times online article “Another sucker’s rally? Stocks are back in bear territory” declared that a bear market has returned. This won’t be the last article you see of this kind. This is just a guess, but watch for headlines that scream, “The Bear (Market) is BACK! What should you do NOW?” These articles sell publications. So what does this “bear market” actually mean to you?

A bear market is a prolonged period in which investment prices fall, accompanied by widespread pessimism. It is typically defined as a decline in a stock index of approximately 20% or more from a previous high.

A stock market decline of that magnitude is certainly noticeable. But once it has already occurred, what should you do? Probably nothing, especially if you have a well-thought-out strategy and properly diversified portfolio based on your individual circumstances.

The Media

Newspapers, magazines, and TV programs make the declaration of a bear market sound significant. They can always find someone who will compare this decline to past ones and make predictions about just how bad things will be. But the media’s attention to a bear market may be a distraction, it may be misleading, and it could lead you to do something harmful to your economic health. It could convince you to sell.

Yes, the stock market has declined more than 20% from its high, but did you actually buy at the high? It would have been quite difficult to have such exquisitely bad timing! Were you 100% in stocks, as if you were channeling a river boat gambler? I sure hope that you weren’t borrowing money to buy stocks.

As for going forward, please realize that it is impossible to know whether the decline will continue or reverse. Magazine articles or TV commentators may talk knowingly about the causes of this bear market, and why it will continue, but my advice is to ignore them.

We’ve had them before

According to Nick Murray’s Simple Wealth, Inevitable Wealth, not counting the current decline, we have had 12 bear markets since World War II. So these declines are actually quite common. And they have all been temporary.

In the past, we’ve had steep stock market declines caused by wars, high inflation, OPEC embargoes, credit crises, over-speculation, corporate overreaching and fraud. We’ve had assassinations, an impeachment and a president resign. We have had hedge funds implode, and seemingly great institutions disappear. Each time, while living through the terrible stock market, it seemed like that was the first time that such a negative constellation of events had ever occurred. But that wasn’t so. Our economy survived and stock prices recovered, as investor confidence returned.

How long withh this bear market last? No one knows! No one. Talking about the “average” decline is not particularly useful. Some bear markets have been short, some very steep, some unnervingly long and relentless.

Seeing your wealth decrease day by day is no fun. But a bear market is something you have to accept in order to get the long term (higher) returns associated with stocks. At least that is the way it has been in the past.

Feel the Fear But Don’t Act on It

With prices declining, and everyone talking about it, fear takes over, quite naturally. The L.A. Times companion article Investors flee as fear factor swamps markets worldwide is all about fear. In a relatively short piece, I counted the word “fear” 8 times, not to mention “worried” “nervous” and “hammered.” And what a litany of terribles. We’re doomed, doomed!

The final quote, “You tell me — why would you want to buy something now?”

I don’t know, maybe because stocks are on sale with prices reduced?

If you act on the fear, and sell in panic, you have lost. You may think that you will buy back, when things look safer, but the odds of your actually doing so are very small.

Conclusion

It is not easy to have the courage to ignore the pessimism, but over the long term, returns from stocks have more than made up for the periodic (and temporary) bear markets. Will the future look like the past? My guess is Yes.

To be continued …

The Cloudy Crystal Ball, Part 3

“You have to keep reminding yourself. We don’t know what’s going to happen with anything, ever.” – Peter Bernstein

Ignore this prediction!

Yesterday’s Wall Street Journal had a very pessimistic “Abreast of the Market” entitled There’s Always Next Year: Hopes Fade for Second-Half Stock Rally As Credit Crunch, Weak Earnings Persist.

For those of you without a newspaper or online subscription to the WSJ, here are some relevant quotes:

“Hopes have all but faded among investors that the stock market will be able to mount a much-anticipated second-half comeback.

Many now think a sustained rebound for stocks may not be in the cards until the middle of next year. Even then, their expectations are limited as the problems in the financial markets continue to spread rather than ease.”

“‘Earlier in the year, we had hoped that the economy would see an uptick in the second half,” and stocks could rally, said Robert Pavlik, chief investment officer at Oaktree Asset Management, which manages some $350 million. Now, he characterizes his outlook for the stock market through the rest of 2008 as “gloomy” and hopes for “some kind of modest recovery in 2009.”

“We just can’t make a case for a sudden bull market or a sudden economic surge,” said Neil Hokanson, a Solana Beach, Calif., financial adviser with client assets of $330 million.

“It’s hard to say what the next leadership could be for the market,” said Linda Duessel, a stock strategist at Federated Investors. With all the crosscurrents, “we’re talking about a sideways market” for the remainder of the year, she said.

Convinced? These “experts” believe that the stock market is going nowhere for at least the next six months. But let’s think about this analysis. What do these strategists know that isn’t already known? Probably not much. And can they predict the future any better than anyone else can predict the future? No, probably not.

So, why pay any attention to them? Good question. Here are words of wisdom from William Bernstein, author of The Four Pillars of Investing:

“It is said that there are only two kinds of investors: those who don’t know where the market is going, and those who don’t know that they don’t know. But there is a rather pathetic third kind – the market strategist. These highly visible brokerage house executives are articulate, highly paid, usually attractive, and invariably well-tailored. Their job is to convince the investing public that their firm can divine the market’s moves through a careful analysis of economic, political, and investment data. But at the end of the day, they only know two things: First, like everybody else, they don’t know where the market is headed tomorrow. And second, that their livelihood depends upon appearing to know.”

To be continued …