Everyone wants to know which way the stock market will be headed. Yet, most people say that they are investing for the long term. Why then do so many people have this fascination with predicting the future? What difference will it make? Maybe they are control freaks, or have some other psychological issue?  Personally, I think it’s because this is what investors have been taught will determine a successful investment program.

In any case, the question seems to come up frequently at social gatherings, “Is this a good time to invest in stocks?” Often, friends will repeat to me a forecast that they have heard. For example, three months ago an officer of a non-profit organization told me her stockbroker said that the Dow Jones would be going down to 7,200; at the time, the Dow was about 7,800. (Wow, I thought, a clairvoyant stockbroker.) As it turns out, his prediction came true. But really, how useful was that prediction, given that the Dow Jones Average is now above 8,400?

Market Timing

More recently, two friends were engaged in a conversation about the direction of the stock market.

One friend had determined that it was a “good time to buy” and had acted accordingly. The second friend had reached the opposite conclusion, saying that the market was “overbought” and he expected a pullback. He had actually “taken some profits” by selling some positions, and he had, in addition, sold short two stocks that he thought would be going down. (Selling short is a way to profit from a decline in a security.)

Clearly they disagreed, and very probably only one would turn out to be right. When asked why I remained mum on the subject, I simply replied that I don’t do forecasts.

Now, back to the original question of “Why Attempt to Forecast the Stock Market?” Well, perhaps as a result of the wild ride we all recently “enjoyed” in the stock market, it’s difficult not to try. From a high on October 9, 2007 to the current market bottom of March 9, 2009, the S&P 500 went down almost 57%. This is the sharpest decline since the Great Depression. Since March 9th, though, the S&P 500 has climbed by about 35%.

Wouldn’t it be great if we could have timed those market swings? As I’ve written in the past, although it would be very nice, it is also virtually impossible. Of course, we keep trying. And some people have placed mistaken confidence in “experts” who seem to know what they were talking about.

The problem is, of course, that market gurus frequently disagree. And choosing one simply because he was recently correct in his predictions could be a big mistake, since there is little consistency in making good forecasts.

Long-Term Investing

I would argue that since no one knows what the short-term direction of the stock market will be, it is a mistake to base your investment philosophy on such predictions. Moreover, it is not necessary to predict the future to have a successful investment experience.

If we really are long-term investors, the only way to benefit from growth in the economy is to invest in equities, which are, in fact, ownership interests in corporations. This doesn’t by any means imply that we should only invest in stocks or stock market mutual funds.

But to ignore the basic difference between a fixed income investment, such as a money market mutual fund, CD, or a bond and equity investments is a major mistake. Fixed income investments have a limited, although more predictable, return. Stocks have higher expected returns, but there is more uncertainty as to just what they will be.

Risk and Return

Why do stock investments have a higher expected return than fixed-income investments? Because they have higher risk. Risk and return are two sides of the same coin.

Nobel Prize winning economist William Sharpe summarized it quite well when he talked about the essence of his award winning research and how risk and return are related. “The bottom line: Yes, Virginia, some investments do have higher expected returns than others. Which ones? Well, by and large they’re the ones that will do the worst in bad times.” (Emphasis added.)

This may sound like a flippant remark, but it is the truth. I think, unfortunately, many people have forgotten the word “expected.” When talking about stock market returns, we got so used to hearing that stocks were superior investments in the long-term, that we forgot about risk. No one ever said that “expected” returns would be “realized” returns, though it seems a lot of people jumped to that conclusion.

A couple of months ago, I thought that some people were unfortunately panicking out of stocks. Their approach was to “go to cash and wait for things to sort themselves out.” Based on past experience, I was concerned  that these frightened investors would miss out on the inevitable recovery. Although no one knows if the stock market did hit its bottom in March, as of now, it was a mistake to have gotten out of the market.

My advice for long-term investors remains the same: To choose carefully an appropriate allocation of stocks and bonds, which depends on your time horizon and your need and your willingness to accept the risk.

After that, you need to diversify properly, keep fees and other costs down, and be aware of taxes. Then follow a buy and hold philosophy, with appropriate rebalancing to your target allocation.

Warren Buffett has famously said that investing is “simple, but it’s not easy.”

I tend to read market commentaries with a jaundiced eye. That’s because the authors generally restate the obvious, i.e. what has already happened, or they attempt to predict the future, which is simply impossible.

The Stock Market is Not in “Uncharted Territory,” the November 17th Market Commentary by John P. Hussman is an exception. Rather than make definitive predictions, he outlines his strategy by putting the stock market and the economy in historical perspective. Here are some quotes I like:

Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are “uncharted territory.” Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions.

Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows.

No thoughtful investor “calls a bottom” in the markets. Stocks are undervalued here, but they could decline further. Economic conditions are poor, but may be over or under-reflected in stock prices. Investors will find out over time, and the ebb-and-flow of information is slow enough to allow very large market fluctuations in the meantime.

Recent market conditions seem like they have no precedent only because so many investment professionals know only the data they’ve lived through. If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives. At this point, further declines in stock prices simply increase the long-term returns that investors can expect over time. We can’t rule out the possibility that investors could get more frightened, or that they might abandon their stocks at prices that would offer extremely high long-term returns to the buyers. It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all.

The main damage that investors can do to their financial security at this point would come from selling into steep but impermanent declines.

As a side note, do your best to filter out comments like “investors are moving out of stocks and into …” or “investors are selling into this decline” or “investors are buying into this rally.” On balance, investors do not sell shares, and they don’t buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the “market” consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you’re at a poker table and you don’t know who the patsy is, you’re the patsy.

Conclusion

No one knows or can accurately predict where stock prices are heading in the short term. It is true that if we have another Great Depression, stock prices will decline further. It is also true that after the steep decline (which we have already experienced, and which is not unprecedented) future returns are likely to be higher, not lower.

In the long term, investors are compensated for taking risks. Consequently, it is highly unlikely that, over the long term, safe investments will have higher returns than equities.

Timing the “market bottom” is impossible, but selling stocks now will most likely result in regrets later.

photo credit: erin MC hammer