Is It Different This Time? Part 5

“One of the fallacies about the recent financial turbulence is that the markets are in ‘uncharted territory’ and that there are no historical precedents for the volatility, panic, or economic uncertainty that we’ve observed. To make statements like this is to admit that one has not examined historical evidence prior to the 1990′s. The fact is that we’ve observed similar panics throughout market history. – John P. Hussman.

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