that people do not succeed in forecasting what’s going to happen to the stock market.
—Benjamin Graham
Investor Beliefs About Trends
Despite overwhelming evidence that the market is not predictable, most investors cling to the belief. It has even become common in our everyday speech. After the market goes up, we routinely say it is going up, and after it goes down, we routinely say it is going down. In truth, we only know where the market has been, not where it is going.
The simplest form of market prediction is trend following and, by nature, we are all trend followers. This means we believe that past price trends will continue into the future. If the stock market goes up, most people think it will continue to go up; if the market goes down, most people think it will continue to go down.
In early 2002, John Hancock Financial Services conducted a ran-
dom survey of 801 people who invest in 401(k) and other retirement plans. When asked what they believed the return of the stock market was going to be over the next 20 years, the average answer was an annualized gain of 15%. Where did the respondents get that num-
ber? Ironically, for the preceding 20-year period ending in December 2001, the annualized return for the stock market was 15%. Respondents unconsciously extrapolated past returns into the future.
The media reflects popular opinion in news stories. In 1979, after several dismal years in the stock market, most magazines were predicting 10 more dismal years. The August 1979 issue of BusinessWeek ran a cover story titled “The Death of Equities.” The article recommended that investors abandon the stock market and buy bonds linked to the price of gold, which had soared to $600 per ounce. Ironically, the story ran very close to the bottom of the market for stocks and the top of the market for gold.
It is very hard for people to fight the urge to follow trends. But it is necessary to resist the temptation if you want to be a successful investor. I am not recommending betting against a trend, but this book advocates cutting back on those markets that make gains, following a continuous rebalancing strategy. You will read more about rebalancing in Parts II and III.
Our Life and the Life Cycles of Markets
Most people will participate in two or three large bull and bear
market cycles during their lifetime. A complete market cycle seems
to run between 15 and 30 years. The total gain during the bull
phase averages between five and 10 times its starting price and the
loss during the bear phase averages about one-third to one-half the
price at the market peak. From start to finish, the total return of a
cycle has averaged about 10% per year compounded, depending on
the rate of inflation during the period. The average, inflation-
adjusted return of the market during a complete cycle is about 6%
per year compounded.
Over the last 80 years, there have been three secular (long-term) market cycles. The first began in 1921 and ended in about 1942. The second started in 1943 and ended in 1974. The third cycle started in 1975 and hopefully ended in 2003, although I am speculating on the end date. In each period, as the market went higher, more peo-
ple jumped on the bandwagon, especially in the final years. This trend-following behavior led to the demise of considerably more investors at the end than had been in at the start. The net result of the “market timing” of sorts was a significant loss in capital for many investors and a loss in the public’s faith in Wall Street.
The stock market boomed in the 1920s, fueled by growth prospects after WW I and easy credit from banks. As a result, over 10% of the working population bought common stocks through brokers.1 In 1929 the crash began. The market downturn was slow at first. Then, as the Federal Reserve tightened credit and Congress enacted a new tariff on imports, the stock market collapsed. Over the next three years, prices dropped 82% from their highs and many people could not pay their banks for loans used to buy stocks. As a result, many major banks became illiquid and closed their doors. The banking crisis sent the economy into a tailspin and threw the country into a period of despair.
The experience of 1929-32 stayed on the minds of Americans for
two decades. Despite the fact that the absolute market bottom in
stock prices was in 1932, public ownership in stocks continued to
decline to a low of 4% in 1951. A turnaround in investor sentiment
came at the end of the Korean War, in 1952, when a new generation
of investors was emerging. As a new bull market pushed stock prices
higher in the 1950s, more investors become enchanted. Many of
these new investors were not in the stock market during the Crash of
’29, so they were less influenced by events gone by. Also during this
period, new telephone technology allowed brokerage firms to
expand their reach to every city and town in America. Brokers even
went door-to-door selling individual stocks and a new product
called “mutual funds.”
Renewed vigor fueled the market until the late 1960s. Then, the
U.S. became more involved in the Vietnam War, draining the country of precious resources. This caused a peak in prices in 1968, although people kept buying the dips. Stocks as a percent of household financial assets hit a high of 38% in 1969. By that time over 16% of the adult population owned stocks, more than any other time in the economic history of the U.S.
Unfortunately, as a result of continued deficit spending during the war, the U.S. dollar was weakening. One unintended consequence of the decline in the value of the dollar was an unprecedented outflow of gold from the U.S. reserves. In 1973, growing political pressure to curb the outflow of gold forced President Nixon to take the country off the gold standard, which pegged the value of the dollar to the price of gold. This major shift in monetary policy resulted in the collapse of the U.S. dollar and a surge in inflation. Since oil trades on the U.S. dollar, price of oil skyrocketed, which caused an Arab oil embargo, which created long lines at the gas pumps, a severe energy shortage, and ultimately, a deep recession. Between 1973 and 1974, blue-chip stocks fell over 40% and small stocks fell more than 50%. The rapid decline in prices and poor economic outlook drove many investors permanently out of the stock market for the second time in the century.
The bear market bottomed in 1974. Then, from 1975 to 1992, the S&P 500 compounded at a 15.6% annual return, beating the return of bank CDs by 7%. Nevertheless, during this period, experienced investors preferred the safety of FDIC-insured bank deposits. Stock ownership fell back to the 10% level.
Finally, in the early 1990s, a third generation of investors ven-
tured into the stock market. The baby boomers started to become an
investment force on Wall Street. Improved information and commu-
nications, along with a growing lineup of new and exciting mutual
funds, fueled the rise in stock prices. By early 2000, there were sig-
nificantly more stock investors as a percent of the adult population
than ever before. According to Federal Reserve data, the number of
households owning equities or equity mutual funds increased from
33% in 1989 to 52% by 2001. This increase was a direct result of
more people participating in employer self-directed retirements
accounts such as the 401(k).
As the number of investors participating in the stock market rose, the amount of their participation also exploded in the 1990s. Stocks grew from 18% of median household financial assets in 1991 to a his-
torically high rate of 45% by 1999. As you can see in Figure 3-1, when the bear market rolled around in 2000, significantly more households had more exposure to equities than at any other time in history.
Figure 3-1 puts a lot of this information in graphic form. The 52-
year chart compares the rolling three-year return of the S&P 500 with the percentage of household financial assets in individual stocks and stock mutual funds. For the entire period, the median household held 25% of its financial assets in stocks. The range was from a low of 12% in 1982 to a high of almost 50% in 2000.
Using the data in Figure 1, I estimated the cost of long-term market timing decisions on a generation of investors. The median amount of household financial assets in stocks during the entire 52year period was about 25%. However, as a group, households moved in and out of the market based on prior period returns. Had the public maintained a constant 25% in stocks during the entire period, instead of changing the asset mix based on past market action, the total return of the static 25% portfolio would have been 3,554% versus a total return of only 2,967% from the trend-following strategy that the public followed.
Market timing is not helpful to investors over their lifetime. You
have nothing to gain by trying to increase stock allocations in a bull
market and decrease stocks prior to a bear market. A better alterna-
tive is to decide on a static percentage of stocks and bonds that fits
your needs and then maintain that allocation for a long, long time.
TIAA-CREF Study
For a more detailed look at how investors reacted to the final years
of the recent bull market, we turn to an in-depth study on retirement
saving habits by mutual fund giant and retirement plan provider
Teachers Insurance and Annuity Association-College Retirement
Equities Fund (TIAA-CREF, New York, NY).2 TIAA-CREF is a major
provider of self-directed retirement plans to public service entities.
These include schools, hospitals, universities, and state and local
governments. The source for the TIAA-CREF study was the compa-
ny’s own vast database of retirement savers. By analyzing their own
client data, the researchers tracked changes in equity allocations as
people aged. Also present in the data is the effect of the bull market
on asset allocations.
From 1987 to 1994, investors with TIAA-CREF showed an increase in their acceptance of equity risk (Figure 2). The average 44-year-old in 1987 gradually increased his or her weighting to stocks from 42% to about 44% by 1994. Then, starting around 1995, investors in all age groups accelerated their allocation to equi-
ty, both with invested money and new contributions. By 1999, the now 56-year-olds had increased their retirement holdings to about 57% in equity, a 15% jump from when they were 12 years younger
At first glance, you may conclude that the increase in the equity exposure from 1987 to 1999 may be a direct result of the bull mar-
ket, and some of it was. However, a closer examination reveals an interesting series of events. From 1988 to 1994, the cumulative return of the S&P 500 was 133%, yet the equity allocations for investors in the 40- to 50-year age group did not move very much. That was because a majority of those investors were putting new contributions into safer investments, such as fixed income annuities. This kept the stock percentage fairly stable. In addition, a small number of middle-aged investors were actively reallocating assets out of stocks as the market went up, which was proper action to take in a well-balanced investment plan.
Perhaps the “crash” of 1987 and the market sell-off leading up to the Gulf War in 1991 instilled some caution in investors for a while, but the picture changed again from 1995 to 1999. During that period, the cumulative return of the S&P 500 was an astonishing 251%, which seemed to result in a significant shift in thinking across all age groups in the TIAA-CREF data, particularly among participants in their 40s and 50s. The conservative strategies exhibited earlier by some investors were no longer identifiable.
Figure 3 illustrates a gradual increase in new cash contributions allocated to stocks over a 10-year period. In 1989, few investors were placing a large percentage of their new contributions into equities. By 1998, more than half the investors were placing more than 50% of new money into equities—and half of those people were investing 100% in equities.
The significant increase in equity exposure occurred for two rea-
sons. In all age groups, people shifted allocations of new contribu-
tions away from safe investments into equities and they let equity gains ride without rebalancing their portfolio. Clearly, people believed that the past gains in the stock market were going to continue. Perhaps this shift in strategy was a result of greed, or perhaps it was a result hope, or perhaps peer pressure had something to do with the increase in risk. Regardless of the motivation, the shift to greater equity exposure as U.S. stock prices climbed to the highest relative value in history proved to be a costly mistake.
The Calm Before the Storm
Stock prices have reached a permanently high plateau.
—Irving Fisher, August 1929
We are in a new paradigm of stock pricing. Old models no longer
work.
—Popular Wall Street saying, 1999
The four most expensive words in the English language are “This time it’s different.”
—Sir John Templeton
There are a signs when the stock market may be getting a little over-
valued. For example, nearly everyone is bullish. Even longtime Wall
Street bears become bulls, or at least they stay quiet to avoid a pub-
lic whipping. Trying to make a case for lower stock prices is about as
popular as screaming anti-American slogans during a Veterans Day
parade. Second, stock prices go up for any reason and on any news.
Even bad news is good news. For example, if a report comes out that
predicts lower interest rates, stocks go up on the prospects for an
increase in economic activity. On the other hand, if the report pre-
dicts higher interest rates, the market still goes up because that
means inflation will stay in check, which is good for the growth of
corporate earnings.
Another sign that the market may be getting expensive is that absolute nobodies reporting financial news become huge celebrities. These people host financial TV shows and radio shows and write investment books that say nothing of value. Worse, the general public actually pays good money to buy these books and hear these people
speak at investment seminars. Finally, and most important, the pub-
lic is sold on the idea that this bull market is different. That means
forget everything we ever learned about relative value of assets or risk
avoidance principles and blindly jump into the market because it’s
going up!
It is interesting to observe that stock prices tend to decrease in price volatility during the final phase of a bull market, which tends to reinforce the false belief that stocks are now somehow safer and that this bull market is different. As you can see from Figures 4 and 5, stock prices surged in 1996 while the volatility of day-to-day price changes dropped to historically low rates. Prices just kept going up and up and up. It was a self-fulfilling event, for a while
Volatility picked up in late 1998 after Russia defaulted on its debts and the U.S. markets shuddered. But the increase in volatility did not persist. Within a few months, the market was hitting new highs day after day and volatility was falling again. This again reinforced the belief that the market was in a new paradigm and that we were in a new economic era. By this time it was hard to find any naysayers. Most people were convinced that our economy and the stock market were poised for unprecedented acceleration in the new century.
After the Shakeout
From the beginning of 2000 to the summer of 2002, millions of retirement savers lost huge amounts of money from the portion of their investment accounts invested in the stock market directly or through mutual funds. In addition, large numbers of people lost their jobs as large numbers of new-era companies collapsed and hundreds of technology start-up companies disappeared. Many employees with these companies had their entire net worth riding on company stock options and stock incentive programs. For them, the idea of retiring early in life was replaced by the need to file for unemployment compensation.
A national cry for fairness swept the nation as investors looked to place blame for their misfortunes. Legal claims against Wall Street firms hit a historic high. Thousands of people sued their brokers for unsuitable investment advice. Congress, the Securities and Exchange Commission, and several state attorneys general launched inde-
pendent investigations. Many corporate executives were indicted and charged with fraud. Investment bankers fired thousands of employees as new business dried up and profits slumped. Mutual fund companies closed or merged hundreds of aggressive growth
funds in an effort to bury the performance numbers of the disasters they had on the books. The added regulations and new changes in the securities industry were on par with the massive regulatory changes that took place in the post-depression era in the 1930s.
Individual investors also pulled in their horns and changed the way they invested. People had heard of investing at their risk tolerance level, but never really knew what that meant until they lost a lot of money and panicked. On the plus side, young people were no longer quitting good-paying jobs to become day traders, because day traders were broke and looking for traditional jobs themselves. For most investors, it was their first taste of a real bear market, and they did not know how to act because they did not know what was going wrong with their portfolio or how to fix it.
If anything good came of the experience, it was that many investors finally realized they needed to develop a viable investment plan for retirement, one that could last through a complete market cycle. They also learned that the money made in the late 1990s was a result of luck and not investment skill—and maybe that means they will not believe the Wall Street hype about how they can beat the market. This press release from Boston-based research firm DALBAR, Inc. gives us some indication of hope:
Boston, MA—June 4, 2001. In a national survey of 1,450 households with incomes of $50,000 or more, DALBAR’S “Turmoil 2001” report found that the downturn in the equity market during 2000 and 2001 has been sufficiently extensive to cause consumers to make changes in their investing preferences. This is in direct contrast to DALBAR’S “Turmoil 1998” report, a study of 1998’s extreme but brief volatility, in which investors remained relatively unshaken by short-term market fluctuations. Among the changes identified in this updated report are:
• A general shift to more conservative investment products, but no overall decrease in total saving;
• Movement away from individual securities and single-sector funds towards products with greater diversification; and
• Investors have a better understanding of both the need for financial planning and the risk they can accept.
Bear Markets in Other Asset Classes
So far in this chapter we have talked about bear markets only as they pertain to stocks. However, bear markets occur in the bond market also. When interest rates go up due to a surge in inflation, bond prices can drop almost as fast as stock prices. Since 1926, there have been 21 negative years in the long-term government bond market. Two of the worst returning years for long-term government bonds were 1994, down 7.8%, and 1999, down 9.0%. In addition, since 1926, there have been six five-year periods when bonds were nega-
tive, most recently from 1977 to 1981, down 1.1% annually.
The market for gold and precious metals peaked over 20 years ago and has been in a multi-decade bear market ever since. The price of gold touched its record high of $850 per ounce on January 21, 1980 and is currently trading at one-third that price.
The 1980s were the decade of the Rising Sun. Japan’s resurgence in manufacturing and banking turned that country’s stock market into a global powerhouse. The Nikkei average was so powerful, it was the first market to fully recover from the 1987 global market crash. By early 1990, the Nikkei was trading above the unprecedent-
ed level of 30,000. But that was the last time that market traded over 30,000. Boom typically leads to bust, and for the next 10 years the Nikkei slid backwards, losing nearly two-thirds of its value. Over the last few years the Nikkei has bounced along in the mid-teen range.
There is always a bear market occurring somewhere in the world. There is nothing unusual about a bear market in a free market econ-
omy. It is a natural phenomenon. Even though our government and business leaders try to mitigate the damage during a downturn, there are no easy solutions or quick fixes. Market pessimism has to run its course. Sometimes a bear market can last a long time, espe-
cially if that market went very high during the late bull phase due to extreme optimism. This was the case with the price of gold in the late 1970s, the Nikkei in the 1980s, and possibly our own stock mar-
ket in the late 1990s. The only cure for a bear market is time.
Business economics need time to catch up with prices.
The lesson for investors is to be well diversified and rebalance
the mix when needed. Having several different types of investments
in a portfolio means that while one is up, the other is down, and
that means selling a little of the one that went up and buying some
of the one that went down. This rebalancing method runs against
the trend-following nature that we all feel, but it is the proper way
to manage a retirement portfolio and protect it from the ensuing
bear market.
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