After a nasty 2-month decline in the global stock markets, the rebound since March 9th, 2009 is no less spectacular. Volatility in the markets has reached levels not seen in decades.
Out of the 122 most volatile days since 1960 (and that is 1% of all trading days), 23 of them are in 2008-2009. Our studies have shown that volatility has the tendency to cluster around peaks and troughs in the markets. Judging by the monstrous bear market we just witnessed, we are not surprised by the strength of the recent rally.
There is no better time to review some basic investment principles than during these difficult times.
- Markets tend to go to extremes and reverse back to their norms over time. Academics call this “reversal to the mean”. Unfortunately, we can neither pinpoint their extreme levels nor can we time their occurrences.
- Stock markets tend to discount economic news 6 to 9 months ahead of time. In other words, stock market declines tend to precede a recession and stock market advances tend to precede a recovery, not the other way around. This is the main reason for the lack of success in market timing strategies by forecasters in general.
To illustrate this point, imagine that investors represent a large group of people or a “herd”. Also, although it’s currently a bright sunny day, in the very far distance, a storm seems to be approaching. Some of the herd decides to leave for shelter. As the storm approaches, more and more of the herd head for shelter as well. (i.e. investors are selling). Most of the herd has already left once it starts to pour! After awhile, a few in the herd notice in the very far distance, that there seems to be a little blue sky appearing in the cloud filled sky and start leaving the shelter. Eventually, more and more of the herd leaves the shelter (i.e. investors are buying) and all are out when it’s nice and sunny! And eventually, the cycle starts again.
Human beings like to read forecasts, whatever they are, ranging from the weather (global warming), horoscopes, the economy (recession, depression) to social changes (demography, social behavior). You just have to go to your local book store and you will be surprised by the number of books related to some form of forecasting.
A worthwhile exercise we should all do is to go back several years or several decades, compile all the books with forecasts published at that time and verify their predictions today. We bet that 99% of them are baloney.
Since we are in the money business, we have compiled some facts of our own. We have gone back several decades and scrutinized the so called “gurus” (those who have correctly forecasted) who had predicted a crisis in financial markets. To our surprise, every crisis had been predicted fairly accurately (i.e. within a year or so) by one or 2 “gurus”. Unfortunately, none of them were successful in forecasting subsequent crises. Worst of all, some of them were so wrong that they were no longer mentioned in the newspapers. We can only conclude that timing (i.e. predicting) the market can be a lucrative activity for authors of books and newsletters but as an investment strategy, it is definitely not a reliable one.
- Discipline, diversification and patience are the main ingredients of successful investing. Moreover, “dollar averaging” is, in general, a good investment strategy. For consumption purposes, a dollar is always a dollar, in contrast, an investment dollar is a lot more powerful in cheap markets than it is in over-priced markets.
- Although there are many ways to evaluate investment vehicles, and that includes stocks, bonds and real estate (commercial or residential), one useful method is to look at the income that an investment generates on a regular basis.
For example, when an investor appraises a multiple dwelling to purchase, he analyzes the cash flows it generates after all the expenses in order to arrive at a rate of return that he would use to compare between different investment alternatives.
After the decision to purchase the dwellings is made, he can only control the rents he charges in order to improve his income, hoping that an increase in the income will eventually justify a higher market value for his property. In the meantime, he neither has control over the daily fluctuations in the market price of his property nor should he care since he is not planning to sell it in the near future.
Carry this concept over to the stock market and the same investor starts reacting over daily movements that affect his portfolio. Yet, the concept of analyzing the cash flows generated by each stock position is no different than the one used in purchasing a dwelling. Moreover, the concept of diversification is much easier to implement in a stock portfolio than in real estate. We strongly suggest investors to view daily pricing as a liquidity advantage (i.e. ease of selling an investment, if we so desire) rather than a psychological trigger that forces us to arrive at irrational decisions.
Have you noticed that the investment business has a very perverse characteristic? It is one of the rare businesses where, if you lower the price of a product by 50%, nobody wants it. Conversely, if you raise it by 200%, people would line up to want more. Talk about irrational …
Why aren’t investors buying stocks when they are cheap? Because they think they could become cheaper … because the economy could be in a recession for a long time … because they just lost money over the last few years …
In short, investors refuse to look past short-term problems and instead are fixated on them. Investors should realize that there has never been a recession that was not followed by a recovery and therefore should take advantage of the opportunities that are present today.