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November 03, 2008

Worried About Stocks? This May Be A Blessing in Disguise
by Tom Madell

Summary: Most people are currently worried about the potential for more losses in stocks in the future. However, data presented below show that dire appraisals and apprehension during the worse 9 periods for stocks (bear markets) over the last 50+ years proved to be completely wrong. The data show that if, rather than halt or withdraw stock investments, starting Jan 1 of the calendar year after at least a 20% drop in stocks has been recorded one put money into the typical stock fund, your annualized total return over the next 5 years would have been quite good. (This includes investing during the most recent 2001-2003 period when investors were also extremely gun shy on stocks.) But, to the contrary, had you invested in stocks during the recent bullish years of mid-1997 to 2000 and 2004 to 2007, when very few people were worried and most were quite willing to invest, your 5 year returns would have been not only poor, but almost solidly negative.

It appears, then, that our feelings of being scared of stocks arising from bear markets and confident of stocks during bullish markets only seems to be warranted by real subsequent returns over the short-term. Based on data going back to 1957, at least, the appearance of a bear market always has turned out to be a good time to consider increasing your investments in stocks. However, given the cyclical nature of stocks ups and downs, whenever stocks have been doing above average for about 5 years (eg 1995-2000; late 2002-late 2007), investors should correctly become apprehensive and begin to reduce their stock commitments.

Bear markets, above all else, test investors' resolve. It is especially during extended market drops lasting more than one year that investors can succumb to such an extreme level of pessimism that they will likely no longer continue to invest regularly, or continue whatever their prior strategy might have been.

This will likely hurt, rather than help, their returns in the future, assuming they are interested in getting good returns for the long term. Needless to say, bear markets can cause many people to leave the market. And once they do, they may take many years, if ever, to come back.

As a public service provider of free investment advice, our Newsletter has always aimed to share with you recommendations that, when looked back upon, will have proven to be above average. This is especially true during periods of extreme investment anxiety, such as now. While we can't say anything with certainty, what we most often have tried to do is to present data showing how what has happened in the past gives you some idea as to the odds of making good decisions now. This is as opposed to what appears to be merely expressing opinions based on what is sometimes called "the dismal science" of economics, or worse, opinions that do not appear based on any empirical data at all - eg "I think that ..." without indicating what data there is to back it up.

The problem with relying solely on economics is that no matter how astute the analysis, there are so many variables affecting investment performance that, likely, no one can predict how things will turn out. That is why we like to look at investments mainly in terms of higher vs. lower probabilities of favorable outcomes, all within the context of a diversified investment portfolio.

If you are like most people, you are probably avoiding making any decisions about your investments during this time of crisis, if for no other reason than fear and uncertainty. We think this is probably one of the smartest moves the average investor can make at this particular time.

While as of this writing, neither selling nor buying seems to us to be a particularly wise strategy, if we had to come down in favor of one, we think that looking to gradually add to your stock portfolio is the way to go. We are tempered, however, in that we think there will be many better buying opportunities within the next 3 to 6 mos., so there is no rush to be a buyer, any more than anyone should be tempted to rush to sell in the event of even more dire warnings of severe trouble ahead.

"Safe" moves into relatively risk-free investments may indeed be safer than the stock and bond markets for the next year or so. But if you consider the data we present below, and if you are investing for results not just over this period, but for the next 5 years or more, we think that serious consideration should be given to taking advantage of the current crisis to lay the foundation for above average future gains.

While the typical forecast now is for a protracted recession, perhaps lasting for about 2 years, virtually no one whose opinion I respect is calling for a "depression". Even a prolonged recession is hardly unprecedented, and will not lead the average responsible investor, retiree, or homeowner to go broke. However, that's not to say that it won't cause considerable hardship to many. But the economy should eventually emerge healthier, as financial prudence becomes more the order of the day than spending money on things that are not at all necessary and are only available by means of excessive borrowing.

I believe it makes little sense to assume the worst about the state of the economy and your investing in the years ahead, especially if you do not need to tap into the majority of your investments for at least 5 years.

With that in mind, here is how I propose you might consider reacting to the current crisis.

Why Feelings of Apprehension Are A Poor Guide When Making Investment Decisions

During the years 1997-2000 as well as more recently during 2004-2007, many people were convinced it was a good time to invest in stocks. Why? Because when taking into account how well things had been doing over at least the prior year or two, they were induced into a sense of confidence which they projected out into the future. In other words, they were largely swayed by relatively short-term past performance. As a result, they also felt a relatively high level of psychological comfort. And the longer that past performance remained positive, the more seemingly "rational" and comfortable making stock investments appeared.

Right now, though, we have the exact opposite situation. For the last year, one can't help but be aware of the market's almost unprecedented horrendous short-term past performance. And almost all economists are projecting that the situation here in the US, as well as worldwide, will continue to get worse. Thus, the prior relative confidence and psychological comfort level of investors has been decimated; many are scared of remaining invested at all, no less of making any new investments.

Taken together, if one accepts the seeming sensibleness of such thinking and the accompanying emotions of either comfort or fear, it suggests that most people tend to both rationally believe and emotionally experience that the best time to make investments is when the market is doing well. And the worst time is when things are falling apart, like now.

While this belief, and its strong emotional component, seems to make sense - why shouldn't we be normally be guided by our current opinion and sentiment when we are determining how to think, act, and invest - surprisingly, it does not appear to be confirmed as a guide when we look at the market's actual past performance patterns.

As we look back over the last 10+ years, whenever investors thought it relatively a good time to invest, it turned out not to have been so. The following two tables show what happened 5 years after investing in the S&P 500 during consistently preceding psychologically-comfortable investing periods:

Table 1 shows long-term investment results made during a long stretch when the prior year's investment results had been good. In fact, investment results had been excellent going back until the early part of 1995. But, no matter when you invested between July '97 and Oct. 2000, the long-term result over the following 5 years was poor although this period might have been good for short-term plays in the market IF you were able to get out in time (most people weren't able to).

Thus, in spite of strong beliefs, positive feelings, and even enthusiasm people had about investing built up over at least a year, returns for investors 5 years after making such investments were consistently poor.

Note: In presenting this article's results for the S&P 500, we are using the Index as a proxy for most stock investments. Of course, there were some categories of fund investments that did do better than the S&P 500, something I have focused on helping investors discover going back to my Newsletter's first issue in 1999.

We can now see that the exact same pattern was repeated beginning in 2004. In spite of being induced into a relatively high degree of psychological confidence by relatively good returns for at least a year prior to investing, we now know that all of investors' long-term efforts made during this period were for apparently for naught: The S&P 500 is significantly lower than it was no matter when you invested during last 4 years. (Of course, over the next few months, or more likely, years, these investments could still recover. That is something that we will have to wait and see. But the general point, which will be shown in Table 3 ahead, is that if possible, it is better to hold off on most new stock investments when prices are relatively high, to await periods when prices are relatively low again.)

Although we don't know yet what the 5 year return made on these investments will be, we do know that currently the return for each is negative since the S&P now is far lower than the 1112 it was at the start of 2004. The S&P would have to rise considerably for any of these investments to eventually show a good return.

Now contrast the above negative results to the period between 2001 and mid-2003, as shown in Table 3, when investors were last in a period like the current dismal one. These investors were, similar to as they are now, very apprehensive, rather in than their investment "comfort zone". Here you can see that they again were more often wrong than right in their gloomy beliefs and accompanying fears, although the extended length of the bear market did cut into the returns of those who ventured forth in the relatively early stages of the eventual 31 mo. bear market which started its slide in Mar. 2000.

In fact, the investing years that followed those shown in Table 3 were the only 5 year periods during the last 10+ years when it was profitable to invest. But even then, if you assumed the markets were safe just because of your profits over the previous 5 years, you would have been wrong.

Investment Results Following the Onset of Each of the 8 Pre-2000 Bear Markets

While the above data can certainly be regarded as a framework with which one can judge how to react to the extremes of bear markets, we felt that just focusing on 5 year results from investing during, and shortly after the last major bear market between 2000 and 2002, could easily be dismissed as "this time (meaning the current bear market) is different." Therefore, we examined the results of investing not long after the start of each of the last 8 bear markets going back over 50 years. In each case, we tested the average yearly performance of the S&P 500 during the 5 calendar years immediately after a bear market drop of 20% of more in the Index had occurred. The following table presents the results:

The data in Table 4, combined with the data on the 2000-2002 bear market (Table 3), show that for the last 9 bear markets, investing back into the market at the start of the new year after an initial 20% bear market occurred consistently produced better than average results for the following 5 years. Note: The 2000-2002 bear market first registered its 20% drop in early 2001, therefore suggesting a good time frame to have increased your investments in the market would have started in Jan. 2002.

In the case of the 3 bear markets that proved to be particularly long and deep (2001, 1973, and 1970), an investor probably would have done even better by waiting longer to put his toes back into the water. Since the current bear market already shows signs of likely being longer and deeper than more shallow bear markets, it may make sense, then, to wait even beyond the start of 2009 to start increasing your commitments to the stock market.

The Bigger Picture

All this appears to demonstrate what I have been writing about since my first Newsletter in mid-1999:

-Success in investing is often counter-intuitive. While the majority of investors comprehend and emotionally react to events in a way that appears commensurate with those events, they are often being fooled. Dramatic plunges in stocks, while wealth destroying in the short run, nearly always present great opportunities for those willing to stop and consider from what historically high point stocks have fallen, and whether or not the fundamentals justify thinking that stocks will not have significantly recovered 5 or 10 years down the road.

Thus, so long as a fund investment is broad and isn't going bankrupt altogether like some individual stocks can, it makes sense to initiate or increase an existing investment after a relatively long period of underperformance such as is apparent now.

-And here is the corollary: While given markets can continue to look good for years and years, once results become "too good", it makes sense to reduce that investment.

Note: In my Oct. 2008 Newsletter, I reported my own research finding that also provides strong statistically significant evidence for these two approaches. Going back to Apr. 1995 through July '03, there has been a high degree of negative relationship between how well large cap stocks did in the previous 5 years and how well they did the following 5 years, and vice versa. High or low prior 5 year returns suggest the opposite subsequent returns over the following 5 years. (For those who are knowledgeable about statistical correlation, the actual degree of correlation shown was -0.61: A correlation of -0.0 implies no relationship; a correlation of -1.0 implies a totally predictable one. Any correlation of the magnitude I found would be considered relatively rare in studies of economics and the behavioral sciences.)

In other words, while "buy and hold" can still produce great results over time intervals approaching 20 years, if you cannot adhere to such a long-term discipline, your best bet is to look for entry and exit points which provide the greatest chance of success.

Tom Madell, Ph.D.
Publisher
Mutual Fund Research Newsletter

Mutual Fund Research Newsletter is a free newsletter which began publication in 1999. It has become one of the most popular mutual fund newsletters on the Internet, ranking number 7 on the Google Directory page for Mutual Funds News and Media Newsletter websites. Since we began publishing our quarterly Model Portfolios, 29 out of the 36 Stock Portfolios have outperformed the S&P 500 Index over the following year (data as of Sept., 2009). Since 2000, 28 of our Model Stock Portfolios have had the opportunity for at least 3 years to pass since we first published it. 25 out of 28 of these Model Stock Portfolios have outperformed the S&P 500 Index over the following 3 years, and ALL Stock Portfolios (20 out of 20) have outperformed over 5 years as well. Mean level of outperformance has ranged from about 3% over 1 year to over 4% PER YEAR over 5 years.

Copyright © 2003-2009 Tom Madell

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