Swedroe: The Bad News Is Old News

In my previous post, we reviewed the historical evidence on bear markets and financial crises, as well as the sources of the latest crisis. Today, we pick up by discussing reasons why all the bad news you’ve been hearing doesn’t mean you should reduce your equity allocation.

Second, after the Asian crisis that hit our markets in the summer of 1998, 1999 was a blockbuster year for the U.S. economy, corporate earnings and the stock market. From October 1998 through December 1999, the S&P 500 returned almost 47 percent. And while the Shanghai Composite Index is now down about 40 percent (as of Aug. 24) from its peak on June 12, it’s basically flat for the year.

Third, recall all the bad news we have had since the market bottomed in March 2009: the eurozone crisis, the United States losing its coveted AAA credit rating, the fears of inevitable rising inflation due to fiscal and monetary stimulus, the fears of the dollar losing its status as the world’s reserve currency (first to be replaced by the euro and then the yuan), the various crises in the municipal bond market (including Detroit’s bankruptcy and problems in states such as Illinois), the Japanese earthquake and the SARS virus—both of which threatened to disrupt world trade.

The market soared despite the bad news. We’ve had the greatest bull market since the Great Depression.

Fourth, as I explain in my book “Think, Act, and Invest Like Warren Buffett,” bad news doesn’t mean markets have to go lower. They should only go lower if the news is worse than already expected. And there is no way to predict if that will be the case, because, by definition, it would be a surprise.

What Would Warren Do?

Fifth, as I also point out in “Think, Act and Invest Like Warren Buffett,” it’s important to not engage in “stage-one” thinking, which leads to selling on bad news.

Instead, you should engage in “stage-two” thinking, recognizing that if the news is worse than expected, governments and central banks are likely to take action to turn the problem around. In this case, for example, problems in the stock markets and global economies would likely cause the Fed to delay any increase in interest rates. It might even cause them to once again engage in more quantitative easing by buying bonds.

Sixth, ask yourself if Warren Buffett is selling. If he isn’t (which he won’t be because he doesn’t engage in market timing), ask yourself what you know that Buffett doesn’t. Or are you just smarter than he is?

If the greatest investor of our generation isn’t selling, should you be? Or should you take his advice to never engage in market timing? If you cannot resist the temptation, then buy when others are panicking.

Seventh, China’s impact on developed nation economies isn’t that great because China isn’t a major importer from them, though it is a significant exporter to most of them.

Eighth, there’s also a fair amount of good news that should not be ignored. The sharp drop in commodity prices, especially for energy products, acts like a big tax cut, putting more dollars into consumers’ pockets and curbing inflation. Typical U.S. consumers are in much better financial shape than they have been in years, having paid down debts and raised their savings ratios. In addition, they have much more home equity than they did in 2009.

Most U.S. states and cities are also in much better financial shape than they were just a few years ago. At the same time, the balance sheets of U.S. companies are in exceptionally strong shape, and corporate profits are at record levels. In addition, the central banks of virtually all developed-market nations are engaged in very easy monetary policies, which has historically been very good for stocks.

Equity valuations outside of the United States aren’t above their long-term averages. Consider that, while the current CAPE 10 of the S&P 500 is about 26 or so (well above its long-term average of 16.6), the EAFE has a current CAPE 10 of about 15, and the Emerging Markets CAPE 10 is about 12.

Markets Tend To Bounce, Not Break

Finally, it’s important to remember that sharp drops in markets are often followed by equally sharp reversals, reversals that are missed if you don’t stay the course. Consider the evidence in the following table showing the returns to stocks in the months following crises. The table provides the returns for the 19 months during the period when the S&P 500 Index, the CRSP 6-10 and the EAFE Index each fell at least 7 percent.

It’s data like this that likely led Warren Buffett to offer this advice: “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie [Munger] and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

He’s also stated that his favorite time frame for holding stocks is forever. And he’s offered the following advice:

• “Inactivity strikes us as intelligent behavior.”
• “We continue to make more money when snoring than when active.”
• “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”

The most successful mutual fund manager of all time, Peter Lynch, offered this advice on the subject of market timing: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Lynch also offered up this advice in his book “Beating the Street”: “Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head, but the stomach that determines [your] fate.”

Lynch’s statement serves as a warning to all investors. If market drops make your stomach rumble and you lose sleep worrying about your equity holdings—or worse, you begin thinking about selling and abandoning your well-thought-out plan—you should take time out to review your investment policy statement to see if changes are appropriate. Perhaps you could lower your financial goal or plan to work longer, either of which would allow you to lower your equity allocation.

It’s also a good time to review the output of your Monte Carlo simulation (assuming you have one) to see if there’s an opportunity to lower your equity allocation by taking some chips off the table, having perhaps benefited from the better-than-expected returns the markets have provided since March 2009.

What You Need To Know

Before I wrap up, we’ll take a brief look at the evidence on the ability of professional investors to successfully time the market. There are many studies showing not only that active managers perform just as poorly in bear markets as they do in bull markets, but that most show a lack of ability to time markets. The following are the results of two of many that could be cited as examples on the subject.

• While from 1986-97, the S&P 500 Index returned 734 percent, the average return of 186 tactical asset allocation funds was just 384 percent.
• A study on performance of 100 pension plans that engaged in tactical asset allocation determined that not a single one benefited from actions.

A fitting way to end this discussion is to walk you through a series of questions that should both provide a good way to think about bear markets as well as lead you to the winning investment strategy of having a well-thought-out plan and having the discipline to stay the course.

1. Are stocks riskier than investing in Treasury bills? Yes, they’re always riskier.
2. So why invest in stocks? Because they have higher expected returns.
3. Do you always get that higher expected return? No; almost 30 percent of calendar years have negative returns.
4. If you always earned higher returns, would there be any risk? Not if there’s no risk of stocks underperforming safe bonds.
5. If there were no risk, would there be any risk premium? No; because if there were no risk, investors would bid up the price of stocks until the risk premium was eliminated.
6. Would you like a world in which there was no equity risk premium? No; most investors couldn’t achieve their financial goals with an equity risk premium being present.
7. We have experienced severe bear markets. If severe bear markets never occurred, and the worst losses were minor ones, would there be any risk in investing in stocks? Yes; there would be some risk, but the risks would be a lot lower.
8. If the risks were less, what would happen to the risk premium? It would shrink as investors bid up prices to reflect lesser risk.
9. Would you like that world? No.
10. Are bear markets good or bad? It depends on whether you’re in the accumulation phase or distribution phase of your investment career. They’re good when you’re in the accumulation phase because you get a chance to buy at lower prices (assuming you are disciplined enough to stay the course). If you’re in the distribution phase, they’re bad because you can’t recover losses on spent assets. Thus, it’s important that your investment portfolio should reflect which phase you’re in.

The lesson is that it’s important to remember that bear markets have much in common with death and taxes: They’re both inevitable. So you must be prepared for them. In the case of bear markets, make sure your investment policy statement doesn’t allow you to take more risk than you have the ability, willingness or need to take. And if you need help answering those questions and determining the right allocation, I recommend “The Only Guide You’ll Ever Need for the Right Financial Plan.”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.