The furious rally over the past month in US and global stocks, not to mention the consistent rally and cyclical bull present over the past few years, prompts us to remind you of a few simple truths:
- The market doesn’t care what you believe. The greatest, most soundly-constructed thesis in history can prove to be the biggest money loser.
- Markets can go up (or down) for a lot longer than you think.
- Markets are structured to serve the greatest amount of pain to the greatest number of people at any given point in time.
Recent history provides another example. Several weeks ago as the markets reached the lowest points during the June correction, we noted that internal market sentiment captured among several indicators had reached some of the most bearish levels since the depths of the global financial crisis. In the past, we’ve discussed the “pain trade.” This has become the pain trade extraordinaire. We were amazed that such a shallow correction (in the grand arc of market history) had generated such negative sentiment so quickly. Of course the broad based fear coalesced around several widely discussed themes, including Fed tapering, China woes, new Europe troubles, a decelerating US economy, earnings stagnation; the list could go on and on. Over the past few years, the broader arguments, and they’ve been forceful and logical, center on decline and stagnation in Western markets, especially Europe, destructive inflationary policymaking, asset bubbles, overvaluation, currency wars, political issues, etc.
In the wake of the upward move, we keep hearing the usual retorts: central banks are blowing bubbles; economic growth doesn’t support equity market gains; markets are manipulated; higher interest rates will kill the rally; markets are overbought; markets are overvalued; good news is priced in; earnings fundamentals don’t support higher prices; Congress is good/bad; the President is good/bad; the Fed and ECB are good/bad.
Perhaps some or all of these arguments are correct. Suffice to say, we’d agree with some of the arguments, such as the fact that US markets are trading above median valuations on a long-term basis. From a market timing standpoint, however, these arguments are irrelevant. In the case of long-term valuation, the market has certainly traded at levels such as the levels currently observed without experiencing a major negative episode in the immediate future.
All of this reminds us there are two broad mistakes many investors make over the long run:
First, many investors have a sound, objective thesis, based on solid data, but they express the thesis too early in the cycle. Some investors have the experience and fortitude to carry the position to a profitable conclusion. Most, however, find themselves unable to hold the line psychologically; often, positions are abandoned at the worst possible moment, right before the thesis is ready to play out. The pain is too great. Many value investors, for instance, were correct in pointing out how overvalued the market was in 1998 and 1999. Unfortunately for many, the market continued its relentless rise. Numerous investors threw in the towel at the beginning of 2000 and chased growth, only to watch growth names crater for two years. Of course, similar decisions take place at market bottoms, such as the bottom witnessed in March 2009. Investors picked up stocks on the cheap during the fall or winter of ’08, only to watch stocks make new lows a few months later. Fear and volatility were high. Many potentially profitable positions were dumped right before markets began rising relentlessly.
Second, and more dangerous, investors make decisions based upon political leanings, economic theories, or similar drivers. We’ll call this the “dogma” trade. In many cases, markets begin moving in a direction contrary to the direction predicted by the theory. Investors then engage in confirmation bias type behavior, seeking opinions from analysts, writers, friends, and others that reinforce prior opinions. The further markets move, the more hardened opinion becomes. Blame is assigned to forces perceived to be outside the investors’ control. We see these types of investment decisions expressed each political cycle, for instance. “XYZ” political party spells doom for markets or presents the greatest opportunity in the history of market time. “XYZ” presidential candidate means the end of the world as we know it or the greatest leader in the history of time. John Q. Smith Fed Chairman is either the savior of the world or the world’s most dangerous economist. “Insert economic theory” is the key to understanding why markets are prepared to rise or fall 80%.
What to do to mitigate these consistently problematic errors (easier said than done in today’s info-saturated world)?
- Never, ever, ever base an investment decision on ephemeral qualitative factors, such as political or economic beliefs. Never let a political or economic stance color or guide enthusiasm or distaste for a course of action. Shun advice from pundits, TV talking heads, etc. Immediately run away from advice that the election or defeat of “so and so” is good or bad for markets. In the economic realm, always be wary of “this time is different” arguments. The past two decades are littered with economic and political investment justifications that proved extremely detrimental to investment success.
- Express immediate skepticism over highly concentrated consensus views. If every newspaper, magazine, and business show in the country is touting something as a “can’t miss” opportunity, there’s a very good chance that the idea has completely played out. Highly publicized and touted ideas deserve deeper scrutiny than other opportunities as far as valuation and future growth forecasts are concerned.
- A corollary: never make decisions solely on the basis of a sell-side analyst report, a magazine article, or an article in the morning paper. This seems obvious. But, we’re always amazed how many decisions, even among skilled institutional investors, are made on the basis of these types of sources. Unfortunately, the pressure to chase missed opportunities is always very high.
On the contrary, DO:
- Develop, test, and use objective criteria such as long-term, stable valuation ratios to inform decision making. Over the long-run, valuation matters, and its relationship to long-term future returns is statistically significant. Understand market history, the nature of risk/reward, and what constitutes an extreme valuation metric on the valuation bell curve. Even individual investors can access this type of data easily and cheaply these days. Buying equity markets when valuations reached single digit or near single digit levels in 1982 or 2009 didn’t feel good, but low valuations were an indication that all bad news had been priced in and that risk/reward was favorable. Conversely, taking risk off the table or shifting into more defensive positions as markets were moving to nosebleed valuations in 1999/2000 didn’t feel particularly intelligent, but proved a lifesaver. Of course, more often than not, valuations are within reasonable range of long-term median levels. Ignore noise when valuations are treading in the fat part of the bell curve and remember that volatility is always a part of investing.
- Concurrently, always develop an objective, executable plan. For institutional investors or experienced individuals, this may involve incorporating technical analysis and/or various objective risk management techniques into a portfolio to objectively guide allocations and trading activity. A trading system could keep someone in the markets to capture a final major up move, for instance, even though valuations are stretched. Conversely, objective systems might help mitigate the problem of “falling knives” or netting value traps. For those with other things to do besides watch markets all day, maybe a plan involves asset allocation strategies with regular rebalancing. These types of strategies ensure that assets are gradually being moved towards out of favor markets and away from overvalued markets. Understand that no plan will work in 100% of situations.
- Avoid complex, impenetrable investment strategies and instruments.
In the end, allowing bias and subjective ideas about how the world works, or how it should work, is a quick way to surrender assets. Of late, we’ve seen enough missives blaming markets themselves or the policy makers supposedly shaping markets to lead us to believe that many have missed moves up in the market in recent months and years mainly due to the “dogma” error identified above. There’s little in the investment world more frustrating than missing the good part of a market move in either direction because subjective beliefs overrode a solid objective game plan.
