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Why Investors Need To See The Light And Slow Down
Don't be happy; worry.
The Dow Jones Industrial Average is up 46% since March 9, when the world itself seemed to be coming to an end. In the entire 113-year history of the Dow, only six rebounds have been bigger and faster. But the swiftness and magnitude of this bounce-back aren't reasons to be cheerful; they are reasons to be cautious.
In March, stocks traded as low as 11.7 times their average earnings over the previous 10 years, adjusted for inflation, according to finance professor Robert Shiller of Yale University. That put the market at its lowest valuation since January 1986. Today, however, stocks are selling at 18.4 times Prof. Shiller's measure of earnings. That isn't only up hugely from March but is above the long-term average of 16.3 times earnings.
Robert Rodriguez, chief executive of First Pacific Advisors in Los Angeles, says that in March, investors feared getting crushed in a further decline. Now all they seem afraid of is missing an even greater rally.
Mr. Rodriguez is convinced that the consensus -- economic recovery by early next year at the latest -- is wrong. 'People are talking about whether the shape of the recovery will be a 'V' or a 'W' or even a 'square root,'' he says, 'but I think we are in what I call a 'caterpillar economy.' It will be up and then down, up and then down. We will be far from normal for a very long period of time. People deploying capital will end up destroying capital.'
I am not as worried as Mr. Rodriguez, but it is at times like these, when a rising market sweeps our spirits up with it, that investors need to evaluate their emotions and consider whether their beliefs and actions are justified.
In August, corporate insiders -- officers and directors of public companies -- sold nearly 31 times as much stock as they bought. From last September through this past March, in the depths of the bear market, that ratio was just 2 to 1, according to TrimTabs Investment Research of Sausalito, Calif. The long-term average is about 7 to 1.
The people who run companies don't know exactly what the future holds, but they do know more about their own firms than outsiders do. If they are furiously selling, how eagerly should the rest of us be buying?
It is well-known that investors chase past performance, buying whatever has just made the most money for other people. What isn't commonly understood is that investors also chase their own past performance, buying more of whatever they themselves have made the most money on.
Research by economist David Laibson of Harvard University shows that 401(k) participants tend to add significantly to whichever funds they already own that have gone up the most. 'Investors expect,' Prof. Laibson says, 'that assets on which they personally experienced past rewards will be rewarding in the future, regardless of whether such a belief is logically justified.'
That is exactly what seems to be happening now: In June, according to Hewitt Associates, 401(k) participants put 41.0% of their new contributions into stocks. In July, as the Dow shot up 725 points, they pushed that rate up to 42.3%. Participants also cut their contributions to 'lifestyle' funds that keep a portion of their assets in bonds and cash.
The market's latest hot streak makes the future feel predictable, but it isn't. The Dow had an uncannily similar 46.5% gain in the 117 days that ended April 9, 1930; it lost almost 51% over the next year. Another 47% upswing in 1971 led to a long, choppy decline of more than 37%. The market also could go nowhere, as it did for months after a similar-size gain in 1975. Or it could hit new heights, as it did in 2004 after rising 47% from the lows of 2002.
In his classic book 'The Intelligent Investor,' the great money manager Benjamin Graham wrote that 'the investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances.' If you can't exercise that kind of emotional control, then by Graham's definition you aren't an investor at all.
I see nothing wrong with dollar-cost-averaging into this market, purchasing a fixed amount every month -- especially in a low-cost stock index fund. But to buy more of what has gone up, precisely because it has gone up, is to fall for the belief that stocks become safer as their prices rise. That is the same fallacy that led investors straight into disaster in 1929, 1972, 1999, 2007 and every other market bubble in history.
The market's light has turned yellow. Don't try to run it.
