What’s An Investor to Do When the Market Won’t Cooperate?
What is an investor who follows the Austrian school of economics supposed to do with a market that has traded in a narrow range for almost two years and refuses to bend to the reality of falling profits and a slow economy? After all, we may already be in a recession, as Peter Schiff thinks, but the market is clueless.
A couple of posts ago I wrote about the fetish with randomness that afflicts mainstream economics and finance. One result of that fetish is the dogma that no one should try to time the market; just pick good stocks and stay with them. The high priests ridicule those of us who make any effort at looking into the future.
For example, Aswath Damodaran, a professor of finance at the Stern School of Business at NYU, recently wrote a blog post with the title “Superman and Stocks: It’s not the Cape (CAPE), it’s the Kryptonite (Cash flow)!” in which he poked fun at market timers:
There are many who warn us that stocks are overheating and that a fall is imminent. Some of this worrying is natural, given the market’s rise over the last few years, but there are a few who seem to have surrendered entirely to the notion that stocks are in a bubble and that there is no rational explanation for why investors would invest in them. In a post from a couple of years ago, I titled these people as bubblers and classified them into doomsday, knee jerk, conspiratorial, righteous and rational bubblers. The last group (rational bubblers) are generally sensible people, who having fallen in love with a market metric, are unable to distance themselves from it.
The professor’s idea is that history does not matter. Only the price of bonds matters because:
“If you choose not to buy stocks, your immediate option is to put your money in bonds and the base rate that drives the bond market is the yield on a riskless (or close to riskless) investment.”
In other words, the alternatives to stocks are worse, so just stay in stocks. But what the professor forgets is that stocks and bonds tend to dance in step with the business cycle.
Are we to assume that there will never be another bear market? Can we believe, as mainstream economists did in the last decade of the 20th century, that there will never be another recession? Of course not. To think either would be sillier than being a “rational bubbler.” But we can’t predict either within even a year of them happening, so should we just eat, drink and be Mary until the deluge? Those who ridicule market timers would seem to be saying that, as Damodaran concluded:
Will there be a market correction? Of course! When it does happen, don’t be surprised to see a wave of ‘I told you so’ coming from the bubblers. A clock that is stuck at 12 o’clock will be right twice every day and I would urge you to judge these market timers, not on their correction calls, which will look prescient, but on their overall record. Many of them, after all, have been suggesting that you stay out of stocks for the last five years or longer and it would have to be a large correction for you to make back what you lost from staying on the sidelines.
As I wrote in previous posts, and in Financial Bull Riding, the damage that a brief bear does to one’s nest egg can take a decade to recover from. To give an example, a 50% decline, like happened to many investors twice in the first decade of this new millennium already, won’t be healed by a 50% recovery because the base has changed. You have lost half your money. A 50% retracement gets you back to just 75% of what you started with. It takes a 100% rise, or doubling, of your returns to make you whole again after a 50% loss and that can take a decade.
Meanwhile, you’re only recovering what you lost initially. You’re also suffering from opportunity costs, that is, the income you could have been making on the money you lost. Assuming that opportunity cost to be 5% per year, then the market would need to rise 150% in a decade just to make up for all of your losses. Only suckers forget about opportunity costs.
Hopefully, you can see the importance of not losing principal in a bear market. Falling behind the S&P 500 in percentage terms during the later stages of a bull market might be worth the cost.
On the other hand, what is the upside to sticking with stocks? If the economy and profits improve, the market may not. It may just absorb the profits and deflate the PE and CAPE ratios to their long term average levels. To force the market to ever greater highs would require an improving economy, higher profits, and investors remaining happy with elevated PE ratios that reign today. High PE ratios are the same thing as a high level of risk tolerance. What are the odds?
In the face of such ridicule as the mainstream shovels on us, all I can advise is to go back to fundamentals. I am a fundamentalist in religion, sports, and investing. Fundamentalists know that the market eventually succumbs to lower profits caused by a recession. We know another recession will happen. It’s as certain as death and taxes. We have traveled more than seven years from the end of the Great Recession and that means historically and statistically, the next recession is late. And therefore the next bear market is late. How much longer it will delay no one knows. As Mises and Hayek used to say, we can never predict exact dates or volumes; we can only know what patterns will follow.
But we know from history and sound monetary theory that the longer the recession puts off its debut, the uglier it will be when it shows up.
Austrian investors should never be perma-bears or perma-bulls. We should stick with the trend when it turns around from the depths of a recession with confidence that it will last many years. But when the bull gets long in the tooth and the economy is crumbling around the market, we have to abandon the bulls and the trend in favor of sound economics and historical facts.
Become An Insider!
Sign up for Affluent Investor's free email newsletter and receive Jerry Bowyer's Special Report, "How to Be an Affluent Investor in the Age of Obama & Ineffectual Republican Opposition."