The new year is almost here. With it comes all kinds of resolutions to improve behavior, habits and results. For investors, it is a reasonable time to review performance. Did you do well this last year? Did you lose money? How might you have improved your performance?
These questions are natural. What is not natural is the manner in which our thinking regarding investing must change.
The World Has Has Become A Very Dangerous Place
Investment performance is always relevant. It has never been more important than in these difficult economic times. Nor has it ever been more difficult.
The world is hurdling toward what seems to be certain economic collapse. If your expectations are similar to mine, then you should be exploring ways to prepare for something that eventually will become an economic dark age. We have passed the point where a return to normalcy is possible. There can be no political solution to our insolvency issue, but there will be a market solution. Things that cannot continue don’t. We will continue down the extend-and-pretend road until markets halt the fraud. A complete financial collapse is likely.
Markets have have already changed and are getting worse. The worst economic period in this nation’s history is ahead. No, I haven’t forgotten about the period known as The Great Depression. The changes ahead will be different in nature but more severe in consequences than that prior debacle.
Investing In The New World
Most of the investing guidelines and assumptions of the last five plus decades are suddenly questionable. They worked reasonably well under a different set of circumstances, but these no longer exist. “Buy and hold” was the golden rule of investing. Today, this rule is likely to cost you dearly. The notion that long term investing in stocks will produce an average 8 – 10 percent annual return was more marketing that truth. How could this return be achieved when the economy itself only grows at 3% real growth per year? The difference is not explained by inflation, or at least what government reports as inflation.
The chart below shows the SPY, an ETF that represents the S&P 500 index. Each bar represents three months (one quarter) of a year. The green bars are periods where prices increased and red where they decreased. The extremes of any bar represent the highs and lows of that quarter.
The last fifteen years looks like a series of steep roller coaster rises and even steeper drops. The S&P is below where it was in 2007 and in 2007 it was below its prior peak in 2000. In 12 years, stock prices have done nothing!.
Think about this performance. When adjusted for inflation investors are worse off than the chart conveys.
Then put this 12 year period into perspective. Anyone who bought and held the S&P 500 has made no profit in the twenty-first century. For humans with working lives of about 45 years and investing lives probably closer to 30, those investing during this time period wasted about 40% of their investing life if they were stock market index investors.
The “W” formation shown in the chart provides painful meaning to the term risk. The high in 2000 to the low in late 2002 represents a fifty percent drop in stock market wealth. The market then recaptured most of this loss, although it took over five years to do so. Then, another 50% loss was incurred when it dropped below its 2002 low. This time it took about a year for fifty percent of stock market wealth to evaporate. Four years later the market is nearly back to it previous high, but still below where it was in 2000.
In a twelve year period, there were two 50% drops in value and two recoveries. The losses were sudden and dramatic as most market drops are. Swings of this magnitude have not been normal. A summary of returns by decade for the US stock market is shown in this chart:
The bad years in the first decade of the 21st Century are not as bad as the 1930s, but they are close. No other decade (including the 1930s) has four years with losses exceeding 10%. How bad might this decade have been without the life support provided by unprecedented (and unsustainable) monetary and fiscal stimulus? What happens when the stimulus stops as it eventually must?
Why Invest In The Stock Market?
Given this poor performance, why does anyone invest in a market that has become increasingly risky and increasingly less rewarding? It appears to be more gambling than investing. For someone trying to acquire wealth for retirement, a child’s education or most other purposes, swings where half your savings is destroyed (twice) within a 12-year period cannot be appropriate for such goals.
The answer is that no one would subject his life and livelihood to such volatility if he had another alternative. But the stock market is the only game left, at least for most small savers and investors. The massive interventions of the Federal Reserve (begun by Alan Greenspan, long before Bernanke was on the scene) has produced the current situation. Equity risks have increased while returns on safer investments (bonds and other fixed income securities) have been driven down. This financial repression forces people out of these safer markets because they cannot get a return that keeps up with inflation.
That only leaves the stock market where many with no knowledge of financial markets desperately seek return. Many of these are the elderly who should not have their retirement funds at risk, but can get no return elsewhere. The costs on citizens of irresponsible government and Federal Reserve policies goes well beyond those imposed on future generations by deficits and bank bailouts. The human cost to the current generation should not be overlooked. Seniors are forced to live out their lives in fear of running out of money. Income earners are unable to develop wealth as a result of damaged financial markets.
Over the last twelve years, those who stuffed money into mattresses fared as well as the average stock market investor. Neither group kept up with inflation, but mattress stuffers did not suffer the nerve-wracking draw downs in wealth experienced by market investors. As the economy worsens, market movements are likely to become more pronounced. It behooves anyone with exposure to the stock market to understand what is happening and protect themselves against these 50% and possibly larger downsides.
What Do I Do?
For those that don’t have investment opportunities outside the stock market, there are only two choices:
- Invest in the stock market and take our chances
- Invest in bonds (or stuff our mattresses)
The latter choice is likely a certain loser given current interest rates and inflation. That leaves the stock market (I do include precious metals as a potential holding in a portfolio). The stock market still offers profit opportunities even in its current condition. It is likely to continue to do so, even as its swings may become more exaggerated.
Let’s take another look at the graph of SPY to illustrate an important point:
If you knew what was coming, you could have left the market at the top in 2000 and re-entered at the bottom in late 2002, left again in late 2008 and re-entered again in early 2009. Now, no one has the required prescience to foresee the future, but if you had, you would have tripled your money. A “buy and hold” investor, however, earned nothing in these 12 years.
Simple mechanical trading rules could have served you better than holding through these fluctuations. A moving average system, for example, would have gotten you in and out of the market as trends changed. For those unfamiliar with such a system, you buy when price crosses up through the moving average of price and then sell when it crosses down through its moving average.
With market swings like we experienced, this strategy can be effective. As prices move up, they eventually cross above the moving average (and you enter the market). When they turn down, they eventually go below the moving average (and you leave the market).
The number of days, weeks or months used to calculate the moving average determines its sensitivity and profit/loss results. An average too short creates lots of false entries and exits. One too long means later entries or exits. Entering too early means foregoing some of the beginning of the upside move while leaving too late means incurring part of the downside drop.
A moving average was used merely to show a simple alternative to the buy and forget strategy that most still employ. There are other techniques that can be more effective than moving averages. The point is that almost any reasonable approach would have done better than buy and hope.
Given the change in markets and my belief that they will become more volatile as we approach economic Armageddon, investors must shorten their time horizons and increase their agility if they are to be successful. The assumptions that buy and hold depended upon no longer are valid. There were two key assumptions:
- The company behind the stock which you purchased will be better off tomorrow than today.
- For that to happen across most stocks, the economy will be better tomorrow than today.
To the extent these assumptions were valid in the past, they are less so today and likely to become even more dubious in the future.
Opportunities to make a lot of money still abound, but they will not be captured with old tools or assumptions. Opportunities to lose great amounts of money also abound in future markets and it is likely that using yesterday’s rules of thumb will enhance your chances of achieving unenviable results.
As an aside, I hope to have a separate website up in the next month to deal with topics such as these. Its oriented toward investments, and trading techniques that hopefully will work in the strange new world we now live in. More on this when the site becomes operational.