Set forth below is the text of a comment that I recently posted to the discussion thread for another blog entry at this site:
What makes you think that the next market drop would be any different than previous drops that would cause people to suddenly look to you and your opinions as to the stock market?
To understand this, you need to understand the concept of the “stock cycle,” Anonymous.
In the short term, stock prices play out in the form of a random walk. There are ups and there are downs. It is not possible to predict whether prices are going to be up or down one week out or one month out or one year out.
It doesn’t work that way in the long run. In the long run prices play out in the pattern of a highly predictable stock cycle. Usually there is about 20 years of upward movement in the stock cycle and then about 15 years of downward movement. The upward movement is due to irrational exuberance. The downward movement is due to irrational depression. Irrational exuberance takes place when investors discover that they set stock prices and that they can vote themselves raises anytime they care to just by persuading other investors to play the game with them. Irrational depression sets in when investors start listening to the voice of common sense and become determined to sell their stocks before prices drop so low that most of their life savings is wiped out. On the high end, the P/E10 level travels to 25 or more. On the low end, the P/E10 level drops to 8 or perhaps a bit less.
We hit the high end of this cycle in 2000, when the P/E10 level hit 44. We are of course a good bit down from that today. But we are nowhere near 8. 8 is a long ways down.
There has not been any price drop in recent history that would cause committed Buy-and-Holders significant concern. We had a sharp drop in late 2008 and we did indeed see some Buy-and-Holders express nervousness about the idea of continuing to hold. But that price downturn was amazingly short-lived. It was over in about six months. That is not even close to being a long enough time-period to bring on the sorts of sales that it would take to bring the P/E1o to 8 and to launch a new upward cycle. To get the P/E10 down to 8, we MUST see investors abandon Buy-and-Hold. It is the sales of Buy-and-Holders that fuel a bear market. You simply cannot get to 8 without the Buy-and-Holders freaking out. If Buy-and-Holders did not always freak out after they lost most of their retirement money, none of the historical return data would show what it shows.
To see how it works, you need to review the historical record. You cannot see it by looking only at things that have happened from the beginning of the current cycle (1982) forward. We have never dropped to a P/E10 of 8 during that time. So you are not going to see what you need to see unless you are willing to go farther back in the historical record. If you are willing to go farther back, you will see that the same pattern has been repeating ever since the day the stock market opened for business. Since it has always been humans buying stocks, the same pattern (which results from the interplay of the basic human emotions) repeats over and over again.
It’s not that people are going to look to me. It’s that people are going to stop “defending” Buy-and-Hpld and all the deception and intimidation that inevitably goes with it when they see by looking at their portfolio statements that Buy-and-Hold has ruined their lives. The appeal of a Get Rich Quick approach becomes greatly diminished once the con has been exposed. Please take a look at what the Madoff investors said about him prior to the time his con was exposed and after his con was exposed if you want to see how emotions can swing from one extreme to the other. Buy-and-Hold will be a dirty phrase in the days following the next price crash.
Once Buy-and-Hold is out of the picture, people will have no objection to hearing what the last 36 years of peer-reviewed research says. Valuation-Informed Indexing is the first true research-based strategy. So what could possibly hold it back once Buy-and-Hold has been buried 30 feet in the ground and you Goons have been placed in prison cells where you belong?
No one is singing Bernie Madoff’s praises today. Investing cons can bring in lots of loot in the short term but they are a stone cold loser in the long run. There has never been a single exception in the history of investing. People do not take kindly to those who trick them out of their life savings.
Gee, I wonder why.
Rob
Anonymous says
Humans….as opposed to farm animals?
Rob says
As opposed to beings from another planet that always act with perfect rationality.
Buy-and-Hold is rooted in a belief in the efficient market theory. The efficient market theory in turn is rooted in a belief in Adam Smith’s mythical “Rational Man.” The idea is that investors always act in their self-interest. If this really were so, Buy-and-Hold really would be the ideal strategy. Investors hurt themselves when they misprice stocks. So, if investors acted in their self-interest, they would always price stocks properly and overvaluation would not exist. Valuation-Informed Indexing obviously does not make sense in a world in which overvaluation does not exist.
We don’t live in that imaginary world, Anonymous. On good old Planet Earth, the humans act contrary to their self-interest ALL THE TIME. Alcoholics act contrary to their self-interest when they go on a binge. Gambling addicts act contrary to their self-interest when they blow their paycheck before the close of the day on which it is handed to them. Drug users act contrary to their self-interest when they take to a life of crime to feed their habit. And, yes, stock investors act contrary to their self-interest when they bid stock prices up so high that the most likely 10-year annualized return on stocks becomes a negative number.
Humans have emotions. If you want to help humans to invest more effectively, you need to warn them of the dangers of Buy-and-Hold, not encourage them to believe that it is all going to turn out different this time. I don’t believe that it is all going to turn out different this time. I think that there is a good chance that it is going to turn out somewhat along the lines of how it has always turned out before.
It will be interesting to see what happens.
Rob