On Not Being an Expert 

John H. Vineyard


June, 15 2017


Most of the time, it's easy to find punditry warning us that we are on the brink of a major stock market break. It's also easy to find punditry saying that our opportunities look very good just now.[1] After all, the level of market prices at any time represents the current battle line in the struggle between these two views. As at most times, we can find evidence to support whatever view we want to take.


It's good to remember that the record of punditry in foreseeing the major market moves has never been impressive. There were few who predicted the severity of the 1929 market crash. In that year, the famous economist Irving Fisher declared that stocks had reached a new, permanently higher plateau. In 1954, the famous market guru Benjamin Graham was asked in Congressional hearings whether stock prices were too high, now that they had at last decisively exceeded the levels before the Great Depression. Graham, said no, the market wasn't too high, but if it went higher it would be. These words were spoken by one of the most revered of all investment experts just at the beginning of the tremendous 1954-1969 bull market. Much as we might think, in hindsight, that it was there, we can't find much evidence that the 2001 market break was accurately foreseen, nor was the magnitude of the 2007-9 drop. Most analysts have been surprised by the length and magnitude of the bull market recovery since 2009. What's a careful investor who doesn't have ready access to the financial chatter to do?


As you ponder how to position your own portfolio, it's helpful to review the experience of recent decades. Since the 1990s there have been three major bull markets, the first ending with the market break in 2001, the second lasting from 2003 until the next peak in October 2007. After plunging a for third time in 2007-2009, markets recovered and are now in the 8th year of the current bull market.


What kind of a break might you expect if we encountered another decline like the last two?


From the peak in January 2001 to the next trough in February 2003, stocks fell 36% over 25 months. The second big decline lasted from October 2007 until February 2009, with the Standard & Poors 500 Index losing 51% over 16 months.


How long has it taken prices to recover from these major breaks and get back where they were before? Recovery from the first break took from the bottom in February 2003 until November 2005, or 33 months. Recovery from the 2007 break took from the February 2009 bottom until March 2012, or 37 months.[2] In both cases, the recovery took longer than the decline. The 2003-2005 recovery was 30% longer than the 2001-2003 decline; the 2009-2012 recovery took about 130% longer that the 2007-2009 decline.


How does this help us position ourselves if we still see ourselves as long-term investors? First, we need to consider the long term to be at least 5 years. You needed that much time to recover from the break and gain enough on your investment to justify all the drama and stress. For some with limited resources, a minimum of a 10-year horizon might be more suitable.


To soften this stark reality, it's good to remember that most people are diversified investors, so that with reasonable allocations to cash and fixed income, their actual investing experience would have been less extreme than the swings in the S&P 500 alone. The 51% decline in stocks from October 2007 through February 2009 would have been more like 27% for accounts that had 40% in fixed income. On the other hand, the 40% bond allocation would have resulted in roughly a 190% gain since the low in 2009, compared to a 290% gain for a pure stock portfolio.


But you could have done worse than hold the pure stock portfolio. If you had hung in there while the market began falling, then finally given up and sold out near the bottom, only to get back into the market some years later, you might have 'earned' most of the decline but missed a good chunk of the recovery.

How do we deal with the natural human reaction to the pain of sudden loss? For most people, this means positioning themselves so that the extreme swings don't knock them out, causing them to make the worst decision at the worst time. They have to recognize that recent history shows they might encounter a 36% loss for their stocks over 2 years, or even a 50% loss over 16 months. Time really drags when the value of your portfolio just keeps sagging. Such declines are sobering experiences even for the most seasoned investors.


It seems appropriate to proceed on the assumption that you can't guess the timing or the magnitude or the direction of the next big market move. But you can be positioned so that when it comes you can take it in stride. Short term investors are a special case. But most people need their accounts to last longer than five or even ten years.


For younger investors, the horizon is usually measured in decades. For investors in the accumulation phase of their lives, market breaks are great opportunities.

My suggestion would be to be positioned so that you could endure a 39% drop, or even a 50% decline in stocks, and then be able to wait at least three years from the bottom to see values get back where they were. Any spending rule you have for your accounts needs to take this reality into account.


This advice is only based on actual market behavior during our lifetimes, not crystal ball gazing. Still, the wide range of events that have buffeted the markets over 30 years covers a lot of experience. It's a pretty good sample.


The rewards of being able to ride out the scary times and focus on the long term can be gratifying indeed.

[1] Just a recent sampling: "One in Five Investors See Internet Stocks as Bubble-Like," John Dietrich, The Wall Street Journal, June 14, 2017; "Bill Gross Warns all Financial Markets 'Increasingly at Risk,' John Gittelsohn Bloomberg.com June 13, 2017; "Don't Fear Today's Stock Market:  It's no Late 90s 'Bubble.' Gary Smith, Realclearmarkets.com, June 14, 2017; "This Rally has Legs, and Broad Reach, Too," Ben Eisen, The Wall Street Journal, June 6, 2017; "Preparing Clients for the Coming Market Correction, Investment News, June 12, 2017. To be fair, there are some sage accounts recognizing the sharp diversity of opinions. See "A Tale of Two Markets:  Politics and Investing!" by Aswath Damodaran, Seeking Alpha, June 7, 2017. The author makes the point that although stock prices appear high they don't appear high relative to the alternatives. Nor does he extend himself to the point of actually declaring whether we are approaching a bear market or a big economic boom.
[2] This leaves out the effect of dividends. If you take dividends into account then the length of the recovery period is somewhat shorter.