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It's no secret that many Americans are financially illiterate -- unable to understand basic principles of money management, including how to save, invest and manage their money. Like other goods stocks can be expensive and can be deeply discounted. Them most fundamental mistake is to buy something that is overvalued. That's waht buy and hold is about: you buy at any price and hold indefinitely.
According to a financial capabilities survey Olivia S. Mitchell - The Wharton School of the University of Pennsylvania, have found that financial illiteracy is widespread -- meaning that a lot of Americans don't know the basic concepts of economics and finance. But it goes beyond financial knowledge. What reserachers have found is that people are not particularly good even in their everyday money management. For example, a certain percentage of investors are investing in stock or bonds while having credit card debt.
Especially alarming is that many people don't hold a buffer stock of savings in cash or cash equivalents (gold, treasuries, etc), meaning they are vulnerable to the shocks that can happen to them.
04.22.09 | forbes.com
The recent 57% collapse in the S&P 500 index to its most recent low on March 9 followed hard upon the 38% decline in the 2000-2002 bear market. And the five-year recovery from that swoon didn't exceed the 2000 peak by much. The Nasdaq index, which nosedived 78% in 2000-2002, recovered only 44% of that decline before falling another 55%. There are only two other global bear markets since 1900 in which stocks fell over 40%.
No wonder that investors' faith in stocks has been shattered, and both institutional and individual investors have been withdrawing. The buy and hold strategy, which was validated by the earlier long, steadily rising market, doesn't work in severe bear markets. Only one of 1,700 diversified U.S. stock funds showed a gain in 2008, and that was a mere 0.4%. The average of these funds dropped 39%, precisely in line with the S&P 500's decline.
The buy and hold devotees say you can't time the market, and if you aren't in all the time, you risk missing much of the gain. A Spanish research firm found that if you removed the 10 best days for the Dow Jones industrial average in the 1900-2008 years, two-thirds of the cumulative gains were lost. But if you missed the 10 worst days, it found, the actual gain on the Dow tripled. These results are in line with our earlier research and reflect the fact that stocks fall a lot faster than they rise.
We eschew the buy and hold strategy because of what's known in classical statistics as the gamblers ruin paradox. The odds may be in your favor in the long run--in this case, your stocks may provide great returns over, say, 10 years. But if you hit a streak of bad luck, your capital may be exhausted before that long run arrives.
Or more likely, a severe bear market will scare you out at the bottom. Many investors bail out then and don't reenter until the next bull market is well advanced. This explains why the returns of mutual fund investors lag well behind the performance of the funds in which they invest. A widespread retreat is what makes a good bottom, as we've noted in many past Insights. All those who can be shaken out are. They've reached the puke point at which they regurgitate their last equities and swear to never ingest any more.
Special Offer: Gary Shilling was right! The housing market crashed, banks went under and now the government is here to save the day. Think the problems have passed? Think again, before you invest. Click here for advice to keep your wealth and subscribe to Gary Shilling's Insight.
We've never understood the U.S. individual investors' fascination with stocks, almost to the exclusion of all other investment vehicles. Stock backers point to long-run annual gains of about 10% but neglect to note that about half of that came from dividends, which were much bigger parts of the total return in earlier years, although they may be again in the future.
Also, stock indexes are revised over time, dropping weak and fading companies and replacing them with robust and growing firms. So the performance of the Dow or S&P 500 over time is much stronger than the performance of the companies that were in those indexes, say, 30 years ago. This is known as survivor-bias.
Even with this upward bias, stocks way underperformed Treasury bonds in the 1980s and 1990s in what was the longest and strongest stock bull market on record. The superiority of Treasuries has been even more so since then. One reason that few realize this is because they don't know much about bonds, despite the simplicity of Treasury obligations and, so, they ignore them. Furthermore, commissions on stocks are usually much bigger than on Treasuries, so brokers favor them.
Our all-time favorite graph shows the results from investing $100 in a 25-year zero-coupon Treasury bond at its yield high (and price low) in October 1981, and rolling it into another 25-year Treasury annually to maintain that 25-year maturity. On March 31, 2009, that $100 was worth $16,656 with a compound annual return of 20.4%. In contrast, $100 invested in the S&P 500 at its low in July 1982 was worth $1,502 last month for a 10.7% annual return including dividend reinvestment. So Treasuries outperformed stocks by 11.1 times!
Long-time Insight readers know we have been recommending long Treasury bonds since 1981. Back then, we forecast secular and huge declines in inflation and interest rates. So we declared that "we're entering the bond rally of a lifetime." Unfortunately, that rally is over. Our target of 3% yield on 30-year Treasuries, down from 14.7% in 1981, was exceeded at the end of 2008 when the yield fell to 2.6%. Nevertheless, it was a grand finale to "the bond rally of a lifetime." The yield drop from 4.5% at the end of 2007 provided a 37.5% appreciation. Add in the 4.5% interest and the total return was 42% last year.
In the long run, the stock market rises with GDP, after accounting for intermediate trends in profits' share of GDP and P/Es. In the next decade, we foresee much slower growth in GDP than in the 1980s and 1990s and deflation, with profits' share of the pie falling along with declining P/Es. In this secular bear market, stock market average gains will probably be much lower with cyclical bull markets shorter and weaker, while bear markets are more frequent and deeper.
Excerpted from the April 2009 issue of Gary Shilling's Insight newsletter. Click here to learn more and to become a subscriber.
From the 2002 bottom until the 2007 market top it was hard to go wrong no matter what you did. Everything from junk bonds to commodities to emerging markets to the major market indices were all headed up. This made people feel they were protected from harm. It was an illusion.
Here is an interesting email from Steve who describes his experiences at attempting to beat the averages during this period.
I used a fee-only financial planner to evaluate our portfolio of mutual funds using a Monte Carlo analysis tool to estimate how much we needed to save annually to hit our retirement "number."
I've been a premium Morningstar member for years and I've tried to assemble the best group of boutique funds to cover every area of the investment landscape. I used a matrix with 3 columns for Growth, Blend, and Value with 5 rows for Large Cap, Mid, Small, Micro, and International funds.
We held 15 funds including all the best Morningstar performers for many years like Primecap (VPMCX), Dodge & Cox (DODFX), Longleaf (LLSCX), Artisan (ARTVX), etc.
All of those funds performed better than the market, but not by much after all taxes and fees are subtracted. To be perfectly frank, it pisses me off that I meticulously chose and invested in the absolute best mutual funds on the planet and the BEST that they could do in 2008 is lose 35% instead of the 38.5% the S&P 500 lost!
It's amazing how limited they are by not shorting, being hesitant to hold large amounts of cash, and having to sell at the wrong times due to redemptions. Let's face it, I truly gave it my best shot and it just wasn't good enough.
It was an interesting exercise, but all I did was outperform the S&P 500 by a few points over a 14 year period.
Diversification Isn't a Savior
Steve followed the conventional wisdom of asset allocation: buy some mid caps, small caps, big caps, foreign equities, etc. Steve proved beyond a shadow of a doubt that diversification is not a savior, not even if one meticulously selects the best of breed.
What Went Wrong?
Diversification obviously did not help because everything Steve invested in was positively correlated to the major market indices. When times are good, such strategies make people feel like geniuses. Bear markets always have a way of exposing the flaws.
On an individual basis, the sad reality is most funds simply want to beat their target benchmark. To do that they frequently feel they must be fully invested 100% of the time. Then by throwing out a few obvious dogs and overweighting a few top performers, managers can beat their target.
Why Fund Managers Are Reluctant To Hold Cash
Steve mentioned mutual funds are unwilling to hold cash. The reason is many fund managers are always in fear of missing a rally and many do not get paid when they are sitting on cash.
To reiterate something I noted in Buy and Hold is Still Bad Advice:
In January of this year, an investment advisor from Wachovia Securities called me up and stated "Mish, I am sitting on millions because I see nothing I like". I told the person I did not like much either and that Sitka Pacific was heavily in cash and or hedged. His response was "Well, I do not get paid anything if my clients are sitting in cash".
I called up a rep at Merrill Lynch and he said the same thing, that reps for Merrill Lynch do not get paid if their clients are sitting in cash.
By the way, that person at Wachovia Securities did the right thing and sat on that cash.
Massive Conflict of Interest
Notice the massive conflict of interest possibilities. Reps for various broker dealers have a vested interest in keeping clients 100% invested 100% of the time, even if they know it is wrong. And so it is every recession, bad advice permeates the airwaves and internet "Stay The Course".
No Gains For 12 Years!
Steve noted his "best of the best" diversification strategy beat the market by a few percent. Unfortunately, on an absolute Return basis, -35% is a horrible year no matter what the benchmark is. Note that the -38.5% decline in the S&P wiped out all gains for the last 12 years.
Off To The Races?
People are expecting it's off to the races again with the rally since May. Not so fast.
Fundamentally the market is very overvalued here. Expected earnings growth is unlikely to happen for many reasons. Clearly that does not preclude a further rally, but the above chart shows what happens to market rallies based on speculation as opposed to fundamentals.
Perhaps the market has bottomed, but perhaps it hasn't. Even if it has bottomed, where is it going? Consumers are 70% of the economy and consumer attitudes toward debt, consumption, and risk taking reached a secular peak. Moreover unemployment is still rising and consumer balance sheets are in shambles.
On November 16, 2008 in Peak Earnings I wrote:
Financial earnings have peaked. And because of reduced leverage, earnings in the financial sector are not coming back for decades. Those earnings were all a mirage in the first place. (Take a look at the charts for BAC, C, WFC, or JPM. Charts for Wachovia, Washington Mutual, Countrywide, Lehman aren't available for a reason.)
Next consider homebuilders given that lending standards have dramatically tightened at banks. Those profits are never coming back.
One must also factor into the earnings equation boomers facing retirement in the wake of falling home prices and retirement accounts taking a cliff dive. Trillions in potential spending power has been wiped off the books.
Expect boomers to travel less than expected, buy fewer toys (boats, cars etc) than expected, gamble less than expected, and downsize much more than expected in every aspect. This in turn will reduce the earnings potential of non-financial corporations for decades to come. Thus expectations that a new rip roaring bull market will commence once the market bottoms is sadly misplaced.
This secular bear market will last a lot longer and be much deeper than anyone thinks. Sadly, very few are prepared for it.
Japan had two lost decades. Might not the US lose two decades as well?
$NIKK - Nikkei Monthly Chart
The Japanese Stock Market is about 25% of what it was close to 20 years ago! Yes, I know, the US is not Japan, that deflation can't happen here, etc, etc. Of course deflation did happen here, so the question now is how long it lasts. Even if it does not last long, there are no guarantees the stock market stages a significant recovery.
Buy-and-hold is no more likely to be a good choice for the next 5 years than it was for the last 20.
Pension Plans In Serious Trouble
Even in a sideways market, the already seriously underfunded pension plans and annuities will eventually become bankrupt. Yet, a sideways market is about the best I think we can realistically hope for.
Pension plan assumptions are simply way too high.
Correlations Still Ugly
And what if the bottom is not in? The sad fact is once again we are seeing the same type of correlations we saw in the markets in 2008 where all asset classes rose or sunk in unison.
Please consider the July Sitka Pacific Monthly Newsletter:
From the hopelessness we saw in February and March, the vast majority of investors suddenly became convinced that the bear market was over that the economy was moving towards recovery. Such rapid sentiment shifts from pessimism to optimism almost never occur at significant market bottoms, and so we were left with what increasingly looked like a standard (but large) bear market rally in its later stages.
It appears we saw the end of that rally in June, and that was the case for most global stock markets as well. And not only stock markets, but many commodities reached a high in June and then turned down, as did many other asset classes. To say all these markets have been correlated is an understatementómoving in lock-step is a more accurate description.
The two charts below are but two examples of these correlations. On the left is the MSCI Emerging Markets index, and on the right is the Nasdaq Composite.
click on chart for sharper image
1. Since a new bull market in not sight, itís important to continue to view stocks as vehicles for trading, not for investment. There will likely be many ups and downs, and stocks could remain relatively range bound for an extended time. We will attempt to stay hedged during most of the declines and open to market fluctuations during most of the advances. However, the key will be to remain uncorrelated to the markets overall.
2. The correlation among markets over the past two years largely reflects the ongoing deleveraging process. Until this dynamic changes, the Modern Portfolio Theory method of managing risk by diversifying among many asset classes and geographic regions will remain prone to the kind of severe draw downs seen in these strategies in 2008.
Looking ahead, one still needs to trade, hedge, or pick strategies that are uncorrelated to the markets. There is simply no reason to expect a buy-and-hold shotgun approach of picking best of breed mutual funds will perform better for the next 5 years than the strategy did for the last 12.
Mike "Mish" Shedlock
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