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IFA's Quote of the Week - 49 (Michael Edesess)

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Step 9 - History

 

"Let’s change our verb tenses when speaking of investment markets."

-Michael Edesess, The Big Investment Lie

 

 

 

 

 

Where’s the Market Going?

It’s a common question that emerges from the mouths of virtually every person living in the civilized world today, and yet it is an inherently flawed way of looking at the investment markets.

In The Big Investment Lie, Michael Edesess brings to bear an important point that IFA has emphasized for some time: when discussing the activity of the investment markets, one should speak only in terms of what the market has done as opposed to presuming what it will do. (You must read Chapter 7 of this book.)

We often hear television journalists or market-timing advisors announce “the Dow is going down” or “Apple stock is going up.” By using the term “going” when they should really say “went”, supposed pundits attach a presumption of continuity to an event that has occurred in the past.

Why is this seemingly innocent misuse of tenses so egregious? The answer lies in the fact that, in making such statements, they ascribe to themselves an aura of knowing what the market will do, making statements or recommendations that have the potential to strongly impact investors’ decisions and the outcome of their investments.  

History continues to show that stock prices follow no discernible pattern in the short-term. As Edesess aptly states, “The stock market can turn on a dime, and always does. Prices are constantly twisting and turning without trend or predictable pattern. Their recent movement gives you nothing to go on.”

As seen in Figure 1 below, prices respond to random and unpredictable news, and already embed the estimated probability of future events. What complicates investors’ ability to predict the future prices is that they don't know the future news. Therefore, we don’t know where the markets are going, and anyone who says they do has no more than a 50-50 shot at calling it correctly. This 50-50 chance is set into motion because equal and opposite opinions from buyers and sellers about the future direction results in a price that sets the odds for the short-term to roughly 50-50, as seen here.

Figure 1
Hebner Model

Even in 2008, when the S&P 500 was down 37%, of the 253 trading days, 126 were positive, 126 were negative, and 1 was break-even.

A French mathematician Louis Bachelier, published a now famous paper, The Theory of Speculation, way back on March 29, 1900. He wrote, "the determination of these [price] fluctuations depends on an infinite number of factors; it is, therefore, impossible to aspire to mathematical prediction of it. Contradictory opinions concerning these changes diverge so much that at the same instant buyers believe in a price increase and sellers in a price decrease." Nothing has changed.

Over the long-term, positive trends do emerge for those who buy and hold a risk-appropriate portfolio. Since 1928, the capital markets have delivered an average annualized return of about 10% a year, but frequently with a whole lot of short-term volatility. The positive upward increase of the capital markets can only be realized when investors set aside their emotions and sit through the sort of stock market volatility that can be very frightening. This is just the sort of volatility we have experienced lately.

The current correction is the second worst in stock market history, with The Great Depression retaining the number one spot. During this time, it’s critically important for investors to understand that the markets are very resilient and can reverse themselves when times seem most dire.

An example of such a time is found when we look at the simulated Index Portfolio 100 returns for the two-year time period from July 1931 through June 1933. This was an incredibly volatile time period in which the worst monthly rolling 12-month time period in the last 81 years was the July 1931 through June 1932 with Index Portfolio 100 losing 72% in just 12 months. In the subsequent 12 months from July 1932 through June 1933, the same simulated portfolio roared back with a 264% gain. The total return for the 2-year period was a positive 3.52%. Any investor who held that Index Portfolio for the first year would have surely agonized over the massive 12-month losses, but would have been soundly rewarded by maintaining steadfast discipline. This is precisely the sort of discipline IFA is advising right now for each of its clients.


Certainly, we cannot predict how quickly the markets will recover. As physicist Niels Bohr put it, “It is difficult to make predictions, especially about the future.” Anyone who says they know where the market is going is not being truthful. The only question is whether they are being dishonest with you or with themselves.

IFA understands that investors are concerned about their investments. These rare and severely punishing drops in the stock market may find investors wondering how long it might take for their portfolios to recover from big losses. IFA’s investment research team has dug into 81 years of stock market data to create the following probability studies for recovery of the S&P 500 Index as well as for Index Portfolios 90, 70, 50, 30 and 10. The probability studies were created using 81 years of historical returns data for each Index Portfolio and the S&P 500 Index. Live data was used when available and was bridged with simulated data to provide returns data that goes back to 1928. See ifabt.com for more details.

The table below shows the percentage amount of loss for the S&P 500 Index as well as for IFA Index Portfolios 90, 70, 50, 30, and 10 during the 16-month time period from November 2007 through February 2009, as well as the percentage gain that is required to restore each portfolio to its end of October 2007 high.

1

The probabilities of achieving those post-drop recoveries are set forth in the line graph below which shows the probability of each portfolio recovering within a specified time period from 1-year through 30 years. The y-axis in the line chart below expresses the probability that each portfolio’s recovery will occur in the number of years expressed along the x-axis. For example, the IFA Index Portfolio 10 has a 70% probability of a full recovery in less than 3 years from the first day subsequent to the end of the time period stated.



As with all aspects of life, in the stock market anything can happen. The probability studies set forth reflect calculations that are based on the returns and standard deviation of returns from 81 years of history. They provide unemotional measures of the likelihood of outcomes based on all of our data. This is the best information available to us for making investment recommendations. IFA provides this important information so investors can make the most informed investment decisions for their hard-earned dollars.