"Markets Can Stay Irrational Longer Than Investors Can Stay Solvent"
The above quote is as true today as when it was first said over 70 years ago by john Maynard Keynes – who fancied himself an investor in the markets and was humbled on more than one occasion. Just how irrational is the market? It depends upon who you ask – and more importantly, what their invested position is at the time. The discussion is rather heated between the bullish and bearish camp with one licking their chops over what is likely to ensue given market history, the other wallowing in the knowledge the markets have not yet been argued lower.
So who is right and more importantly what are the market implications. Here is where it gets muddy very quickly. As Keynes acknowledged, it is not really about being right about the economy or for that matter the market – eventually – it is about staying in step with what the markets are telling you today. We have all heard about the stories of a handful of investors that made a killing during the crash of 1987 or the housing collapse in ’08 by making big bets that were exactly on the mark. However, more than likely we find many more that “called” the market tops/bottoms than actually did during real time. The goal is not to make “the call” but to listen to the markets and invest accordingly. Let’s look at a few examples of what the markets were saying “way back when” – with the knowledge that today we have perfect knowledge of the events in the past.
First, let’s look at the tech bubble of 2000. With the seeds of the boom sewn during the mid-90s, stocks as measured by the SP500 traded well ahead of every market save the technology laden OTC market. When looking at the relative performance between stocks and bonds through the 1990s it is very evident that stocks are the big winners during the latter half of the decade. The hic-up was the Long Term Capital Management meltdown that was quickly forgotten amid the fury over technology stocks.
Remember, the chart is a comparison of the performance between the Lehman bond index and the SP500. If you look at the chart beginning late in ’99 and early in ’00, it is small but unlike any period since 1995, bonds looked to be holding their own vs. stocks, but have yet to demonstrate anything more than a temporary period of rest for the SP500 as compared to bonds. If we fast forward to the next section of the chart we’ll see the early stages of decent performance by bonds, which became more of a rout.
By December, it was evident that something more than just a spike (ala Long-Term Capital) was at hand. Yes, the overall markets had already begun trading lower, down over 9% for the year as measured by the SP500, but not yet as destructive as what was to follow. By the end of 2002, bonds had more than gained back all the relative losses to the SP500 going back to 1994 and by the end of 2003 were already giving up some of those hard fought wins. Finally, the chart today looks as follows:
For the years between 12/31/03 to 12/31/07 the SP500 rose just over 9% compounded and beginning early in 2008, bonds once again began outperforming stocks and with the spike higher corresponding with the financial collapse culminating with the market bottom in 2009 put in one of the best decades of relative performance in the history of the markets.
Interesting history, but what does that tell us about today? Since late in 2010, stocks have wrested performance back from bonds and their strength continues to today. The markets are saying that the best place to be is and continues to be stocks. Unless we get back to a period like the 1980s and early ’90, where stocks and bonds traded in lock step – not showing any long-term outperformance by either asset class – stocks (in today’s environment) are the investment of choice.
What is interesting as well and supports stocks at this point is the advance/decline line or the net number of advancing to declining stocks. The chart has been trending higher since mid’09. Below is the advance decline line since 1990.
Compare this to the relative performance charts between stocks and bonds. During the early 90s, stocks and bonds traded relatively equal, however beginning in 1995, stocks began their 5 year explosion. Beginning in 1995, many more stocks were rising than falling during that period as well; however that dynamic began changing in 1998, well ahead of the shift toward bonds and away from stocks. During those last few years of the tech bubble, the markets were dominated by technology and very little else. As the relative performance swung back to stocks in 2003, the advance/decline line was already rising and peaked out in mid-’07, again ahead of the shift toward bonds and away from stocks. As the market bottomed in ’09, the advance/decline line also bottomed and has not looked back.
Swimming against the market tide is not the most successful way to accumulate market wealth. At this point, signs point to still higher stock prices with the occasional bump along the way. A major shift in the market tenor is not yet in the cards.
About Paul J Nolte CFA
Paul J Nolte CFA Archive
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