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Relationship Between Market Trends and Bad Investment Decisions

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Despite overwhelming evidence that the market is not predictable, most investors cling to the belief leading to bad investment decisions. It has even become common in our everyday speech. After the market goes up, we routinely say it is going up, and after it goes down, we routinely say it is going down. In truth we only know where the market has been, not where it is going.

 

The simplest form of market prediction is trend following and by nature, we are all trend followers. This means we believe that the past price trends will continue into the future. If the stock market goes up, most people think it will continue to go down.

 

In early 2002, John Hancock financial services conducted a random survey of 801 people who invest in 401(k) and other retirement plans. When asked what they believed the return of the stock market was going to be over the next 20 years, the average answer was an annualized gain of 15% where did the respondent get the number? Ironically, for the preceding 20-years period ending in December 2001, the annualize return for the stock market was 15% . Respondent unconsciously extrapolated past returns into the future.

 

The media reflects popular opinion in news stories. In 1979, after several dismal years in the stock market, most magazines were predicting 10 more dismal years. The August 1779 issue of Business Week ran a cover story titled “The Death of Equities.” The article recommended that investors abandon the stock market and buy bonds linked to the price of gold, which had soared to $600 per ounce. Ironically, the story ran very close to the bottom of the market for stocks and top of the market for gold.

 

It is very hard for people to fight the urge to follow trends. But it is necessary to resist the temptation if you want to be a successful investor. I am not recommending betting against a trend, but this book advocates cutting back on those markets that make gains, following a continuous rebalancing strategy.

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                      Our Life and the Life Cycles of Markets

Most people will participate In two or three large bull and bear market cycles during their lifetime. A complete market cycle seems to run between 15 and 30 years. The total gain during the bull phase averages between five and 10 times its starting price and the loss during the bear phase averages about one-third to one-half the price at the market peak. From start to finish, the total return of a cycle has averaged about 10% per year compounded, depending on adjusted return of the market during a complete cycle is about 6% per year compounded.

 

Over the last 80 years, there have been three secular (long-term) market cycles. The first began in 1921 and ended in about 1942. The second started in 1943 and ended in 1974. The third cycle started in 1975 and hopefully ended in 2003, although I am speculating on the end date. In each period, as the market went higher, more people jumped on the bandwagon, especially in the final years. This trend-following behavior led to the demise of considerably more investors at the end than had been in at the start. The net result of the “market timing” of sorts was a significant loss in capital for many investors and a loss in the public’s faith in Wall Street.

 

The stock market boomed in the 1920s, fueled by growth prospects after WW I and easy credit from banks. As a result, over 10% of the working population bought common stocks through brokers. In 1929 the crash began. The market downturn was slow at first. Then, as the Federal Reserve tightened credit and Congress enacted a new tariff on imports, the stock market collapsed. Over the next three years, prices dropped 82% from their highs and many people could not pay their banks loan used to buy stocks. As a result, many major banks became illiquid and closed their doors. The banking crisis sent the economy into the tailspin and threw the country into a period of despair.

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The experience of 1929-32 stayed on the minds of Americans for two decades. Despite the fact that the absolute market bottom in stock prices was in 1932, public ownership in stocks continued to decline to a low of 4% in 1951. A turnaround in investor sentiment came at the end of the Korean War, in 1952, when a new generation of investors was emerging. As a new bull market pushed stock prices higher in the 1950s, more investors become enchanted. Many of these new investors were not In the stock during the crash of ’29, so they were less influenced by event s gone by. Also during this period, new telephone technology allowed brokerage firms to expand their reach to every city and town in America. Brokers even went door-to-door selling individual stocks and a new product called “mutual funds”.

 

Renewed vigor fueled the market until the late 1960s. then, the U.S. became more involved in the Vietnam War, draining, the country of precious resources. This caused a peak in prices in 1968, although people kept buying dips. Stocks as a percent of house-hold financial assets hit a high of 38% in 1969. By that time over 16% of the adult population owned stocks, more than any other time in the economic history of the U.S.

 

Unfortunately, as a result of continued deficit spending, during the war, the U.S. dollar was weakening. One unintended consequence of the decline in the value of the dollar was an unprecedented outflow of gold from the U.S reserves. In 1973, growing political pressure to curb the outflow of gold forced President Nixon to take the country off the gold standard, which pegged the value of the dollar to the price of gold. This major shift in monetary policy resulted in the collapse of the U.S. dollar and a surge in inflation. Since oil trades on the U.S. dollar, price of oil skyrocketed, which caused an Arab oil embargo, which created long lines at the gas pumps, a severe energy shortage, and ultimately, a deep recession. Between 1973 and 1974, blue-chip stocks fell over 40% and small stocks fell more than 50%. The rapid decline in prices and poor economic outlook drove many investors permanently out of the stock market for the second time in the century.

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The bear market bottomed in 1974. Then, from 1975 to 1992, the S$P 500 compounded at a 15.5% annual return, beating the return of bank CDs by 7% Nevertheless, during this period, experienced investors preferred the safety of FDIC-insured bank deposits. Stock ownership fell back to the 10% level.

 

Finally, in the early 1990s, a third generation of investors ventured into the stock market. The baby boomers started to become an investment force on Wall Street. Improved information and communications, along with a growing lineup of new and exciting mutual funds, fueled the rise in stock prices. By early-2000, there were significantly more stock investor as a percent of the adult population than ever before. According to Federal Reserve data, the number of households owning equities or equity mutual funds increased from 33%  in 1989 to 52% by 2001. This increase was a direct result of more people participating in employer self-directed retirements accounts such as the 401(k).

 

As the number of investors participating in the stock market rose the amount of their participation also exploded in the 1990s. Stocks grew from 18% of median household financial assets in 1991 to a historically high rate of 45% by 1999. As you can see in Figure 3-1, when the bear market rolled around in 2000, significantly more households had more exposure to equities than at any other time in history.

 

 

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