Just Four Things

Story Notes:

• Rather than focusing on how to navigate short-term market swings, investors should be looking forward at what stocks are likeliest to do over the next year or so.
• Stocks can only do one of four things: Be up a lot, up a little, down a little, or down a lot.
• By focusing on one of these four scenarios, investors can avoid being reactionary to near-term market action.
• In our view, the likeliest scenario is up a lot, so investors should ignore near-term volatility and focus on the future.

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Subprime fears! Falling home prices! Fed rate cuts! Dogs and cats, living together! What should investors do today to combat day-to-day volatility and growing fears?

It depends—what do you expect to happen going forward? The market only ever does one of four things on a forward-looking basis: It can be up a lot, up a little, down a little, or down a lot. Sounds simplistic, but try to find the market doing anything else any time in history.

The next question is: Over what period are you making your market prediction? Typically, we look out over the next 12 to 18 months—no more, no less. Why? Stock prices are driven by supply and demand imbalances—just like everything else you buy. In the near term, supply is relatively fixed (IPOs and stock buybacks take time, and we get plenty advanced warning), so all you need do is determine where demand is likeliest to go. In the longer term, supply pressures tend to drive market direction. Because stock supply can contract or expand nearly infinitely, and no one has any way to predict far future stock supply, forecasting beyond the next 12 to 18 months is an exercise in futility.

This is also why it doesn't matter how much near-term volatility there is between now and where you're trying to go. In the very near term, psychology can take over—so you must have a framework for thinking about markets going forward. Without that discipline, we can fall prey to the market's most devious tricks. Corrections, like the one we're likely experiencing today, are inherently short-lived—short-lived meaning 3 to 6 months. What does it matter if you experience occasional short-term downturns if you end up with superior, market-like returns over longer periods?

Said another way: Pretend it's 1998 (the last time we had a true bull market correction), and you have a million dollars. On January 1, you take a magic pill allowing you to blissfully ignore market activity. On December 31, US stocks are up about 28%—and so are your million bucks. Awesome! The market ended up a lot and so did you—that's all that mattered. Now, pretend your neighbor Bob didn't take the pill. When markets corrected 20% that summer, he panicked. It felt as if markets couldn't withstand an alleged global financial crisis—the Asian Contagion, the Russian Ruble crisis, and a massive hedge fund implosion in America. When fear hit its peak, Bob sold. On December 31, he had about $800,000. Now—which of these people would you rather be? The one with $1.28 million? Or the one with $800,000?

In our view, the likeliest scenario for stocks looking forward is up-a-lot. (We'll enumerate why extensively in the days and weeks to come.) The least likely is down-a-lot. Sure, they could be up a little or down a little—not as likely as up-a-lot—but even if those scenarios play out, the best place to be is largely in stocks. The only time it's appropriate to deviate and move largely to cash or bonds is if you anticipate the down-a-lot scenario.

Stay in stocks, even if you anticipate down-a-little? Absolutely. What if you're wrong—and stocks end positively? That's a huge opportunity cost. The difference between down-a-little and up-a-little can be a tiny psychological year-end wiggle. Plus, consider transaction costs and taxes if you sell—you're likely severely cutting into the benefit of avoiding a minor downturn. Stocks' long-term averages include down years. The average isn't hurt by those years—nor are you—particularly if you have a long time horizon.

By basing market forecasting on the forward-looking, four market scenarios, you'll be less troubled by near-term volatility. Two major ways to know we're likely experiencing a correction and not a down-a-lot market—duration and magnitude. We're just three months from a relative peak and world stocks are down about 14% (US stocks down 13%)—classic correction territory. Bear markets don't announce themselves with a bang—bull markets die with a whimper, rolling and grinding from a peak that's usually not identified until long after it's developed. A steep, three-month drop—no matter how it feels—is classically characteristic of a correction and short-term. Short-term moves have no predictive power for stocks looking forward. Further, bull market tops are generally marked by euphoria—not what we have today.

We cannot find a time in history, three months from a legitimate peak that lead to an actual bear market, the world ever being so united in its conviction we're in a bear market. This tells us it most likely isn't so. Folks who fall prey to fears end up like your neighbor Bob, who sold in midst a correction—the worst possible time to sell. Keep your eye on the longer-term prize, and ignore short-term hysteria.

Source: Thomson Datastream