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Gravity – The Stock Market’s Mortal Enemy

On January 14, 2000, the stock market hit an all-time high, with the Dow Jones Industrial Average reaching 11,722.98. On October 9, 2002, the Dow was at 7,286.27 – a decline of nearly 40% in less than 21 months.

Five years later, on October 9, 2007, the market hit a new all-time high with the Dow at 14,164.53. But by March 9, 2009, the Dow closed at 6,547.05 – a decline of 54% in just 17 months.

Again, almost five years later, on December 31, 2013, the Dow reaches a new all-time record of 16,576.66. As of Friday, January 31, the Dow closed at 15,698.85, down almost 900 points – or 6% – in one month. What happens from here is anyone’s guess. But…

Do you notice a pattern?

Just based on the performance of the stock market in the short years of the 21st century (and we can make a case for the 20th century as well), the market is in very dangerous territory right now.

Gravity - The Stock Market’s Mortal Enemy

Gravity – The Stock Market’s Mortal Enemy

Based on market patterns, we are either at or very near a top. The current pattern is virtually textbook – five years of a bull market, culminating in an all time market high.

Is this the end of the bull’s latest charge up the hill? We can’t know that for certain, but the dominoes are certainly lined up for it.

You can’t time the market, but…

The buy-and-hold crowd likes to say that you can’t time the market. And that’s certainly true if absolute precision is the goal. However, we can look at patterns and see clearly that there are excellent times to buy into the market – and outstanding times to get out.

Feel free to disagree, but I think this is one of the times to get out.

The oldest rule of successful investing is buy low, sell high. That trumps even buy-and-hold. If you get out now, that will ensure that you will sell high. And without even having a crystal ball, you can bet there will be better times to buy in the not so distant future.

No one can time absolute market tops and bottoms. But you can reap bigger rewards – and avoid nasty crashes – just by getting close.

From stock market patterns over the past 15 years, notice that while bull markets are running about five years, bear markets last substantially less than two. But the havoc they wreak in such a short amount of time can easily spook you into selling at the bottom, and returning to the market only after several years of positive performance.

We can never disconnect human emotion from investing. It is exactly what will cause you to sell low and buy high – the precise opposite of what you need to do. It’s what fear does to people.

Perpetual double digit returns: The Perfect World

I can fully appreciate why people find discussions of a negative stock market turn to be so distasteful. Let’s face it, in a world of perpetual double-digit investment returns, all things become possible. People can envision becoming millionaires. They look forward to early retirement. They begin planning the day they’ll quit their jobs and live on the beach.

Asserting that the perfect world of investing won’t continue forever is not a position that will make you popular. After all, you’re not just challenging people’s assumptions about their investments, you’re casting doubt on their dreams. That’s where it gets emotional, personal, and the fur starts to fly.

Bull markets and complacency

One of the factors that makes market downturns so difficult to identify is complacency. For example, this market has been on the upswing for nearly 5 years. Human vision being so limited, particularly as it relates to history, it’s easy to convince ourselves that a rising market is the normal state of affairs, and the condition that will always be.

It’s not just that a rising market is the outcome we desire, but we get used to it. We are, after all, creatures of habit. A rising stock market is a habit that we enjoy. It’s where we want to camp out. And that’s the problem…

We are never more vulnerable to a serious reversal of fortunes than when we are confident of a certain outcome – particularly a very optimistic one. Right now, it’s probable that the vast majority of investors are emotionally and financially wedded to the promise of double-digit returns forever. That sets us up for slaughter.

Personal observation: Bull markets take years to play out, but bear markets – and especially crashes – strike before anyone has time to realize what’s happening, let alone to prepare for it. That’s why people panic and sell out at the bottom.

The odds against the stock market right now

Let’s take a closer look at that gravity thing, and what it means to the stock market.

There is no force – certainly none created by man – that can go up forever. As the saying goes, what goes up, must come down. That applies to the stock market, just as it does with any other human endeavor.

The market is now at record levels. Low interest rates – the driving force behind every bull market – bottomed out at historic record lows in the spring of last year. They are now rising. The Federal Reserve’s Quantitative Easing program – the magic spigot that has greased the wheels of this anemic economic recovery for the past five years, is finally being “tapered”. Tax rates were raised last year, and are slowly snaking their way through the economy. Meanwhile, evidence is mounting in the developing world that economic conditions are beginning to worsen.

We can reasonably conclude that the best macroeconomic news is behind us, particularly in regard interest rates. The exit signs should be flashing brightly.

Why we always need to look beyond the stock market

We’ve already discussed how a prolonged bull market causes people to start thinking about getting rich, retiring early, or cashing out in favor of a life of blissful nothingness. Whenever people have an opportunity to make a lot of money in a speculative investment – be it stocks, real estate, precious metals, or whatever – it tends to become “the only game in town”. People load their hopes, their dreams, their plans, and their money, on the investment that “can’t miss“.

But the investment that seems so certain can miss – and it will. It always does – otherwise we’d all be incredibly rich. Once it does, everyone will come back to earth, just as they did after the 1987, 2000 and 2007 crashes. But there’s no reason to wait for a crash to begin changing your outlook and your behavior.

  • Reduce your exposure to stocks, especially if you’ve already had a good run, or have money you can’t afford to lose.
  • Even if the market doesn’t turn this year, be purposeful about focusing beyond the stock market. Look for alternative investments.
  • Redouble your efforts with your career or your business; that should always be your first financial concern.
  • Investigate and pursue promising new opportunities closer to home.
  • Get closer to family and friends.
  • Find or reconnect with your faith.
  • Actively improve your health.
  • Get involved with your community.
  • Help where you can, especially the people who can’t do anything for you.
  • Realize that cash isn’t always the worst place to park your money – even if returns are pathetically low.

These are things that people refocus on only when they realize that the investment miracle du jour isn’t going to materialize. But don’t wait for it to happen; there’s plenty you can be doing right now.

One of the best ways to make money is by not losing it. I believe that theory is about to be tested once again. Have you considered the likelihood of a negative turn in the stock market this year? If so, what are you doing to prepare for it?

( Photo by reubinaingber )


3 Responses to Gravity – The Stock Market’s Mortal Enemy

  1. Nice argument and well thought out!

    Since I still have a ways to go before I reach retirement age, I’m a long term-investor (but then again, a recently retired couple with a joint life expectancy of 25 years are also long-term investors!).

    So I stay simple and take the long-term view in light of Modern Portfolio Theory, banking on the free lunch of increasing average expected gain while reducing the probabilities of both average expacted loss and maximum loss achieved through proper diversification.

    In other words, I’m not willing to pay for a reduction in portfolio volatility by way of reduced returns, so I stay in the market, diversify globally and take solace in the fact that though the short-term can be painful,

    - market crashes come quickly and the bulk of the recovery is soon after the bottom
    - on a real-return basis, the global market has never gone more than eight years without setting a new high
    - over the long haul, in almost all ivestable countries, stocks have outperformed bank accounts and bonds

    Of course there’s more to it than that, and personal goals and worldview are giant considerations!

  2. Hi Chaz – I appreciate theory as much as anyone. Where I have a problem is how people behave when the wheels start coming off the market. For example, if my portfolio loses 50% in a bear market in just 18 months, I may decide that I can’t afford to lose the other half. If I sell – to preserve what I have left – I’ve locked in my losses.

    This scenario isn’t as isolated as it sounds. Bear markets, especially steep or prolonged ones, are typically accompanied by economic disturbances that result in the loss of jobs or closing of businesses. If you face that in addition to a big investment loss, it will be very difficult to stay the course.

    I’m of the opinion that a little bit of judicious advanced maneuvering goes a long way! I’m not suggesting a wholesale move out of the market, but rather a significant reduction in exposure. That will keep you in the market if it continues to rise, and reduce your losses in a slide.

  3. I hear ya Kevin, and you make a lot of sense. For me, though, my paranoia of missing the entire run up after a major correction is stronger than my fear of losing more. :)

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