Once Stock Prices Drop Hard There’s Only One Way They Can Go

Beyond Buy-and-Hold #99

When prices are high, where do you think they are going to go?

They might go even higher, right? That could happen. But, when prices are high, the odds are that they are going to go down, possibly hard.

When prices are low, it’s the opposite. When prices are low, it’s not too likely that they are going to drop too much lower. When prices are low, they are going to go up, possibly hard.

The part that trips people up is that these rules do not apply in the short term.

Stock prices must always move toward fair values

What we are talking about here is logic. Prices must ultimately move in the direction of fair value. High prices signal a period of bad returns and low prices signal a period of good returns. But there’s another factor — Momentum. Momentum cuts in just the opposite direction. Momentum causes low prices to go even lower and high prices to go even higher.

But only in the short term!

Momentum often prevails over logic in the short term. Logic always prevails over momentum in the long term. That’s the message of the 140 years of historical return data available to us today.

It’s hard to keep this straight in our heads. The message of the return data is clear enough. But the crazy, emotional momentum factor sends its own message to our brains. And that crazy, mixed-up, dangerous momentum message often exerts more influence over us because we all live in the short term.

Separating reality from momentum in the stock market

We need to train ourselves to tune the market’s short-term message and focus in on the helpful, enriching, long-term stuff. I think that the best way to do that is by looking at the numbers.

Say that stocks are priced as they were priced in 1982. What will a $100,000 stock portfolio be worth in 30 years? Let’s compare that to what a $100,000 stock portfolio will be worth in 30 years if stocks are priced as they were in 2000. Let’s assume a 70 percent fixed (Buy-and-Hold) allocation in both cases.

Our friend The Investment Strategy Tester was created to give us the ability to make such comparisons. Here’s the graphic it produces when I compare these two scenarios:

Momentum graphic
Momentum graphic

Here’s the results table it produces:

Momentum table
Momentum table

The starting-point valuation level makes a big difference. That graphic is scary.

Best—and worst—case scenarios

The best-case outcome for the scenario in which stocks were insanely overpriced at the beginning of the 30-year returns sequence is that the $100,000 will be worth $600,659. That’s the worst case for the scenario in which stocks were insanely under priced at the beginning of the 30-year returns sequence!

The best case for the scenario in which stocks are insanely under priced at the beginning of the 30-year returns sequence is a portfolio valued at $1,304,998. The difference in the initial market price translates into a final portfolio more than twice as large!

Now please take a look at the five-year numbers. The portfolio that started at a time of lower market prices still performs better in most cases. But not in all cases! The worst-case outcome for the portfolio that started at a time of low prices is worse than the best-case outcome for the portfolio that started at a time of high prices. It’s possible for momentum to beat logic for five years or even a bit longer.

But logic always prevails in the end. Understanding this is the key to becoming a successful long-term stock investor. This is what all investment advisors should be teaching their readers and clients. You need to resist the message that short-term momentum-influenced price changes send to your brain, not succumb to it. That’s the entire deal.

It’s not possible to invest successfully for the long run without taking valuations into consideration when setting your stock allocation. It’s really not.

Rob Bennett argues that the taboo on talking about money hurts us. His bio is here. For background on the Big Fail of Buy-and-Hold and on the need to move to Valuation-Informed Indexing, please check out the “About” page at the “A Rich Life” blog.

( Photo from Flickr by Helico )

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