What The Markets and Taylor Swift Have In Common

March 11th, 2013

by Lance Roberts

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The other day I was driving my daughter to school and a Taylor Swift song came on the radio. She immediately pleaded with me from the back seat to turn it up. As she was bopping her head back and forth and singing the tune, the lyrics got me to thinking about how investors approach the financial markets much in the same way Taylor Swift approaches her relationships.

At one point the tabloid covers show her happy, smiling, holding hands and laughing. Not too long after we see her heartbroken and her next hit song, which makes her a few million more dollars, rings of the love lost. Then, her love comes back into her life promising that this time will be different. Only it isn’t. On again, off again and back on again.

The interesting thing is that it is not so very different with our continued love/hate relationship with the financial markets. Investors fall deeply in love with the markets as they are rising. Rising asset prices create a euphoric feeling that begins to cloud our judgment. We overlook the flaws, and the early warning signs, with willful blindness. After all… "ain’t love grand?"

Then, as the end of the love affair eventually comes, as it always does, we become disillusioned, angry and depressed. We swear to ourselves that we will never be lured back into that trap again. We have learned our lesson. However, as the markets once again recover, and the pundits chastise investors for "missing out" they are once again lured back in thinking that this time they will know better. This time will surely be different.

Lately, there have been numerous articles discussing that, with Dow at all-time highs, now is the time for investors to jump in. Most of these articles, however, are based on the same tired and worn out arguments of market timing, buy and hold investing and an improving economy.

1) You can't time the markets.

It's true - you cannot time the markets. Being "all in" or "all out" is a sure way to eventually blow up your portfolio. However, a "buy and hold" strategy is also not realistic. While buying and holding a balanced portfolio over the last hundred years would have certainly made you very wealthy - there are several reasons why this it is also untrue.

First, even though it is possible for someone to live to the ripe old age of 100 it is highly unlikely that they begin investing as soon as they left the womb. The majority of individuals don't start saving, much less investing, until very late in life. In the majority of cases individuals that are seriously saving, and investing for their retirement, have on average about 15 years to reach their goal.

Secondly, such analysis assumes that individuals are emotionless beings that are not affected by the volatile swings in the markets which ultimately destroy their savings. The breakups, and makeups, with the markets are clearly shown in the chart below which shows the emotional cycle that investors go through with the markets.

Investors continually make the same emotionally driven mistakes, with the help of plenty of hype from mainstream pundits, which leads to buying "high" and selling "low". This is, of course, exactly the opposite of what logic tells you to do. Emotions are a much stronger force than logic – and while life should be filled with emotion, our investing should not.

2) You should "buy and hold" because there is no 20-year period where stocks have had a negative return.

There are two problems with this statement. First, as stated above, the average person has less than 20 years to save for retirement. This means that "buying and holding" during the wrong secular cycle can be devastating to retirement and savings goals. The chart below shows the S&P 500 on an inflation adjusted bases with secular "bull" and "bear" markets defined. With the exception of the very short secular bull market from 1920-1929 these secular periods range from 14-18 years normally.

The argument that you should stay invested because every rolling 20-year periods is positive is also flawed. When adjusting for inflation, we can clearly see that there are multiple periods where negative real returns existed. Of course, it isn't surprising when you look at the devastation caused during the secular bear market periods in the chart above. (The chart below uses monthly Shiller data going back to 1900 and shows rolling monthly 20-year periods)

Successful investing, over the specific time frame that you have to reach your retirement goals, is mostly dependent on being in the right secular cycle. Currently, despite the current cyclical bull rally, the markets remain contained within a secular bear market period. As we discussed recently the current secular bear market likely still has several more years, and at least one more major market correction to go.

This is due to the one consideration that is often ignored by the mainstream pundits which is that the domestic economy is no longer in the same position as it was in the early, or even mid, 20th century. During those time frames were wither engaged in World Wars, which boosted domestic spending and production, OR the U.S. was primarily the sole manufacturing and production facility for the rest of world post the devastation caused by WWII. Today, that is no longer the case. With the domestic economy now based largely upon finance and service, which are low economic multipliers, the burden of high debt levels and weak economic growth is likely to yield weaker returns for longer than investors are prepared for.

3) The economy is set to take off.

Of course, the argument for continued weak economic growth undermines one of the primary arguments for a continued surge in the financial markets. That argument revolves around the notion that economy is set to have an explosive resurgence of growth beginning this year. With the Fed, and central banks around the globe, dumping money into the economic system it is just a function of time until the economy gains traction and jumps higher.

This is highly unlikely to be the case for a two reasons. First, the diminishing rate of return of increases in debt relative to economic growth is getting worse. The chart below shows the rate of increase in debt versus the rate of increase in economic growth since the beginning of 2009. The current trend is unsustainable and potential cuts to government spending and increases in taxes may further retard future growth.

Secondly, the amount of slack in the overall economy, as shown by a near 6% output gap, is going to continue to restrain organic economic growth in the future.

The reality is that high debt and deficit levels, declining wages and low savings rates are eroding economic growth as productive investment is inhibited. The large amount of slack in the economy gives little reason for companies to ramp up hiring, production or investment beyond simply maintaining current levels of demand. This supports the premise that the markets will likely remained mired in a secular bear trend for longer than currently expected.

Changing Our Behavior

If we truly want to win the long term investment game we have to learn to behave differently. Instead of jumping into, and out of, our relationship with the market – we need to develop an understanding that the equity markets are not "long term relationship" material. That puts us into a position to manage our exposure to the markets accordingly.

While Taylor Swift is either all in, or all out, of her revolving relationships and swears that she will "never, ever, ever – get back together," as investors we just need to strive to have a healthy, but emotionally unattached, relationship with the markets.

A relationship built on the proper understanding of the risk, how to manage those risks, and keeping expectations in line with reality are key to attaining your investment goals. When the markets are being friendly we can enjoy their company – but we do not have to fall in love with them. Conversely, there are times that we should spend more of our time with other friends like Mr. Bond and Mr. Cash. There has never been a rule that investing should ONLY be done in the equity markets. Our job, as investors, is to deploy cash into the best opportunities available, at any given time, which will inure to our benefit within our specific time frame. If there are no opportunities currently available – cash is the best place to be.

It is absolutely true that you will miss out on some of the highs, however, you will also miss a bulk of the lows. However, missed opportunities are much easier to replace than lost capital. The one thing that can never be regained is the time lost along the way.

While it is our human nature to be eternally optimistic - it is much healthier, as an investor, to remain a bit of a skeptic. The reality though is, like the continuing sagas that seem to be Taylor Swift's relationships, we are continually lured by the appeal of the markets. " This slope is treacherous, This path is reckless…and I, I, I like it."


Originally posted at Lance's blog: streettalklive

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