Thursday, February 22, 2007

The Ultimate Market Irony

George Costanza was a genius. The more I study the stock market, the more I realize that it pays to do the exact opposite of whatever comes naturally.

One result of this principle is already well-known: the wise investor buys when everybody else is panicking, and he sells when everybody else is euphoric. We're all human, so it's easy to get swept up into the wave of emotion that occasionally washes over the investor mob. Our emotions tell us to stay out of the stock market when everybody else hates stocks, even though such times are usually the best time to buy. Similarly, we are compelled to buy stocks when everybody else thinks that the sky is the limit, even though such enthusiasm usually means that people have used up all of their stock-buying power. So acting against the prevailing emotion may be difficult, but it is almost always the best thing to do.

But there is an even more amazing irony to stock market behavior. Partly because of the emotional component to stock prices, the market tends to be overvalued when the economy is strong, and undervalued when the economy is weak. In other words, it tends to be a good investment during recessions, and a poor investment during boom times!

This sounds crazy, right? Want proof?

Consider the early 1980's, the nadir of the recession that began in the 1970's. Inflation had reached 12% in 1980, unemployment peaked above 10% in 1982, and economic growth (GDP) was at a standstill. People were pessimistic about the economy, and stocks were very cheap - the market's P/E ratio was less than 10. Yet if you had purchased a simple S&P 500 mutual fund in 1982, you would have tripled your money in only five years, for an average gain of 25% per year.

That situation in the 1980's was quickly followed by the opposite case. After a small recession in 1992, the economy resumed its growth and corporate earnings doubled over the next 4 years. By 1996, things looked very rosy, and the consensus was that the sky was the limit, both for the economy in general and stocks in particular. But an investment in the S&P 500 at the end of 1996 resulted in a return of only 10% over 6 years, or less than 2% per year. People who bought stocks in the boom years of 1998, 1999 and 2000 fared even worse, losing up to half of their investment by 2002.

Pop quiz: In the last 100 years, when was the absolute best time to buy stocks? If you answered "sometime in the Great Depression," then congratulations - you're catching on! A purchase of Dow 30 stocks in July 1932 would have quadrupled your money in 4 years, (40% per year) and that's not even including the record-breaking dividends (up to 10%) paid out in the early 30's.

When was the worst time to buy stocks? You probably already know that it was 1929, just before the largest stock market crash in history. But do you know why the market was doomed to crash in the first place? For starters, the economy of the 1920's was so strong that it contributed to the decade being named the "Roaring Twenties." Yes, that's right: the economy was growing like gangbusters. And the stock market rocketed up right along with it ... to a point. The optimism of a strong economy and euphoria over an ever-rising stock market compelled people to buy ever more stocks by any means possible - particularly by borrowing the money. When the buying finally topped out, the market had nowhere to go but down, and down it went. The Great Depression began when stock-owning borrowers could no longer pay their debts. Defaulting debtors caused lending banks to go under, and the downward spiral began.

What's the situation today? On the one hand, the economy is booming again, stocks are expensive (P/E of 19), and yields are lower than they've ever been, (less than 2%) so history tells us that we should not expect large stock market returns over the next 5 years or so.

On the other hand, investors are not as euphoric as they were in the 1920's or 1990's. In the long run, pessimism tends to be followed by positive market performance, because investors have nowhere to transfer their money to except into stock funds. In other words, it's the opposite case of the overextended investors of 1929 and 2000.

So if the booming economy keeps stocks overvalued (P/E ratio above 15), and pessimism ensures future gains when investors eventually get back into stocks, then the market ought to make small-to-moderate gains over the next few years. Stated another way: pessimism ensures there will be gains, while the good economy ensures that the gains won't be large. It sounds insane, but history clearly shows that that's how the market behaves.

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