We often hear the question, “when is the best time to invest
in the stock market?”
From a financial planning perspective, the answer is when you
have the ability to do so. That is, after you have covered the
basics, such as enough insurance, a sufficient cash reserve, and
proper debt management. Only once those needs have been taken care
of do you have the capacity to take on market risk.
Okay, we are going to make the bold assumption that all of you
meet that condition or you wouldn’t be receiving this letter.
Now when is the best time to deploy your money?
Well, from a statistical standpoint, the answer is simple: immediately.
Since the stock market generates positive returns over time (in
other words, while there are bear markets to contend with, the
long-term trend is up), each day in the stock market has an expected
absolute positive return, and that expected return is superior
to cash savings. Therefore, the sooner your money can start compounding,
the better.
That, of course, assumes we have no idea of whether the current
market conditions are favorable or unfavorable for such an investment.
For example, if we knew the market was about to go down for the
next six months — it would obviously pay to wait in cash,
right?
Well, not so fast. We would have to know that it was going to
go down for EXACTLY six months -- not a couple of weeks (or perhaps
even a few days) less!
Why?
Because gains and losses in the market don’t come in nice
smooth increments each day -- but in big gulps. If you have been
with us for a while, you have probably heard us mention the following
fact, but it bears repeating: Over the past 20 years (1986-2005)
if you missed just the 10 best days in the market (10 out of over
5,000 trading days!), you would have given up a staggering 42%
of the market’s total 20-year return.
And just when do those big up days occur -- yes, you guessed
it, quite often right around market bottoms. For example, three
of those top-10 days came within nine days of each other beginning
just 3 days after “Black Monday” in October 1987. The
result is that investors waiting in cash for the market to “get
better” will almost assuredly miss those big up moves.
Now, we do not pretend to be able to accurately predict short-term
moves in the market, so our advice on when to invest generally
follows the statistical answer of “immediately.” If
a client is too uncomfortable with that we may “dollar cost” average
them in over several months — understanding that barring
any special knowledge of the market ahead, the result is statistically
likely to be suboptimal to investing it all at once.
But we can offer you some guidance about how to assess whether
or not current market conditions are “favorable” for
investment. In short, the best time to invest is when everyone
else would think you were nuts for doing so. As Sir John Templeton,
the legendary money manager and founder of the Templeton Funds,
said: “Bull markets are born on pessimism, grow on skepticism,
mature on optimism and die on euphoria. The time of maximum pessimism
is the best time to buy and the time of maximum optimism is the
best time to sell.”
There are many recent examples of this aphorism at work. One
direct measure of investor sentiment is mutual fund flows. In July
of 2002 stock mutual funds experienced a record net outflow. The
market rallied in late July (including two more of the best 10
days of the past 20 years) and while there were more down days
to come, October of that year marked the beginning of a powerful
bull move. And it goes both ways. The all-time record inflow into
stock mutual funds occurred in February 2000 — immediately
before the S&P 500 lost half of its value and the Nasdaq (a
proxy for tech stocks) lost three quarters of its value.
Where are we today? Well, this past June was the worst month
for stock mutual fund outflows (we haven't seen the July data yet)
since February 2003. After February of 2003, the market (S&P
500) gained 21% over the next six months.
Another measure of investor sentiment that we have discussed
before is the American Association of Individual Investors sentiment
poll. As tracked by Ned Davis Research, the percentage of AAII
members who say they are bullish (bulls/bulls+bears) was in the
extreme pessimistic area at the end of this July.
According to Davis, since 1987, when the individual investors
are extremely pessimistic (less than 49% bulls), the market generates
future 12-month returns of nearly 20%. When sentiment is overwhelmingly
positive (more than 67.5% bulls), the market's future returns are
actually negative over the next 12 months. When sentiment is neither
at a bullish or bearish extreme, then returns are positive, but
below average. In other words, the only environment (all else being
equal) that generates above-average stock market returns are when
investors are overwhelmingly bearish.
Both of these sentiment indicators suggest better market times
ahead.
But What About The Fed?
The Federal Reserve next meets on August
8. The question regarding whether the Fed will raise short-term
rates yet again has been
one of the leading reasons cited why market volatility has increased
in recent months. Much ink has been spilled attempting to guess
what the Fed will do, and say, on August 8.
Why do we pay so much attention to the Fed? For starters, there
are news cycles that need to be fed. Second, the Fed is often conveniently
used as a scapegoat when trying to explain macroeconomic behavior.
For instance, it would be easier to blame the Fed for a recession
because they “excessively” raised interest rates, instead
of attempting to explain the reality that the economy moves due
to the complex interplay of various economic variables and conditions.
To be fair though, what the Fed is worried about is, in fact,
what we all should be worried about, not only as investors, but
as individuals in a global economy: stable prices and sustainable
economic growth. The future level and trend of prices in the economy
is indeed a critical factor in future stock, bond, cash, commodity,
and other asset class returns. If we see higher inflation, that
will eventually be reflected in higher interest rates and lower
stock valuations (all else being equal). Low inflation meanwhile,
which we have enjoyed for years, should mean continued low interest
rates and higher stock market valuations (all else being equal).
While we don't know, of course, what the economy will exactly
do in the coming years, we do have a perspective based on research
and experience. And to us, the current inflation outlook remains
mixed. On one hand, there are short-term factors (slowing economic
growth, softening real estate prices) and long-term factors (globalization,
productivity gains, demographic trends) suggesting that inflation
should remain contained in the near future.
On the other hand, a compelling argument can be made that inflation
will return. Certainly, the long-term supply/demand picture for
commodities, particularly energy, remains worrisome. Perhaps as
significant, however, are the enormous future liabilities concentrated
in social security and healthcare that the government will need
to pay. Taxes could be raised and government spending in other
areas could be cut, but another response could be to inflate their
way out of those obligations.
Currently, our portfolios are built with this mixed outlook in
mind. We have some funds that should do better in a lower inflation
environment and we have funds that should perform better in an
inflationary environment. We believe that a properly diversified
portfolio should own a variety of securities that perform differently
in various market conditions.
In sum, the news headlines this summer have been heavy with negative news ranging
from the Middle East conflict to raging summer heat. Falling house and stock
prices haven't helped matters much either. Nonetheless, if history is any guide,
current sentiment conditions suggest this is a better time to buy than to sell
- regardless of what the Fed does August 8th.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
