Index Funds Don’t Work in Bear Markets

This is a guest post from Rob Bennett. In the Carnival of Personal Finance we recently hosted, we included a submission from Mike Piper at The Oblivious Investor that Rob disagreed with. He asked if he could rebut it, and because he largely met the Control Your Cash guest post criteria, we said yes. We then gave Mike the opportunity to rebut the rebuttal. He politely declined, so we’ll consider today’s post to be the terminus of this issue. (So if you want to leave a comment today, you’d better make it count.)

As for Rob, his claim to fame is developing “the first retirement calculator that contains an adjustment for the valuation level that applies on the day the retirement begins.” His bio is here.

Some people LOVE a bear market


Mike Piper at The Oblivious Investor blog argues in a recent article that Index Funds Work in Bull and Bear Markets. The argument is that index funds earn the market return and that, if you try to pick good stocks, you might pick wrong and end up earning less than the market return. So index funds are your best choice.

 

I don’t buy it.
If stock investing were not so intensely emotional an endeavor, we would all be able to spot the flaw in this logic chain in 10 seconds.

 

Stocks do not do well in bear markets! Index funds are stocks! You do not want to be invested in index funds in bear markets! D’oh!

 

I have a stock valuation calculator (“The Stock-Return Predictor”) at my web site that performs a regression analysis on the historical stock-return data to reveal the most likely 10-year return for stocks starting from any of the possible starting-point valuation levels. It shows that the most likely annualized 10-year return in 2000 was -1%. Treasury Inflation-Protection Securities (TIPS) were at the time paying a government-guaranteed return of 4% real.

 

That’s a differential of 5 full percentage points of return per year for 10 years running. The investor who chose stocks over TIPS in 2000 was setting himself up to over the course of 10 years lose 50 percent of his accumulated savings of a lifetime. The investor with a $100,000 portfolio was likely to end up $50,000 poorer at the end of 10 years. The investor with a $500,000 portfolio was likely to end up $250,000 poorer at the end of 10 years. The investor with a $1 million portfolio was likely to end up $500,000 poorer at the end of 10 years.

 

Those who appreciate the power of the compounding returns phenomenon will understand why those numbers are only the beginning of the story, not the end of it. Investors who won for themselves a $50,000 differential or a $250,000 differential or a $500,000 differential will be seeing the size of those differentials grow and grow over the course of however many years they will be continuing their walk through the valley of tears.

 

It’s not just crazy Rob Bennett who says that valuations affect long-term returns. Yale Economics Professor Robert Shiller showed this in research published in 1981 and explained why it works this way in his widely praised and best-selling book Irrational Exuberance. There is now 30 years of academic research backing up Shiller’s findings. The latest study making the point is a study by Wade Pfau, Associate Professor of Economics at the National Graduate Institute for Policy Studies in Tokyo. You’ll find that one here.

 

Pfau’s study states: “On a risk-adjusted basis, market-timing strategies provide comparable returns as a 100% stocks buy-and-hold strategy but with substantially less risk. Meanwhile, market timing provides comparable risks and the same average asset allocation as a 50/50 fixed allocation strategy, but with much higher returns…. Valuation-based market timing with P/E10 has the potential to improve risk-adjusted returns for conservative long-term investors.”

 

So we do not need to be invested in stocks via index funds or through any other means during bear markets!

 

Long bear markets are not random events. They only show up following runaway bull markets. And they always show up following runaway bull markets.

 

Pay attention to the price of the stocks you buy, going with a lower stock allocation when stocks are insanely overpriced than you’d go with when stocks are fairly priced or low-priced, and most of the risk associated with buying stocks no longer applies for you. Yet you obtain higher returns! Investor heaven!

 

This approach (Valuation-Informed Indexing) sounds so easy and so rewarding and so rooted in common sense. Why doesn’t Mike Piper follow it? Why doesn’t everybody follow it?
Stock investing is an intensely emotional endeavor. When stocks were priced at three times fair value in 2000, the numbers on the bottom line of the last page of our portfolio statements overstated by a factor of three the amount of lasting wealth we had accumulated up to that time. We all wanted to believe that it was the portfolio statements that had it right and the last 30 years of academic research that had it wrong.

 

We tell ourselves that index funds always work even though there is a voice of common sense within each of us that tells us that it cannot possibly be so. How could there ever be an asset class that is worth buying at any price?

 

Mike uses numbers in his arguments. But it is emotion that drives his analysis of the numbers and it is emotion that makes Mike’s analyses popular with his readers.  Mike and his readers very, very, very much want to believe that index funds work during bear markets. But it is not so, at least not according to the 140 years of historical data available to us today.

OMG THE MARKETS TOOK A HIT TODAY

No, they didn’t.

The markets are among the least volatile things in commerce.

EVERY trader looks like this, all the time. He could have just found out that his daughter got engaged and he'd still look the same way. "Crap, now I have to pay for a g.d. wedding."

Last Thursday, the Dow fell 11 points, which is a big enough story to lead the business news. Considering that the Dow opened the day at 12,037, that means it lost a crushing .09% of its value.

Granted, that means that at that rate, the Dow’s entire value would be worthless by May 2015.

By the same logic, the temperature in Fairbanks, AK was 85º on July 9 and -15º this morning. At that rate, by May 2015 Fairbanks will hit absolute zero, everything will turn solid and motion will stop.

These things are cyclical. Everything rebounds, and it usually doesn’t take that long.

Biggest Dow % losses of the last 75 years
October 19, 198722.6
October 26, 19878.0
October 15, 20087.9
October 18, 19377.8
December 1, 20087.7
October 9, 20087.3
October 27, 19977.2
September 17, 20017.1
September 29, 20087.0

The chance that 6 of the 7 biggest losses of all time would happen in the same 19-day annual period are 145,337 to 1.

Why was October 19, 1987, a/k/a Black Monday, such an outlier?

Two major reasons.

The market was unduly, maybe artificially high that morning, fueled by speculation that had kept the Dow rising all summer. The Dow was actually higher at the end of 1987 than at the start.

Also, it took the traders a while to get used to new technology. This was the first time that firms could program computers to take certain orders at certain prices. Not only that, but for the first time brokers could now process orders contingent on what level other stocks were selling at. A shareholder of railroad operator XYZ could order his broker to sell if railroad stock JKL fell to a certain price. We take this for granted now, but back then the traders were still only recently removed from executing every trade by hand.

What happened a week later?

Overworry. The traders were reeling from the previous week’s fall, plus all weekend long they were anxious to get to work and act conservatively – i.e. get into cash and not be part of the volatility. That works fine for one trader, but when everyone does it, you get the very volatility you were trying to avoid – the human equivalent of cows overgrazing on public lands, then ultimately going hungry.

Same thing. This one is attempting to negotiate with God, swearing to quit snorting coke once and for all if He'll only let the dry cleaner not notice the baggie he left in his suit pocket

What are the chances of 4 of the top 9 losses coming in the same 9-week period in 2008, during which we not only elected a new president, but had one of the two biggest ideological shifts in history between a president and his successor?

283,026,075 to 1. Almost the same as the chances of us choosing a person at random in the United States, and that person turning out to be you.

Does that mean we’re heading to an inevitable future of up-and-down stock prices? Not necessarily, and this will wrap up nicely with one more chart, below.

Look at the numbers. A 7% loss happens about once a decade. People frequently lose 7% of their savings balances – withdrawing $140 when you have $2000 in the account – and rarely feel aghast about it. How is that different than if it happens with any other investment (or in the case of the Dow, a representation of a mere 30 investments of the hundreds of thousands available)?

Oh, one more thing:

Biggest Dow % gains of the last 75 years
4 days after the 6th biggest loss11.1
15 days after that, i.e. 13 days after the 3rd biggest loss10.9
11 days after the biggest loss10.1
3½ months after the 5th biggest loss6.8

If you want to sell your position in a Dow index fund, and you’re worried that it isn’t at a high enough price, wait a couple of weeks.

Here are the top 20 advances and declines of 2010:

May 103.90May 20-3.60
May 272.85May 6-3.20
July 72.82June 4-3.15
June 102.76June 29-2.65
September 12.54February 4-2.61
December 12.27July 16-2.52
June 22.25August 11-2.49
June 152.10January 22-2.09
July 221.99May 4-2.02
August 21.99January 21-2.01
November 41.96April 27-1.90
September 241.86November 16-1.59
October 51.80May 14-1.51
February 161.68October 19-1.48
August 271.65June 22-1.43
November 181.57April 30-1.42
February 91.52June 24-1.41
January 41.50August 19-1.39
July 131.44August 30-1.39
May 121.38May 7-1.33

Just about every large movement (to the extent that these movements are large) is nullified by a comparable movement on the other side of the ledger. If this doesn’t convince you to buy-and-hold, and not obsess over daily market movements, nothing will.

**This post is featured in the cupid edition of the Carnival of Personal Finance**

and

**Baby Boomers Blog Carnival Eightieth Edition**

What do numbers and humans have in common? The irrational ones predominate.

This week marks the 23rd anniversary of Light Gray Wednesday. On October 19, 1987, the Dow Jones Industrial Average lost 23% of its value. Alas, no Goldman Sachs employees jumped out of their windows and ended up literally on Wall Street, which would have been awesome.

Over the course of one shocking trading day, the typical individual pension fund went from having 20 years worth of reserves to having 15. Stock options were instantly rendered worthless. Frightened American seniors started pricing cat food brands (Fancy Feast Classic Savory Salmon, 39¢ for a 3-oz. can.) High school juniors started downgrading their aspirations and applying to state colleges. The kids’ parents started smoking off-brand cigarettes – even the non-smoking parents – and saving up the frequent-buyer points. President Reagan and Congress were under pressure to do something to stop the carnage (more on this later.)

The first 100-point drop in the Dow began early in the morning: and this was back when the index itself was at barely 2000, less than one-fifth of where it stands today. Panicking investors copied the lead of previously panicking investors, selling their shares and forcing stocks to drop another 100 points by lunchtime. People on the West Coast woke up, assessed the devastation and followed suit. By the time investors in Honolulu and Anchorage were in a mood to eat breakfast, they’d seen their portfolios blown apart.

The drop wasn’t confined to the United States, nor did it originate here. It hit our shores after already overwhelming Hong Kong, not unlike Pai Gow. Once Hong Kong’s market crashed, so did the markets in Australia, then Western Europe. (An ancillary point: one of the biggest differences between international commerce of a generation ago and that of today is that back then, there was a 6000-mile swath ranging from Singapore to Tallinn that had no stock markets to speak of.) That very month, R.E.M. released “It’s The End of The World As We Know It”, a clear choice for the opening track on the soundtrack to the financial apocalypse that we were all going to have to face.

Who or what to blame? Favorite culprits included:

-computers. Those newfangled machines were blindly selling stocks, often to each other with negligible human input;
-an anti-inflation policy in the United States, though Europe had nothing similar and even if it did, something as gradual as that wouldn’t explain such a sudden drop in one day.

The real answer to what caused the crash is “it doesn’t matter.” What no one mentions is that within 2 days, the market had regained the vast majority of its losses. On net, the Dow actually rose that year. The relevant politicians at the time were either wise enough to know – or too busy to worry over the fact – that you can’t legislate opinions. Which is exactly what stock prices are.

So many of the indicators that we use to measure our prosperity are subjective, but especially the Dow. If you select a random public company, read its financial disclosures, and examine its income statement and balance sheet, a fair and reasonable stock price ought to correspond to that data. But that’s not necessarily the case. A profitable oil company with a rich history (BP) can suffer one huge setback and watch its market cap tumble. An over-the-counter company with almost no assets and no finished projects (Prime Sun Power) can trade at tens of thousands of times earnings, just because of its ecologically correct name.

The point? If you see unjustifiable movement, step away and breathe for a second. Investors sold off on the afternoon of October 19, 1987 for no better reason than investors were doing the same thing that morning, too. Playing lowball was, to put it simply, a fad. Just like bidding up the prices of online toy retailers would be 13 years later.

Collective rationality, or some form of it, usually wins out. In the case of Black Monday, it took almost no time at all for that to happen. The crises are rarely as important as the mundane, day-to-day activity, and the extremes rarely represent any market’s true level. Think about that when mortgage rates and home prices hit another nadir this week.