The high road and the low road

March 1, 2005

One aspect that makes investing so frustrating is the unpredictable pattern stocks follows. The market is like a drunk stumbling home from a bar - you can’t expect a straight path, but you can be reasonably sure of the final destination – home.

Let’s say we know the market is going to go up on average 4% a year over the next ten years. With dividends, that could work out as a 6% a year return on average, as the S&500 yields just under 2% at current prices. A 6% annual return over ten years means about an 80% total return. 

Assuming our modest estimate is correct, the Dow, now at around 10,800, will hit 16,000 in ten years, or a 4% return each year.

Let’s pretend the 16,000 in ten years figure is set in stone, when if fact it could be higher or lower based on earnings growth or prevailing interest rates, or general market valuations in the future.

Knowing where the market is going to be in ten years, and what your investing time horizon is, means stocks would be a pretty low risk investment. As long as you absolutely would not need your portfolio for ten years, it doesn’t really matter how it gets to Dow 16,000 – just so long as it gets there.

For example, the market could get stuck in the 10,000 to 11,000 range for the next nine years, then rally up sharply to 16,000 in year ten. Or, it could jump up this year and next, hitting 16,000 in short order, and then stay at that level for the next 8 years. Or the market could even fall 50% to around 5,500, then climb a solid 13% a year – ending up at the same 16,000 in each case.

There is another way to look at the market’s gyrations. If you assume the future target level is a fixed point, like a destination, then all these ups and downs in the shorter term are really advances and give backs of future returns. In this way a 50% rally this year would basically be a cash advance on stock market prosperity over the next ten. A 50% crash this year would mean the market is giving back some returns, only with the plan to earn them over coming years.

When the market moves up in big double digit jumps year after year, it is very likely you have taken an advance on future returns to the point that easing up significantly on stocks is a good idea – particularly if other assets like bonds offer a reasonably good expected return over the next five to ten years. 

This situation describes the stock market in 2000 – if the Dow is going to be at 16,000 in 2014 (our ballpark estimate), then when it went above 12,000 back in 2000 a smart investor would realize that for the Dow to get to 16,000 in 14 years it would only need to rise an average of 2% a year. Factor in a near 2% dividend yield and that’s a return below what bonds were paying at the time for similar time frame investments. Of course, at the time nobody had reasonable estimates on the long term value of stocks. Rather, most were based on the recent double digit growth continuing forever. Anybody remember the best seller, <i>Dow 36,000</i>?

Conversely, when the market crashes significantly, it is very likely that an investor’s expected return over the next ten years is going to jump proportionally. Any money an investor had left out of the market should be put to work.

We have a reasonably conservative estimate on what the stock market will be worth in the future, and we try to underweight stocks in our model portfolios if they get ahead of themselves in the short term and overweight stocks if they fall to more reasonable levels. We never truly know what the market is going to do, so we’re always in stocks to some extent in every model portfolio. 

One of the best signals we have to determine when a good time is to overweight or underweight stocks is by watching the behavior of other investors. Since investors as a whole do not behave rationally we tend to try to do the opposite (as much as possible) with our model fund portfolios that they do as a group. 

Fund investors as a group under-perform the market not just because of high fund fees. Knowingly or not, they set their estimates of future market growth based on recent market growth. If they had a target for what the market should be in 10 years – even if it was off by a fairly wide margin – then a big market move up wouldn’t get them more excited about stocks, but less so.