According to AMG Data Services, which tracks the flow of funds into and out of different categories of mutual funds (e.g., equity, fixed income and international), for the third quarter, a record $51.1 billion was drawn out of equity funds, both U.S. domestic and international, and a record $43.5 billion was deposited into bond funds.
What happened in October? Equities rallied and bonds fell. In essence, millions of investors, I'm assuming with some degree of intelligence, sold low and bought high. Isn't that the opposite of what investors are supposed to do?
In most economic transactions, lower prices generally lead to more demand. For example, if steak is on special at the grocery store, more shoppers will buy steak than veal roast. If car manufacturers offer zero-percent financing, more cars are sold. This is called getting good value. But, as has been rehashed ad nauseam, investors wanted the most valueless stocks during the Internet bubble, and the higher the price, the lower the value, the more demand increased. By the calculations I documented in "Stock Market Valuations: Too High, Too Low or Just Right?", the S&P 500 peaked at 70% overvalued in March 2000. During the peak selling of equity funds in July 2002, the same calculations showed the S&P 500 to be at least 40% undervalued.
I have a couple of explanations for why this phenomenon occurs, and a couple of strategies to help you get a better handle on buying low and selling high.
Tyranny of the Straight Line
"Since housing prices are up these past five years, they'll be up next year." "If stocks are down over the last 30 months, they'll be down for the rest of the year." The human psyche looks at a series of data points and automatically draws a straight line to eternity. This simplistic model will trip you up, time and time again.
Consider interest rates: From 1953 until 1981, a casual observer would assume rates would continue rising indefinitely, while from 1983 until the present, the same observer might project that interest rates would eventually fall to zero. Interest rates factor into the valuation of both housing prices and the stock market, so a good chunk of the appreciation of both investments over the last 20 years is attributable to falling rates.
10-Year Treasury Note Yield 1953-2000
Source: Federal Reserve
In fact, it is increasingly unlikely that the yield on the 10-year Treasury will again touch the low of 3.55% set in the first week of October. I'm not too worried about the stock market falling in the background of modestly rising interest rates (it's about 32% undervalued at current rates, according to calculations from First Call). However, I've shifted my clients' fixed-income investments to the short-term (least interest rate sensitive) part of the Treasury market, and I'm very leery about real estate right now, which, given 80% financing, is an investment highly leveraged to interest rates.
In planning your investment strategy, consider under what scenarios a long-term trend might change direction and whether a change in direction would benefit or harm your investments. Consider also that a solid long-term trend may have short sharp countertrends. I often use the example of the tide coming in -- successive waves may have no apparent pattern, but at the end of the afternoon the ocean is at the top of the beach. The S&P 500 exhibits a long-term growth rate of 8%-10%, but as we've seen over the past 10 years, there can be considerable deviation, positive and negative, from that trend.
S-Curves
I wrote an entire column on the S-Curve concept some years ago. In brief, a trend that looks like a hockey stick (flat to rising sharply) may often be the midpoint of a trend that is ultimately S-shaped (flat to rising sharply, but then flattening out again). Adoption of new technology (like DVD players, for example) often shows an S-curve growth pattern. Investors often assume that the hockey stick part of the curve will continue to eternity, and jump on a trend just as it starts to peter out. Remember when investors were hot for Y2K stocks in the mid-'90s? I always asked, "What happens to these companies on Y2K+1?"
Running With the Herd
It's easy to buy what everyone else is buying, and it's very uncomfortable to be selling what everyone else wants. One of the most succinct statements of contrarian investing I have ever read was contained in the Berkshire Hathaway 2000 Annual Report: "I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement." Can you imagine bragging at a cocktail party in 1999 about your Old Economy stocks? Warren Buffett can, and that's why he's a billionaire.
Fortunately, you can run with the herd for a while -- just be sure to step out before it runs off a cliff. Back in January 2000, I incurred the ire of my clients by taking profits in about half of our technology positions. Had I known how violently the tide would turn against technology, perhaps I would have taken profits on all the tech companies.
Two simple strategies to ensure that you buy low and sell high:
Rebalance Your Portfolio Annually
Portfolios should have target allocations -- for example, 70% equities/30% fixed income, or 25% each to technology, health care and financial services. Since investment sectors rarely move in sync, you'll find that your portfolio drifts from the targets. By selling the overweight sectors and investing the proceeds in the underweight sectors, you'll always be selling overvalued stocks and buying undervalued stocks. I rebalance my taxable accounts in January, usually generating profits, so I have the whole year to look for offsetting losses. For tax-deferred accounts such as 401(k)s, pick an arbitrary date like your birthday to rebalance.
Dollar Cost Averaging
Many of my clients have automatic monthly deposits into stock mutual funds in addition to their 401(k) contributions. Several called me this summer wanting to know if we should cancel the automatic investments, or at least hold the transfers in cash. I said, "Other people are liquidating their life savings at fire-sale prices -- why shouldn't we take advantage?" Now that we've had a bit of a rally, the purchases of the last year are starting to turn profitable.
Final thoughts
U.S. stock markets have rallied impressively over the past five weeks, with a 12.3% gain in the S&P 500, 19.5% gain in the Nasdaq, even bigger gains off the Oct. 9 lows. You might feel "stupid" for not having jumped back into the stock market already. Don't worry if you haven't. To make new highs, the S&P 500 has to gain an additional 67%, and the Nasdaq an additional 262%. Even at 10% annual growth rates, that's five years for the S&P 500, and 14 years for the Nasdaq.
David Edwards is a portfolio manager and president of Heron Capital Management, a New York management firm. Edwards was a contributor to Harry Domash's Fire Your Stock Analyst: Analyzing Stocks On Your Own available at Amazon. At the time of publication, his firm held no positions in any companies named in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Edwards appreciates your feedback and invites you to send it to David Edwards.
