This week world markets have broken through some key upside resistance: 9000 on the Dow, 950 on the S&P, 1900 on the NASDAQ. It’s been quite a week, adding to an already record run in equity prices from the March 9 lows. The issue for thinking investors (as always) is what does reasonable risk management suggest one do.
The bullish argument is that in March world markets hit a 12-year low after a historically large 63% decline on the S&P and that the extent of this decline was overdone. Those bullish of the stock market here believe that it has started into its next cyclical expansion forecasting an economic recovery that is now underway. This may be true. I, for one, hope that it is.
The bearish argument is that we are in a period of deflation similar to the 1920 and '30's and that the world economy will continue to contract for the next few years leading the stock market lower over the next many months. This may be true. Sprott (and many others) sell gold and commodity funds as the answer. See Sprott's July 2009 comment for a good summary of this argument.
It is actually impossible to predict which of these arguments (or any other) will win in the end. Admission of this fact is the first step to enlightenment. But what then is a realist to do with investment capital?
In practice we have developed some key rules to help us navigate through uncertainty, and it can be useful to review them.
1. Stock markets are a dangerous place to blindly park one's savings. As Peter Bernstein put it, the stock market is more likely to destroy fortunes than to create them. Preservation of capital must be the primary goal at all times; through all cycles.
2. Prices always revert to the mean eventually; always.
3. Pay attention to the overarching investment climate as overall trends and cycles (not our intelligence) are the most defining characteristic of investment outcomes. Seek to become underweight of risk assets near economic peaks and to accumulate risk assets again as the economy is starting into recovery.
4. Once there is reasonable indication that an economic recovery is in progress, use stock market weakness as an opportunity to buy the dips in order to accumulate risk assets at discounted prices.
5. A fool tests the depth of the water with both feet, ease in gradually and systematically.
6. During secular bears (like we are in now) cyclical expansions tend to be shorter and more muted while contractions tend to be deeper and longer than average. Never grow complacent with holding risk assets. Always be on guard for evidence that the overall expansion is stalling or ending.
7. Define your exit strategy in advance so that you will move to the exits on an objective metric if a bullish trend breaks down. Devise a method to limit your losses.
8. Accept that you will have to miss out on some of the “market gains” in order to outperform the market over your life time. Your life time is the only relevant time frame.
9. Accept that you will likely never get out at the peak or in at the bottom, be happy if you can capture and retain a chunk of the in between.
10. Accept that in the short term you will often look wrong; stick to your process anyway.
The recovery may now be underway but it is still early days at this point. A little more time will tell us a little more about the economic prospects for next year.
Even if things look well for a few months, a double dip recession in the future cannot be ruled out. But then, that was the fear coming out of the last recession also and then at least, it didn't happen. Although last time we had housing equity and a flood of consumer credit to tap; funding for this expansion is much less apparent.
The risk of a market retest ahead is at least 50%. Whether we have already bought equities, or plan to buy more, a plan that acknowledges the 10 rules above will be helpful.
