Market Timing

Still working my way through "The Four Pillars of Investing". I have read it once through and now I'm down to making some notes and trying to see if I've learned anything new.

Bernstein believes that no one can make a sustained profit from timing the market. He believes in the "random walk" theory of how the market works.

He refers to studies that found that stocks/mutual funds that have good returns for a number of years then mean revert and do poorly. So, using past performance to predict future performance is usually wrong. However, at one point in the book, he refers to a study that found that in the short term past performance is a good predictor of future performance.

This short-term prediction data is perhaps what draws the public to the market, like a moth to a flame, during the periodic bubbles. You don't have to be a math expert to see "the correlation".

Over the last few years the stock market has done great. For example, the last year has seen returns in the 20-30 % range for Canada and the US. If you take only that data set (its called data mining), pick short time periods at random, and use them to forecast the future returns, I expect the results would show a high correlation. Hindsight is 20/20.

So here we seem have conflicting realities. Short term data is a good predictor but longer term data is a bad predictor. I guess this means that the farther one gets from the beginning of a bull market the less confidence we can have that it will continue. The market moves from being a "good investment" towards being very speculative (a gamble).

One of the easy ways to measure this phenomenon is to look at P/E ratios for stocks. P/E is often shown on charts. For example, the Royal Bank is near a P/E of 15. Not extreme but not a great investment. Farther afield, looking at Research in Motion (RIM), it now has a P/E of 47. That is considered very speculative by any standard.

The reality is that the stock market changes over time. Sometimes it is a great place to invest but at other times it is like going to the Casino.

As the P/E ratios increase, the probability of a "Black Swan" appearing on the horizon increases.

It's not simple math. The equation changes over time. Maybe P/E or similar measurements needs to be brought into the prediction equation. Maybe it's not just "a random walk". Perhaps it is just a problem yet to be solved.

Market Corrections

I was reading Canadian Dream's blog this morning. His post and the comments by others got me thinking.

The TSX market has had a few down days and that will make some people take notice. If your at all interested in the stock market its hard to avoid this type of news. The media is "part of the system" that drives the markets.

Some people will take action. Some people will just get nervous. Some will actually sell shares. Some will see it as a buying opportunity and buy more shares. At this point we can't know whether the market will continue to drop lower or whether it will quickly resumes its upward climb.

The most normal human reaction is to be a little nervous when one looks at the chart. The TSX has done very well lately and a larger correction may be over due. Running at the first sign of danger is a trait that has saved many humans over the ages. It is at times like this that one learns whether they are cut out to believe in the "buy and hold" investment philosophy.

The best buying opportunities lie somewhere ahead...when the next large correction occurs. And it will occur...we just never know when. It may be very sudden and almost overnight or it may be a slow dragged out process. We can't know when it will happen and what triggers it could be something that never happened before.

It is very important to understand that market corrections are more of a risk to those who have a lot of money invested in a few stocks.

The TSX Comp Index will always come back. You can bet the farm on this. Yes, for larger corrections, it may take years, but it will come back. The 2000 to 2006 was the last good example. It took about 6 years for the correction and subsequent recovery. I wouldn't be surprised to find out that most private investors sold at least part of their holding during this bear market period.

In sharp contrast, some individual stocks never recover. One of the nice things about the index is that it benefits from "survivorship bias". When the price of a share drops below a minimum threshold value the stock is dropped from the index. This important fact can mislead people into thinking that any and all stocks perform like the index.

If your like me... you missed the last great buying opportunity. In hindsight, if I had borrowed all I could and invested it in the market index at intervals throughout the 6 year correction I would be a lot richer today. My excuse today is ignorance at that time. If I fail to catch the next great buying opportunity my only excuse may be a lack of courage and conviction.

Stocks and Bond Returns 1900-2000

Here's an interesting chart from Bernstein's book..."The Four Pillars of Investing". Two things stick out, that stock returns have been superior compared to long-term and short-term (bills) bonds, and that every so often the stock market crashes. The 1929 and 1973-74 market corrections are very evident on this semi-log scale. The worse case scenario for a new retiree, one who is totally dependant upon a personal portfolio, would be to retire just at the beginning of a large market crash. This is a low probability sequencing of events but it can happen. Therefore, it is preferrable if one's retirement income/spending plan is robust enough and/or flexible enough to weather a possible large stock market crash storm event. A safety factor is is good idea.

To see more detail of the graph (photo) click on the image.

Nortel and TSX Comp Index - The Impact

One of the things I think I have learned about how the stock market works, is that individual stocks can do extremely well for a period of time, then crash and burn, with little hope of ever recovering their former peak price. For this reason, investing (betting) on individual stocks is a real crap shoot. In contrast...it seems that betting on the market index to always comes back and exceeds it's former peak a much safer and profitable bet.

What happened to Nortel and the TSX Comp Index is an extreme example of this important aspect of how the market works. According to a back issue of "Money Saver", Nortel accounted for about 33 percent of the TSX Comp Index when the Tech Bubble Peaked. That's a lot!

Nortel achieved a peak price of $120 in late 2000 as part of the Tech Bubble that took the TSX Comp Index to a high of ~11,500. The Tech Bubble burst, Nortel fell to $0.75 and the TSX fell to ~5,800.

Since then, Nortel has recovered to ~$27 but the TSX Comp Index has surpassed the "Tech Bubble Peak" and is now at ~13,800. Today, 6 years later, Nortel has recovered to only 23 percent of it's former peak price. In contrast, the TSX Comp Index has recovered completely, and has exceeded it's former peak and is currently at 120 percent of it's peak level.

More and more, I have come to agree with those who believe that chasing the next hot individual stock is a fool's errand.

Chart Links:
TSX Comp Index 10 Year History
Nortel 10 Year History

PS...Now that "boating season" has started my posts will be less frequent.

70 % Question

From time to time I run across references to 'the 70% of pre-retirement income being needed to maintain one's standard of living in retirement". I also see references to 'perhaps 50% is all that is needed'. I don't recall ever seeing the calculations and assumptions behind the 70% estimate but someone likely did it years ago. I expect there is some logical rationale behind this percentage estimate.

I wonder...did those calculations include "an equivalent income" from a home that is owned during retirement?

In many cases, the rent one would have to pay to replace one's home is not a small sum, and it should therefore be considered in the "How much do I need for retirement?" question.

When financial advisers are giving conservative advice to the general public the 70 % estimate may not be that far off the mark if one's home is included as part of the income. There may also be a bit of a safety factor in the 70% estimate.

For example, if one owns a $200,000 home, this "net worth component" could be sold and the money invested. It would provide perhaps $14,000 per year ($1,167/month) before tax at 7%.

The Four Pillars of Investing by William Bernstein

I'm currently working though a book I picked up at the library. I'm impressed with it so far and would recommend it to anyone who has money to invest. It is not an easy or quick read, but it contains critically important information for the investor. With respect to small investors, Bernstein points out that they (we) fail to understand the relationship between risk and reward, and that we fail to stay the course when things get tough.

I agree that ignorance about how the markets work and inexperience with the psychological aspect of being invested in the market, are important obstacles to overcome. Like Bernstein, I feel lucky (in a way) to have experienced a good sized bear market. I watched as co-workers got excited about the dot.com stocks soaring to ridiculous heights. It was a real time lesson in human nature during the building of the dot.com bubble. The media did a great job of cheer-leading everyone on.

It was difficult to keep from getting caught up in it all. One would have had to live like a hermit in a cave not to be effected by it. I must admit that in 2000, I owned shares of Nortel for about 10 days when it was at $65, before I came to my senses and sold. Crowd psychology can draw you in even when you know at an intellectual level that it is a dumb move.

Holding on to stocks during a bear market must be the most difficult. I have not experienced it first hand but saw the effects on others. During the dot.com bear market I was selling short and buying Puts. I didn't make any money, in fact even though I had a number of profitable trades, on balance I still lost a little, but I did have more fun than those who stayed in long positions.

Alcan Update May 24, 2007

Further to my last post about Alcan, it has now jumped up above the $90.00 level. Now...does my forecasting method work or was I just a lucky coin flipper?

Alcan Chart