The wall next to my desk is, as they say, an "information-rich" environment,
featuring a dizzying array of charts, tables, and notes of
various sorts. (Mostly) constructive criticism from clients typically
finds
some wall space. Of course, being a parent, handmade art from
my children (Come Home Dad!) has a prominent place, as well.
One constant among this disparate collage of information, is a list
of somewhat unusual and thought-provoking statistics that I keep
positioned right at eye-level:
- 82% of people say they are among the safest 30% of drivers
-
80% of students think they will graduate in the top half of
their class
-
19% of people believe they are among the richest 1% of U.S.
households
As a professional, these statistics serve to constantly remind me
that it is very easy to become overconfident. While having a slightly
overconfident view of one's capabilities can often be beneficial
when it comes to daily living, it tends to work against us when it
comes to investment decisions. For individual investors, overconfidence
can lead to unhealthy investor behavior in a variety of ways, from
extending into areas beyond their circle of competence, to excessive
portfolio trading, or extreme portfolio concentration.
The drive to "outsmart" everyone else feeds into this
misperception of one's investment acumen. The reality, however,
is that lasting success is mainly due to factors of temperament and
adherence to classic investment principles, as opposed to raw intelligence
and mastering vast amounts of trivial data. An effective way to offset
the behavioral tendency to be overconfident is to maintain a balanced,
diversified portfolio that is appropriate for your own unique situation.
Overconfidence is bred in a variety of ways, but one common scenario
occurs when the consensus of opinion leans strongly in one direction.
There is comfort in numbers, comfort in being part of the crowd.
The problem, however, is that (almost by definition) consensus thinking
tends to lag, not lead, the market. Current opinion is typically
shaped through the news media's attempts to explain recent
(i.e. past) market action. Opinion is framed by what was: The markets
reward what will be.
Climbing The Wall Of Worry
Currently, investor sentiment remains strongly negative. As
is typically the case in the explosive early stages of extended
market rallies, the stock market seems to be climbing the proverbial "Wall
of Worry" as many investors remain skeptical of the recent
gains. In fact, according to the American Association of Individual
Investors (AAII) sentiment survey taken with only a few days left
in May, the percentage of individual investors with a negative
outlook for the stock market over the next six months was nearly
50%! This is the most bearish investors have been since early March
when the rally began. This level also ranks among the top 5% bearish
sentiment readings since the beginning of the AAII survey data
back in the late 1980s.
Though a popular view, this extremely defensive market sentiment
actually suggests that enterprising investors should have an optimistic
outlook for the next twelve months. Studies of investor sentiment
by Ned Davis Research show that when investors are excessively bearish,
the stock market typically generates an above-average return over
the next twelve months. Conversely, when investors are displaying
excessive optimism, the market tends to produce a negative return
over the ensuing year. When investors are neutral, the market produces
below-average, though positive, returns. In short, when the majority
of investors agree with your outlook, rather than being confident
and comfortable, you should be wary and questioning.
There is one more interesting item about current sentiment. While
the level of investors negative on the market is clearly elevated,
the number of investors positive on the market is basically at the
long-term average, the difference is that level of investors who
say they are neutral on market direction is near it lowest level
ever. Given this sharp polarization in market outlooks, we expect
that volatility in the stock market will remain elevated.
Stay the Course
This said, our own outlook is not as favorable as it was three
months ago. The market is no longer very cheap, as it appeared
to be in early March. It is no longer vastly oversold. Earnings
estimates and guidance are no longer being relentlessly hammered
down.
In addition, the dollar is falling and interest rates on long-term
Treasuries are rising. Such behavior in these markets is typically
not considered to be stock-market-friendly. I believe this behavior
is driven less from a returning appetite for risk, than from a dissipating
appetite for safety. U.S. Treasuries and the U.S. dollar are often
seen as safe havens during times of extreme market stress. The "flight-to-safety" trade
that dominated 2008 appears to be in the process of unwinding.
Regarding corporate earnings, we remain in the camp that growth
for 2009 is going to be fairly positive on a year-over-year basis.
However, we still have plenty of concerns about this view. One interesting
item from the economic data released late in May was embedded in
the University of Michigan Consumer Confidence data. Even though
confidence surprised sharply to the upside – and over-all consumer
confidence is often a leading indicator of consumer spending – there
was one notable item that concerned us. Expectations for income
growth (+0.2%) are the lowest they have been in the history of the
survey,
dating back to 1948. It seems hard to reconcile that view with
the notion that consumer spending will return to anywhere near the
levels
it did earlier in the decade. It also puts a pinprick in the
balloon of rising inflation fears that seems to be on the mind of
many investors.
In forming a long-term view of the market, valuations
are critical.
While short-term market calls based on valuations are dicey,
over periods such as ten years, stock market returns have
a strong connection
to what valuations were at the beginning of the period.
Though valuations are still fairly attractive, the 40% rally
in the S&P 500 off
the March 6th intra-day lows has squeezed some juice out
of future return expectations. The normalized price/earnings ratio
was just
above 10 in early March (its lowest level since 1982),
but at the end of May it was quickly approaching 15. While this is
still approximately
25% below the 50-year average, it's simply not as attractive
as it was a few months ago.
Given this mixed bag of disparate market factors, what should investors
do? As you can probably guess by now, our counsel is the same as
our antidote to overconfidence: stay the course with a balanced,
diversified portfolio appropriate for your situation. There are always
cross-currents swirling in the economy and markets. If you are in
the market, stay in. If you are currently out of the market, we recommend
that you set up a plan to become involved.
Set It and Forget It?
For the most part, this entire article has been a roundabout
way to answer the most common question we get these days: "Is
buy and hold investing dead?" (Some now derisively refer
to that strategy as "buy and hope.")
That depends on how you define "buy and hold." Does buy
and hold mean having a long-term investment plan? Does it mean finding
and maintaining a strategic mix of assets that has the right balance
of growth potential and portfolio stability to accomplish your specific
objectives? Does it mean controlling portfolio activity to minimize
both direct and indirect costs?
To me these are key attributes of long-term -- otherwise
known as buy and hold -- investing. These attributes have
worked well in
the past and I believe they will continue to work well in
the future.
The problem with the concept of "buy and hold" is really
the word "hold." One shouldn't simply "set
it and forget it," as Ron Popeil used to say in his infomercials.
Being a long-term investor does not mean buying something and then
never monitoring the position again, or not correcting or adjusting
a situation where action may be required. Instead, a successful long-term
investment approach should be called something more along the lines
of "plan, invest, monitor and adjust." Not quite as succinct,
as "buy and hold," but something I think worthy of putting
up on my wall, nonetheless.
Sincerely,
