“I Can’t Remember A Time I Wasn’t Scared”

The title of this article is a quote from a highly respected investment professional, Martin Whitman, whom I met at a recent investment conference in Cancun. Whitman’s comments obviously concerned the risk in a market as overvalued as this one. Surely, many of our clients are concerned about these lofty levels, and this article will provide some information about our attitude toward the market and our strategy for your investments.

If we were to sell out of the market because we feel it is susceptible to a downturn, we would be practicing an investment strategy know as “market timing.” Of course, if we were to sell, we would also have to make a decision about when to repurchase. Two decisions are required, not just one. Market timers rely on a system of indicators to tell them when to sell and when to buy into the market.

There have been many studies done on market timing. Researchers have concluded that forecasts about where the market is going would have to be extremely accurate for market timing to work. We would have to be:

  • 80% accurate in a bull (up) market and 50% accurate in a bear (down) market, or
  • 70% accurate in a bull market and 80% accurate in a bear market, or
  • 60% accurate in a bull market and 90% accurate in a bear market.

Much of the problem with market timing is the way the market itself behaves. A large percentage of the total gain in a bull market tends to occur very rapidly at the beginning of a market recovery; secondly, it is extremely hard to determine when you are in (or about to emerge from) a bear market. To illustrate, a study by Trinity Investment Management Corp shows that:

  • 60% of the gain in the typical 41 month bull market cycle occurs in only 8 months, and
  • 3 to 4 months out of 10 are “up” months in a bear market.

Researchers have this to say this about trying to time the market: “The evidence on investment managers’ success with market timing is impressive – and overwhelmingly negative. There are tremendous natural odds working against them, and the risks of trying to time the market outweigh the rewards. There is probably no situation where caveat emptor is more apropos for the portfolio owner than in interviewing prospective market timing managers.”

On the other hand, if we saw certain “real” forces at work, we would decrease our exposure to equity investments. However, we do not see strong evidence which would indicate that we are on the precipice of a prolonged bear market – interest rates are relatively low and stable; prices, wages and inflation are not a problem; and corporate earnings continue to be good. In the long run, the U.S. lead in many fields (finance, technology, medicine and drugs, etc.) and growing worldwide consumer markets in which to sell our products (China and Asia, eastern Europe, and Latin America) suggest to us that we should continue our course for the time being.

Furthermore, we note that the 50 largest stocks in the S&P 500 accounted for more than half of the increase in the index, and the remaining 450 stocks rose an average of less than 10% in 1996. Obviously the major gains which are receiving all the press coverage were concentrated in a few large stocks. (The S&P 500 is a weighted index, and is more affected by the price movement in large stocks).

In the words of Charles Ellis: “The real opportunity to achieve superior results is not in scrambling to outperform the market, but in establishing and adhering to appropriate investment policies over the long term – policies that position the portfolio to benefit from riding with the main long-term forces in the market.” (Ellis, Investment Policy, pp. 22-23) This is good advice, which we will continue to follow.