Investment Newsletter #12 (Nov. 14, 1999)
Tom Madell. Copyright 1999
How Long Can Up or Down Market Trends Continue?
One of the truly amazing features of virtually all investment markets is their tendency to persist in moving in a given direction long past what seems reasonable, and often, beyond most people's wildest expectations. As a result, an upward or downward trend, once established, can continue largely unabated year after year.One might easily reason that after several months, or even say a year or so, of experiencing prices having continually gone up, that those investors who had greatly profited would move toward the exits, while those looking for a buying opportunity would be frozen on the sidelines awaiting periods of significant declines. If so, sellers would easily outnumber buyers and prices would fall. Exactly the opposite might be expected happen if prices entered into say a 6 mo. to one year downswing. In this case, one might readily predict that market forces would soon begin to weigh in on the side of a turnaround to the upside.
This eventual reversal does indeed appear be a valid way of looking at the psychology of markets, but mainly over extremely long periods of time, say over 7 or 8 years or even more. But to make the assumption that such major changes of direction happen quickly is to vastly underestimate the staying power of a trend once in place.
An analysis of the psychology of investing shows that just the opposite often seems to happen over many periods of less than 7 or 8 years. That is, as a bull market continues, people tend to become more and more convinced subjectively that the assets in question are intrinsically valuable and the harder it is for even a succession of negative events to shake their faith. The same scenario seems to be true for flat or down markets, only in reverse; the downtrend often continues far longer than most people expect.
As a result of the buoyant optimism over these shorter, but still quite extended periods, those in the market are likely to stay invested and perhaps buy even more; those out of the market tend to reason that it's better late than never and decide to jump in anyway despite the higher prices. It is perhaps only through a traumatic event or a long series of market setbacks that the psychology of the market finally reverses its course and a long bout of pessimism finally sets in.
But maybe this isn't really as mystifying as it might seem. After all, in spite of what some market technicans might assert, the movements of the stock, bond, and other investment markets are not essentially governed by mathematical principles, but rather, represent the collective psychological judgments of the participants, either optimistic or pessismistic, as to how much the assets under consideration are worth. People usually do not readily change their way of thinking except when forced to do so by dramatic external events. So it stands to reason that once either a strong degree of either optimism or pessimism is bred, it's likely to stick around for a long time.
How This Applies to the Current Situation
Over the last ten years or more, I have heard many people say something like: "When stocks went above x,000 on the Dow, I decided to sell everything; at this level, stocks are just too high."But, as I have suggested in earlier Newsletters, the problem with this approach is that it's just too subjective and risky. (Here, I am defining "risky" as involving the risk that your will portfolio will leave you short of achieving your stated goals, such as a comfortable retirement.) And from what I've stated above, such an approach may fail to fully consider the surprising longevity of these long-term trends. Since no one can fully anticipate these trends which often seem to roll on much further than common sense would dictate, it would seem to be a fundamental error to make your stock investing program an all or none thing. That's why no matter how overpriced an investment might appear, you should never reduce your allocation to zero unless you are truly ready to cash out for good. You need to remain relatively diversified in all major investment categories no matter how high prices within some categories get, or no matter how low.
As a further consequence, I suggest you change your allocations to the various fund categories by no more than maybe 10 or perhaps 15% a year at most. So, for example, if your "normal" allocation to stocks is around 60%, I would almost never recommend changing it to anything less than 45% or more than 75% in a given year period and even that would probably be too much.
Just as the broad trends that control the mass psychology of the markets are very resistant to change, so too are often our own individual opinions about investing, or about a given category of investments. Once we develop a certain mind set, like, for example, that stocks are too overpriced, sometimes we just can't readily alter our opinion even in the face of otherwise contradictory evidence. So, if the stock market goes higher, that may only serve to strengthen one's belief that stocks are too expensive. (Also see Newsletter #7 for some information on how too much skepticism can often lead us to make choices that we will later regret.)
I do admit to having been fairly skeptical about large growth stocks for the last few years. But as I have suggested in earlier Newsletters, it is not very sensible to try to outguess the markets with the majority of your long-term investments; they should remainly solidly in place regardless of perceived over- or under- valuations in a given asset class.
That's why as skeptical as I have been about the large cap growth area, a large majority of my stock investments have remained in that area. As I reported in Newsletter #5 back in July, two-thirds of my US stock investments were still invested there, with most still invested in growth or growth-value blends as opposed to a focus on "value" funds. This has changed only slightly since July; I am now down to around 60% in the US large cap area with the remainder of my US funds in small and mid-caps. My foreign allocation remains unchanged at 40% of my total stock portfolio, all in large cap funds.