Friday, July 17, 2009

Stocks & Gravity

I think of the overall stock market returns as the equivalent of gravity for an investor.

On Earth, a person with a four foot vertical leap would be considered a world class athlete. On the Moon (with gravity at 1/6 the Earth's), obviously a person could jump a lot higher with no additional skills or effort.

The same is true for investing. From 1982-2000 suddenly even below average investors seemed to get good results. When a market goes up 10x everyone feels pretty smart. As an investor, moving from the 1966-1982 era to the 1982-2000 era was like moving from the Earth to the Moon. Investor "gravity" changed dramatically. Those that gauged their investment returns from the 80's and 90's without this in mind overestimated their talents.

"I would consider a year in which we declined -15% and the [Dow Jones Industrial] Average -30%, to be much superior to a year when both we and the Average advanced 20%." - Warren Buffett in his 1960 Partnership Letter

The -30% market return is, for investing purposes in the short run, that years functional equivalent of gravity. Sometimes over the short run, sometimes very much longer. So "leaping" twice as high as the, in this case, declining average is more than a solid performance.

"You make most of your money in a bear market, you just don't realize it at the time." - Shelby Davis

Being down -15% won't feel good with all those red arrows and paper losses but people felt great buying at the height of financial euphoria in 1999; the worst possible time to buy.

From an investor perspective, we have been back to the Earth's gravitational pull (and then some) for a while. When you have excess returns over a long period like 1982-2000 the following period is a painful process of normalizing returns. That process historically takes a long time. Whether it is, as Art Cashin says, a 17.6 year cycle or not, the relevant point is it usually take more than a decade. Mr. Market is a bit like Jerry Seinfeld, annual returns end up "even Steven", or around 7-10% annualized, over the long haul.

So the everyone feels like a genius market of the 80's and 90's has been replaced in the past 10 years with the I'm starting to feel like George Costanza market:

Kramer: "You're wasting your life! George: "I am not. What you call wasting, I call living. I'm living my life!" Kramer: "OK, like what? No, tell me. Do you have a job?" George: "No." Kramer: "You got money?" George: "No." Kramer: "Do you have a woman?" George: No. Kramer: Do you have any prospects? George: "No." Kramer: "You got anything on the horizon?" George: "Uh...no." Kramer: "Do you have any action at all?" George: "No." Kramer: "Do you have any conceivable reason for even getting up in the morning?" George: "I like to get the Daily News!"

No doubt we will eventually enter a period like 1982-2000 where everyone begins to feel smart again.

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in his book: A Short History of Financial Euphoria (Page 87)

Of course, many will probably actually believe it thanks to Galbraith's 20 years of financial memory.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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