“THE ERROR OF OPTIMISM DIES IN THE CRISIS, BUT IN DYING IT GIVES BIRTH TO AN
ERROR OF PESSIMISM. THIS NEW ERROR IS BORN, NOT AN INFANT, BUT A GIANT.”
ARTHUR CECIL PIGOU
In the field of behavioral finance, there
is a phenomenon called “barn door
closing”. It describes the tendency of
market participants to do today what
would have worked yesterday—or last
month, or last year. The best currentexample is the massive flight to
perceived “low-risk” or “riskless”
assets (bonds and treasuries), which
fared very well during the market slide
of October 2007 through March 2009,
but which now have bloated prices
and rather dim prospects. Yields onT-Bills are essentially zero and the
10-year note yields 3.7 percent—both
far below long term averages.
Lately, a very common request is
an investment vehicle that is hypersensitive
to (and avoidant of) downsiderisk, even at the expense of a
considerable upside opportunity.
Undoubtedly, this desire was
precipitated by a decade during which
investors were stung—not once, but
twice—by severe bear markets. The
only other decade that stocks suffered such declines (losses exceeding 40
percent) was the 1930s. Pessimism
has clearly been born a giant in the
aftermath of the credit crisis. Even now,
with a market 63 percent above its
March lows, fund flows in 2009 indicate
that the investing public is still terrified of stocks and enamored with “low-risk”
assets like bonds and treasuries.
Year-to-date, U.S. equity funds have
seen outflows of $22.8 billion dollars,while $330 billion has poured into U.S.
Bond Funds, a trend which has only
become more pronounced towards the
end of the year.1 In the ever-shifting
risk tolerance of the investing public,
it is clear that right now investors would rather sleep well than eat well.
This surge into fixed income comes at
the end of a 25 year period where
bonds have beaten stocks in the
trailing one-, two-, five-, ten-, 15-, 20-,
and 25-year periods.2 Even a cursory
glance at history would inform these
investors that the worst time to invest
in an asset class is when it has had
such a long run of strong relative
returns. It is very likely that bond
investors are positioned at the wrong
end of a powerful mean reverting
cycle. At current prices bonds and treasuries seem to us more likely to
offer “return-free risk” rather than
downside portfolio protection.
Of course, the best investment policy
is one that looks forward not
backwards, but this does not stop investors from systematically making
market-timing errors. In a famous
study conducted by Dalbar, in the 20-
year period of fund flows analyzed,
market timing stock fund investors lost
an average of 3.29 percent per year
while the average investor gained just 3.51 percent. Compared to a market
that compounded at 12.98 percent in
the same period, these investors were
extremely unsuccessful.
Our opinion of stocks versus bonds
has been very clear cut all year—
in earlier commentaries beginning in
January 2009,* we have outlined why
2009 was a once-in-a-generation
opportunity to buy stocks and why
investors making large allocation shifts
away from equities and towards bonds
are likely making a very costly mistake.
We are fortunate to have access to
additional market data that helps put
the recent stock market into historical
perspective. The purpose of this study
is to analyze what types of stocks do well at various points surrounding bear
market declines in the U.S. since 1926.
Since we are sitting at tail end of a
severe bear market, the most pertinent
portion of this study is what types of
stocks perform well for the one- to three-year
period following bear markets. For an investor trying to build a portfolio with
good downside protection without
sacrificing upside potential, the behavior
of various types of stocks following
bear markets is interesting and
important information to understand.
This paper will begin by outlining the nine U.S. bear markets since 1926 and discuss what sorts of stocks performed well during and after those markets. During the nearly nine months since the March 9th market bottom, market trends have closely mirrored those of other severe bear markets. If history continues to repeat itself, the lessons from this study could prove to be extremely valuablefor the next two years.
To continue reading, go here.
(c) O'Shaughnessy Asset Management
www.osam.com
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