Was That a Bottom? Should We Even Care?

Was that a bottom and should we even care? Maybe, maybe not. We don't know and no one else does either. At least not today.

Nonetheless, it's tempting to say that Tuesday's intraday low of 1200.44 for the S&P 500 certainly looks like the trough--for the moment. Yesterday's bounce skyward already has some pundits speculating that a return of the good ole' days is imminent. And, of course, there's a few select bits of news to support that notion, including a sharp drop in oil prices, a confidence-boosting announcement for the battered financials by way of a dividend hike for Wells Fargo, and some better-than-expected news on business conditions for three stalwart names in the Dow Jones Industrials.

Of course, we could easily counter the upbeat reports with bearish ones. In fact, that's always true. There's never a shortage of reasons to worry, or to hope. Depending on your mood, you can find corroborating evidence to support the forecast preference du jour.

Alas, there's virtually no chance of calling bottoms or identifying tops, at least not in advance, or ex ante, as the academics say. The rear-view mirror, on the other hand, is always reliably lucid. No wonder, then, that looking backward tends to have an oversized influence on investor sentiment today. The problem is that the past, sans an informed and thoughtful historical perspective, is of little help to the strategic-minded investor.

Indeed, developing strategic perspective is an unnatural act for the human species. That's not to say that it can't be learned. But the path of least resistance is one of extrapolating from the very recent past as a basis for anticipating the very near future. That may work for traders and sail boat enthusiasts checking the weather at sea, but it's bound to lead you astray eventually when it comes to finance.

For those with an investment horizon of considerable length--five years or more--there's a better way, or certainly a way that's less prone to egregious error. The better path starts by admitting that the 14 oz. mass of tissue within our craniums isn't normally suited to thinking strategically. Tactical notions are more its style. Exhibit A is the rush of pleasure most of us get when we buy or sell when doing so with the crowd; or, the pain we suffer when we act alone.

Volumes have been written on how investors are at risk of becoming their own worst enemy when it comes to strategic thinking on matters of investing. We won't belabor the point here, other than to remind that the intersection of human psychology and money is a broad and rich field of study that's dispatched a sea of insights into how Mother Nature has left us high and dry for thinking prudently on matters financial. (For any one who's curious about behavioral finance, here's a solid overview of the literature.)

Reprogramming our heads for winning the investment game isn't easy, nor is it clear that there's a solution per se. More than 50 years of research in financial economics has taught us much about what works, and doesn't work in money management. But there are still no guarantees, and much of what we've learned has application only for long-term investing horizons. In many ways, we're as clueless about the short run as we've ever been, although that doesn't stop many from asserting otherwise.

As for the basic strategic lessons, it all boils down to:

1) Diversify broadly, across as many asset classes as you can reasonably and efficiently own; if you're not sure about how to weight and choose assets, Mr. Market's asset allocation will probably fare modestly well over time.

2) Minimize trading, reserving it for those times when your confidence about the future is relatively high. If you don't have much confidence about weighing the odds for what will happen down the road, then rebalance your portfolio every year or so, or perhaps more frequently when markets move dramatically. This advice, of course, requires a solid asset allocation benchmark as a basis for rebalancing. Not sure how to proceed? See item 1 above.

3) Keep expenses low, which is to say favor index funds as a general rule unless you have a deep conviction otherwise. But for most investors, passive investing will do quite nicely, even though it won't win the horse race.

4) Stay focused on the long run. Alternatively, if you don't have a long-run horizon, act accordingly with risk allocations.

If you're inclined to be active in your portfolio decisions, start by looking to take advantage of extreme moments on an individual asset class basis. That requires patience, since extreme moments, by definition, don't come along every other Tuesday. That said, if stocks are selling at high valuations, pare your exposure; if they're selling at relatively low valuations, raise the equity weight in your portfolio. The same concept also applies to the other asset clases. In sum, be opportunistic, but neither chase performance or fall into a perma-bear state when prices slump for an extended period. And when you do rebalance, look to roll out the changes over the course of a cycle so that you don't bet the farm on thinking we've identified the bottom, or top, in real time.

Recognize, too, that almost everything we've learned about strategic-minded investing is less about boosting return than it is about lowering risk without paring much, if any return.

Finally, try not to get caught up in the tick-by-tick mentality of trading. We humans are highly vulnerable to what's happening now, this minute, this second. And we like to judge our success, or failure, based on what happened in the previous week. It doesn't help that we like to mingle with other investors at cocktail parities and compare notes. No, we're not suggesting that we all become monks and cancel our news subscriptions and real-time data services. But strategic success will require some compromise and concession, and that includes giving up some of the entertainment that comes by watching markets in real time.

A little common sense, in other words, is also necessary for strategic success. Perhaps there's some hope of investment victory after all.

Comments

[peterthepainter]

way to go. right on bro. John Authers said something essentialy in agreement last Sat.
www.ft.com/cms/s/0/79a...

[scimitar]

This is how you build lasting wealth - not by day trading or getting the "hot stock tip" (and buying in at the top), but through simple, boring techniques that most people have heard of but few actually practice.

There's a reason Buffet bet big on index funds against the flashy hedge fund managers - index funds work, and they are cost effective. The number one rule of investing is to keep costs low - that will ultimately determine more over the long run than anything else.

[morgan77]

I agree completely with Mr. Picerno (and scimitar). In this current market, this may be a time for people to learn how to become an investor, not a trader. Here's a podcast about monitoring the conditions and staying in cash until you can find a stock that is fundamentally solid in the long term- www.greenfaucet.com/sh.... Maybe people learned yesterday not to be complete momentum traders as nat gas and crude tanked.

[MuddlingInvestor]

Just a reminder from John Maynard Keynes: "In the long term we are all dead"... And from Jim Cramer: "Pigs get slaughtered".
Not mentioned in this article, and in scores of others: investor have to review his/her portfolio all the time. Buy and hold can get you wiped out too. And overly broad diversification can reduce your earnings to the level of 3 year CD. As well as dumb rebalancing.
One note on Buffet: he's made significant amount of his money on arbitrage. His investment/trading strategies are much more complex than financial press wants us to believe.

[theoakman]

in the long term we are all dead. But our children are alive and their children will be too. Keyne's policies only allow us to sacrifice our children's future for our own benefit.

[ignorant]

I though it was pigs get rich and hogs get slaughtered. In any event, CNBC and the rest of the financial media would not be in business if they did not pretend that their guests could predict the future. Well let's see, to predict the future we need to predict terrorist events, energy prices, financial bubbles, political events, climate changes- on and on for the rest of the one million variables in the equation. My only prediction is that mankind will somehow muddle through to solve problems and make some small advances.

[contender]

I contend that in the year where crooks like gs and the NYSE can operate opaquely, where the financial institutions can make up their own rules as they go along and create vehicles that could destroy the financial system, retirement savings, and well-being of a whole country or world, where the treasury secretary (aka GS) can openly buy shares to prop up failed businesses with /the small investors' dollar/, that there is no place to hide.

The manipulators kill you in the short run -- the dollar inflators and government liars kill you in the long run.

Small investors dont know about hedge funds because they are not allowed to benefit from them.

I want a system where uncle sam bears my risk, and I get the profits.

[MuddlingInvestor]

to contender: "I want a system where uncle sam bears my risk, and I get the profits."

Start a bank, make it as big as possible. Case in point: Bear Stearns.

[inthemoney]

Buy and hold index fund? Just hearing this makes my blood boil.I f you were not investing before 1999, and you were investing in an index fund every month in your 401K after 1999 , your return would've been very close to zero at this point, taking into account inflation.
They say S&P returns average 7% and I tell you, - show me the money. Where is this 7%?
The only thing that worked last 7 years was emerging markets and then commodities. Now, when US equity is getting close to being oversold it makes sense to buy it at some point. If you just bought S&P500 fund and you are hoping it will provide your retirement, stop dreaming, it is not going to happen.
I think with the advance of technology and internet , the market has become much more efficient. So, to take advantage of it, one has to be flexible and quick.
Index funds only work for those who have no idea about the markets (like people with 401K) and so unable to choose appropriate investments for themselves. But they are not going to average 7% anymore, no way.

[docmike]

Agree about S&P 500 being flat. It is - USA has a mature economy and it is not going to grow rapidly.

That said, I would not give up on "index funds-like" investments alltogether. VWO or EEM - emerging market ETFs - did much better than SPY and will probably do better for years ahead. VB - US small caps ETF - will probably beat SPY as well.

Sector funds, country ETFs, asset class ETFs - I believe they do have a place in a good portfolio.

Disclosure - long VWO, VB.

[contender]

Nahhh I want a mortgage guarantee outfit, where I can use $50 as collateral (we wont say anything about the good faith of our co-conspirators) and guarantee everyones mortgage... for a small fee, of course !

If you know the right people you'll get the support of the whole population !

[User 228118]

Muddling Investor: AMEN Brother!

[xmplary]

I don't know if it was the bottom, but I'm glad there's a stop on naked shorting. It was being used for nothing, but to steal steal cheap shares from weak hands.

[WeeklyWealthLetter]

OK, we've made oodles by short-selling AIG, GM, MER, FNM and FRE. Now what looks interesting on the long side? Let's start with some appetizers... HA, ERIC, OZRK, NOK, CALM, OSK, FCSX, KEY, LEA and TEN. More next week. Stay tuned...

[truthinvesting]

if you buy KO MO PM RAI KFT UST MSFT PFE you will outperform and have great dividend income as well.

[rank17]

RE 'Muddling investor' and his reviewing/rebalancing comment - good advice, though as a criticism it applies more to direct stock portfolios than funds/ETFs where the ongoing index rebalancing occurs internally.
Constructing a simple portfolio via ETFs can work well.
For those looking for a secure strategic approach (which is the gist of James' article), why not set aside, say, 20 per cent of your investable balance for active/tactical/tradin... positions and then focus on a strategic portfolio approach with the balance. This 80 per cent rump can have a simple allocation (say, 60% US equities (assuming this is your home market), 20% overseas (which could be split 50/50 on a BRIC/developed basis) and 20 per cent yield (bonds/money market)).
Rebalance according tho market risk (ie over the past six months you would no doubt have de-weighted equities, re-weighted bonds). For what its worth i'd be back onto the core portfolio balance after the past weeks action. To give a feel - I wouldn't anticipate rebalancing this for another 3-6 months.
Re the 60 per cent core equities, you can rebalance between subsectors on a regular basis (i'd be 30 per cent financials, 30 per cent tech, 20 per cent transports, 20 per cent mining/oil going into this week).
Just a thought.

[najdorf]

inthemoney: I don't think you understand the argument for indexing. You seem to think that an efficient market means you should trade and somehow leave the boring old index fund behind. Now, how agile and efficient are you? What percentage of the companies in America do you have in-depth knowledge about? How quickly do you assimilate relevant new information? How easy is it for you to change positions, and what does it cost you in expenses?

In all of these areas, you are behind a professional trader - and even the professional mutual fund guys don't beat the market after expenses! What edge do you have that will allow you to use trading to beat the index? Remember, the more efficient the market becomes, the harder your job gets.

You also don't know what average means. Average means that sometimes you do better and sometimes you do worse. The years from 1982-2000 have to be balanced by some bad years at some point. You can whine about how you missed the good times or you can look for the next opportunity, but let's not pretend that the stock market wasn't a good enough investment between 1982 and 2000 to make up for some medium-term suffering that we're in the midst of now. The 7%+ returns are in our parents' and grandparents' accounts. We may have to wait a long time to make the same sort of returns.

The index fund looks terrible in the last 10 years because stocks were vastly overvalued in 1998 and the economy has been pretty lousy in many of the years since. Active stock trading strategies look equally bad and in many cases even worse (tech funds, individual investors who bought on 90s tips, LMVTX, etc.). If you want to give up on stocks, I'd be happy to take yours off your hands at a low low price. But you should probably read a history book about the 40s or the 70s before you decide that U.S. stocks are in permanent decline.

[mkttrdr]

Many good things have been stated here.
Facts vs figures-please.

Fact-pigs get fat and hogs get slaughtered.
Fact-stocks in general have gone no where since 1999 bubble bursting. The market treand is your friend, which is now sideways to down.
Least we not forget going back to the start of the longest bull run which ran from 1982 to 1999.

Gee I guess I am right again -economic cycles average 17 years. Thanks again RR.
IE-I'll keep trading sideways in this bear cycle -both up and down until 2015, when the pattern will return to up agian.

Technology advancements will create a new boom cycle then(2015)-what is it?-robotics will be near perfect and affordable. Man gets displaced slowly.

The only constant in life is CHANGE.
Learn to adapt to survive.