stock market ignorance

Friday's column advocated self-awareness. The stock market's movements seem to be meaningful, but their signals are spurious. Therefore, investment wisdom consists of learning to avoid the temptation to trade. The investor who acknowledges his ignorance is better off than the investor who does not.

A reader, Marvin Menzin, noticed. "Your advice implies that investors should buy and blithely hold. It ignores the possibility they might want to reduce your exposure because of excess stock-market valuations. I think it would be an excellent column if you were to address when investors should rebalance to lower-risk portfolios, especially when it's a retirement account and taxes are not germane. Investors are told to stay the course. The Titanic stayed the course!"

Well, Mr. Menzin, this is that column. Although I must confess, the "when" is exceedingly rare.  Since World War II, I can think of only one clear and obvious occasion when U.S. stock investors should have reduced their exposure.

To start: A portfolio's stock position should indeed be traded regularly, through mechanical rebalancing. If stocks perform well, such that a portfolio that was initially 60% stock/40% bonds becomes 70/30, then it's logical to return to the original allocation. After all, nothing changed from the initial decision.

Rebalancing, however, is more easily said than done, because while maintaining a consistent asset allocation makes economic sense, it's not much fun to implement. Selling winners feels good if stocks then decline, but if they do not, the opportunity cost can sting. Worse yet is the opposite situation. Mr. T had one word to describe how people feel after they buy equities when the headlines are urging otherwise, only to see stocks fall further. Pain indeed.

Thus, rebalancing is best done automatically: Establish a trading rule; follow its instructions devoutly; and suffer no regret if the transaction turns out badly. After all, the decision was the model's, not yours.

Unfortunately, I do not see how mechanical processes can guide investment strategies that are based on stock-market valuations. Those who have tried--most famously by using the Shiller CAPE P/E Ratio, which examines stocks' cyclically adjusted price/earnings ratios--have failed. Such measures work well in hindsight, but they have not been useful predictors. Their explanatory power has been academic rather than actual.

Historical Assessments

For 20 years following the conclusion of World War II, there was no judgment to be applied. Remaining in equities was the correct decision.

Then came 15 terrible years, through the mid-1980s, when the stocks were devastated by inflation. For that stretch, investors would indeed have done well to avoid equities. However, making that choice involved understanding the economy, not judging the level of equity valuations. It wasn't that stock prices were particularly steep. It was instead that inflation spiked far higher than it had been, and also far higher than it would become.

Since the early 1980s, stocks have crashed three times.

Two of those occasions, I believe, were almost impossible to anticipate. Black Monday in 1987 came out of nowhere; even in hindsight, it is difficult to understand why. The 2008 financial crisis, on the other hand, happened for well-documented reasons. But once again, the determinants were economic. Across the globe, banks collapsed and housing markets sunk. No stock-market indicator could have anticipated that.

The one occasion in which judgment served was during the "New Era," when technology stocks posted valuations that still exceed all subsequent levels. Sentiment was equally overheated. That truly was a time to slash one's stock-market exposure. Even then, though, the timing needed to be right. Those who sold equities in 1996 fared worse than those who stayed the course and held through the worst of the downturn.

In short, Friday's column overstated its case. Sometimes stocks do cost too much. But recognizing when that situation arises, and profiting from the knowledge, is a severe task.

-- John Rekenthaler