Market-timing Proves Itself Again! November 21, 2008

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Sy Harding

Wall Street likes to suggest that investors can readily handle a bear market by simply selecting the right stocks or sectors, the ‘defensive’ stocks. That has never worked in the past, and did not in this bear market.

Even the best ‘stock-pickers’ in the world, like Warren Buffett, and mutual fund managers, were again unable to avoid the carnage. Buffett for example, is down 40% for the year. His undeniably superior stock-picking ability has almost the same loss as the market itself. (Buffett was also down 49% in 1999-2000). Can an ordinary investor hope to do a better job of selecting stocks or sectors than Buffett? I don’t think so.

The truth is that just like a rising market lifts most all stocks, as in the old market adage, ‘A rising tide lifts all boats’, so a declining market carries even good stocks down with it.

 For instance, the thirty stocks in the Dow, being diversified across the economy, as well as being substantial, conservative, dividend-paying companies, should be a source for the likeliest stocks to stand up against a bear market. Yet only one of the 30 stocks is up for the year, WalMart, and that by only 7%, hardly beating interest on cash. Those are not very good odds for coming out on top when the average decline of the others is 45%.

In a column last July titled Investors Need Facts From Wall Street Not Fiction, I wrote that “Constant advice to buy stocks only works in bull markets”.

Yes, people still have to eat, drink, take their medicine, and use electricity, even during economic slowdowns. So food, beverage, drug, and power companies may continue to have stable sales, and perhaps even growing earnings. But that does not mean, as Wall Street assures investors in every market decline, that those companies or sectors will be safe havens during a bear market. As I pointed out in my 1999 book Riding the Bear – How to Prosper in the Coming Bear Market, they never have been safe havens in the past.

The problem is that it doesn’t matter to the price of a company’s stock that people are still buying the company’s products, or even that the company is still enjoying impressive earnings growth. All that matters is how many years of earnings investors are willing to pay for, in advance, in the stock price (the price/earnings ratio).

In strong bull markets, investor optimism sometimes reaches a level of euphoria where paying even 40, 50, 60 times a popular company’s annual earnings seems to make sense.

However, as the market begins to decline on the other side of the constantly repeating bull market/bear market cycle, that previous “buy them at any price” optimism fades and begins to give way to increasing pessimism, until it eventually reaches an extreme of “I don’t want them at any price”.

So, if a company’s stock is trading at 30 times earnings and investors begin taking profits, it can soon be a case of that same stock selling at 15 times earnings. The P side of the P/E ratio has declined. And if the E side of the ratio has stayed the same the stock price has been cut in half.

The stock price will probably decline in a bear market even if that company has continued to be successful, even if its earnings have grown another 20%.  For instance, thirty times $1 of earnings equals a $30 share price. Fifteen times $1.20 of earnings equals an $18 share price, a 40% price drop even though earnings have grown 20%.

Abbott Labs (ABT) is a good example. Abbott has seen its sales and earnings grow every year since 1981, regardless of recessions or bear markets. So it is true, as Wall Street says, that people must take their medicines even in economic slowdowns.

Yet even as ABT has had continuous sales and earnings growth, its stock has not been immune to sizable declines in bear markets. That has been because in bull markets confident investors have been willing to pay as much as 27 times earnings for the stock, while in bear markets worried investors were willing to pay as little as 12 times.  So the stock fell 42% in the 1987 bear market (when the Dow declined only 36%). It declined 44% in 1999-2000, 48% in 2002, and 25% in 2008.

So, do think for yourself when someone recommends stocks or sectors they claim will do well even in a bear market. The odds are hugely against success with that approach.

The best, and perhaps only way to conquer a bear market is through market-timing. Yes, I know. Wall Street says the market can’t be timed, which is also aimed at keeping investors buying Wall Street’s recommended stocks.

But even a very simple timing strategy based on the market’s seasonality, and using just two trades a year, in and out of an index fund, has proven that claim to be wrong. It more than quadrupled the S&P 500 over the previous nine years to the end of 2007 (with no down years), and kept those gains. And now this year the market has given back all of its gains of the previous nine years.

And that strategy is saying that investors waiting until now to panic out may again be putting themselves on the wrong side of the cycle. After all, with this week’s additional panic selling this bear market has brought the price of stocks down more than any bear market of the last 70 years. And the bull market/bear market cycle has not gone away.
 

Sy Harding publishes the financial website http://www.streetsmartreport.com/ and a free daily Internet blog at http://www.syhardingblog.com/. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!