As I read the financial media these days, the conversation seems to have largely shifted to the following two topics. 1. When will the stock market correct (or crash)? 2. What should investors do now? That second question is naturally defined by the particular author's answer to the first. Authors who believe a crash/correction/bear market is imminent are inclined to bail out immediately. Those who believe a bear market is still likely a ways off are more inclined to stay invested. Notice this first question is a matter of when, not if. Everyone should recognize that this bull market will peak and yield to the next bear market at some point. On this there can be no argument — there is no such thing as a perpetual bull market. As surely as night follows day, this bull will eventually be followed by a bear. The question is when. And what should you do until then. Austin's post from yesterday hints at SMI's response to the second question:
Following the plan means staying the course. Usually you hear me preach that during the bad times, but it applies to the good times as well. Sometimes that can be just as emotionally challenging.

At some point in your life, someone has probably asked you, "Do you want the short answer or the long one?" I'm going to give you the blogging equivalent of that today. First the short answer(s): Nobody knows when this bull market will roll over into the next bear market. Because nobody knows when, the best course of action is to follow your long-term plan. Feel free to stop right there. That's really what you need to know. But for those with inquiring minds, let's run through some questions and answers.

  • Why does everyone seem so hung up on whether the stock market is in a "bubble"? Mainly because we've watched other bubbles inflate and end badly recently. At least some of those (some would argue all of them) have been driven by Fed policy — low interest rates inflating asset prices, like stocks in the late 1990s and house prices in the 2000's. And the Fed is at it again, keeping interest rates at sub-market levels five full years into the economic recovery, with the apparent intent of pushing much of the free cash in society into the stock market (by making other options so unattractive). As this MarketWatch blog post points out, it's not as if central bankers have a lot of other options to help the economy right now. So it's pretty much stick with this a while longer or do nothing to try to help (which many of us would prefer, but that's another issue).
To some, delay does no more than store up bigger problems for the future in terms of potential asset bubbles. But to ourselves, delay is appropriate. We don’t disagree that liquidity that’s primarily funnelled into assets, like stocks and housing, rather than the real economy, could create a bloodbath but, to a significant extent, policymakers have little option but to try to create asset-price-related wealth effects given that policy rates can’t go any lower and fiscal policy is tapped out as well. The only other option to lift growth would seem to be to gain competitiveness through currency depreciation but we all know that’s a zero sum game
  • So does that mean the stock market is in a bubble? Some people sure think so. Brett Arends, whose work I almost always find interesting, points to long-term measures like the "CAPE" (or Shiller) price-to-earnings ratio and "Tobin's Q" ratio as definitively pointing to stocks being significantly overvalued currently. Both of these measures seem to indicate that returns from these levels aren't likely to be very good over the next several years to a decade. His assertion is that, using long-term valuation measures like these, a person can successfully (if not roughly) time the market by simply getting out when these measures get too high, and buying back in when they drop during/after severe bear markets. A few comments on that idea.

    First, it may surprise you that I don't think that's crazy. The market does move through the type of long (secular) bull and bear market periods Arends describes. The chart of 10-year inflation-adjusted returns he produced (above) shows clearly that the markets aren't "efficient" as most people understand the term. They get massively expensive as investors get overly optimistic, then fall dramatically and/or stagnate until investors get overly pessimistic and they cheapen again. The problem with Arends' approach is there probably isn't one investor in a hundred that can successfully execute that type of long-term market-timing approach. Think about what it requires from an investor emotionally. It basically is asking an investor to determine, at a time like we're in now, if the market has advanced far enough to warrant selling their holdings. It then requires them to sit idly by while the market potentially goes much higher. It then requires them to wait until the next big bear market (think 2008), at which point it requires them to load back up on stocks - at a time when they may well be losing their job, the economy is in dismal shape, people are talking about the next depression, etc.

    Realistically, most people aren't going to be able to handle that type of approach. But if you squint just right, the idea behind it is similar (just dramatically scaled down) to what I've encouraged some retirees to do to help manage their portfolio selling to cover living expenses:
The ideal situation for a retiree generating income from a mixed stock/bond portfolio would be to sell stocks only at peaks in the stock market, thus getting top dollar with every sale. Unfortunately, identifying the absolute high and low points of the stock market isn't realistic. It's simply too difficult to do. However, it is reasonable to recognize that along the market's long-term upward path, it takes many detours both up and down. This volatility presents an opportunity to the retiree who is prepared for it. This is done by combining a money-market account (MMA) with your stock/bond portfolio. By putting three years worth of living expenses into the MMA initially, the retiree doesn't need to sell any long-term investments for income unless they wish to, that is, unless an attractive market opportunity presents itself. (Establishing a four- or five-year fund, if you can afford it, would provide even greater flexibility.)

The amount in the MMA will fluctuate between zero and the full three-year amount. During times of poor stock market performance, living expenses would be drawn from your MMA rather than selling any of your stock holdings. This might last for a year or longer. During periods when the market has been doing particularly well, selected stock holdings could be sold and the proceeds placed into the MMA, bringing it back to full strength. Since the market tends to have significant peaks and valleys every three-to-four years on average, it would be rare that a retiree would ever need to sell when stock prices are poor. And even in those events, the sales would occur only after the MMA had been exhausted, meaning fewer sales took place than would otherwise be the case... -The Retirement Investing Challenge

The other primary problem with Arends' approach is that even if you're right that the stock market is expensive, the market can keep going a whole lot higher before you're eventually proven right. These indicators would have gotten an investor out of stocks in the mid-90s, with huge gains still ahead. Ultimately proven correct, but way too early.
  • But isn't investor sentiment also pointing to a stock-market bubble? By some measures, it seems to be. Anthony Mirhaydari thinks it's time for traders to sell, noting "Jason Goepfert at SentimenTrader notes that the sentiment of newsletter writers like me has reached levels that haven't been seen since at least 1997, active investment managers are carrying their heaviest load of market risk in seven years, and the ratio of assets in Rydex's bull and bear funds has reached levels preceding the last three market corrections." Others point to the fact that investors have poured $106 billion into stock mutual funds so far in 2013.

    Of course this ignores the fact that over the past five years, even after accounting for these recent inflows, investors have withdrawn $309 billion more from equity funds than they've put in. This helps explain how, despite this year's purchases of stock funds, Blackrock could release poll results this week showing that among U.S. investors, 48% of investible assets were being held in cash, with just 18% in stocks and 7% in bonds. These are hardly the type of numbers that scream "bull market peak," regardless of how optimistic the pros are.

    If you've been a blog reader for long, you've seen me explain that bull markets don't typically die until monetary policy tightens (see here and here for examples). That definitely is not happening yet. Jon Markman, another long-time favorite of mine, reported this week on a new study showing that the two most common factors related to significant (15%+) stock market corrections were a sharp rise in crude-oil prices and Fed rate hikes. Neither of these are happening now. That doesn't mean a sharp correction couldn't happen now, it just means that neither of the two factors most prevalent in those historical situations are present currently.

    He also makes the point that while P/E multiples have expanded quite a bit this year, "as long as [economic] growth outpaces inflation, price/earnings multiples will continue to expand." Is sitting tight really the best thing to do? Yes! (I like getting to make up the questions.) Unless your plan calls for you to make changes, don't be swayed by the talking heads. They don't know if this bull market has two more weeks or two more years left in it. Better to follow a mechanical strategy, like Upgrading or Dynamic Asset Allocation (DAA), which will pick up changes in the market as they actually occur, rather than trying to guess in advance when they may start. That won't keep you from ever experiencing losses, but it will help you stay invested. And those who stay in the market typically do better than those who try to time it, even though some short-term losses are inevitable when you take the "always in" approach.

A word of encouragement

When I was looking at some different things last month, I ran the total returns for the new DAA strategy from 1996 through the end of September 2013. This period included two horrible bear markets (2000-2002 and 2008-2009). An investor who had simply kept things on autopilot and stayed fully invested through both of those bear markets would have still earned 12.3% annualized over the entire period. Those are fantastic results, without the worry of making any broad market-timing decisions. An Upgrader who did the same thing fared nearly as well, earning 9.8% annualized (in an environment better suited to the defensively-oriented DAA).

Yes, by some historical measures this bull market looks overextended. It has been a long time since we've had any kind of correction, and one could be in store. Eventually this bull market will end and a new bear market will arrive. But this bull has been driven by extremely powerful Fed stimulus, and as we saw in the late 1990s, that can cause bull markets to run longer and higher than anyone imagines. But even if that turns out to be incorrect, I'm confident Upgrading and DAA will help those SMI readers who stick with them to survive the next bear market just fine. And by staying invested, will be positioned to take full advantage on the other side.