Monday, February 09, 2009

Going against the flow

In the past four months there has been a record movement of funds inside 401(k) and IRA retirement accounts out of stock funds into "safe" bonds or money market funds. This move didn't happen before the plunge in stock prices of September, when it would have avoided the huge losses. Instead people sold their stock at the low price, essentially locking in the loss and missing the chance to take part in the recovery. The Hewitt Associates 401(k) Index indicates that in each of the last four months of 2008, 401(k) participants transferred nearly a billion dollars out of equities and into fixed income investments.

If you had moved your money out of stocks last summer, I would congratulate you on your unusual foresight. I've given up on trying to predict short-term stock market fluctuations years ago. Most people who try that game end up losing. In the ten years from 1998 to 2007, the S&P 500 returned 11.81% annually. "Safe" Treasury Bills returned 4.53%. The average 401(k) account returned 4.48%. People who try to "beat the market" or avoid down markets consistently do worse than they could do with a simple "buy and hold" discipline.

Today people are still doing the wrong thing. Two years ago there was a general agreement that stocks were a good buy, when stocks were priced at about $15 per dollar of earnings. Today stocks are "on sale" in search of buyers, with the price discounted to $9 per dollar of earnings. If stocks were a good buy at $15, shouldn't they be an even better buy at $9? I think so.

It is a mathematical certainty that $100 invested in stocks today will return more in the future than $100 invested two years ago. Historical data also supports my claim that today is a prime buying opportunity. Steven Leuthold studied the returns of stock bought at different valuation levels. He divided the initial price per earnings into deciles. Stocks bought in the top 10% of P/E lost 1.3% on average over the next five years, while stocks bought in the lowest 10% of valuations returned 19.3% annually, on average.

This should not come as a surprise to anyone who has heard the motto: Buy low, sell high.

Right now stocks are well below the average price per dollar of earnings. According to Leuthold, stocks bought at our current level of valuation have historically returned 14.1% over the next five years. Admittedly, it will take a majority of that upswing to recover the loss from the last year, but if you flee to safety now, you won't ever recover those losses.

"Buy low, sell high" is easy to understand but very hard to do, mainly because it requires that we not join in with the mania of the day. When everyone is abuzz about the killing they made in the latest craze, be it internet stocks, real estate, or tulip bulbs, remember that someone is going to be stuck with those when the bubble bursts, and you don't want to be that person. On the other end of the spectrum, when things look grim and the outlook for the future is doom and gloom as far as the eye can see, the emotional response is to get out. When you go with the flow you will always buy high and sell low.

Nathan Rothschild once said to "buy when the blood is running in the streets." But to actually do that requires a really strong stomach. In the late 1990's, people were buying up internet stocks, tech stocks, and telecom stocks with no regard for the fundamental value of the companies they were buying. The price per earnings of companies like Lucent Technologies soared as high as $300. Other companies were snatched up at even higher prices, and their P/E could not be calculated because they had no earnings. At the same time, the Asian stock market was in the tank, making today's S&P 500 look rosy by comparison. The Japanese index was down 80% in one year. Today Lucent no longer exists and most of the "internet" stocks are worthless, but investors who bought Japanese stock that year were rewarded with an average return of 21% annually for the next ten years.

So I am resolutely doing nothing. My retirement savings, what is left of them, are staying right where they are, and each week I continue to contribute eight percent of my paycheck to my 401(k), invested primarily in the same diversified assortment of stocks I have used for years. I am counting on a principle which has held true in the past: I don't know if today's stock price is high or low compared to tomorrow or next month, but it is certainly low compared to 2036, when I plan to start selling.


The Donald said...

D², is "buy high, sell low" tongue in cheek? After all, that's been very easy to do lately, not difficult.

As you point out, the best thing to do is to stay put if you're already in the market, and, if possible, practice dollar cost averaging.

Don Dodson said...

No, it was me getting mixed up. Thanks for the catch.

David H said...

I too have left my 401k alone; not so much due to my financial expertise as to my inability to know what else to do with it. In fact, I find it hurts less if I just don't look at the bottom line very often ;)