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Worried About Stocks? This May Be A Blessing in Disguise

The Implications for Investors of 28 Years of Declining Interest Rates

Worried About Stocks? This May Be A Blessing in Disguise

Summary: Most people are currently worried about the potential for more losses in stocks in the future. However, data presented below show that dire appraisals and apprehension during the worse 9 periods for stocks (bear markets) over the last 50+ years proved to be completely wrong. The data show that if, rather than halt or withdraw stock investments, starting Jan 1 of the calendar year after at least a 20% drop in stocks has been recorded one put money into the typical stock fund, your annualized total return over the next 5 years would have been quite good. (This includes investing during the most recent 2001-2003 period when investors were also extremely gun shy on stocks.) But, to the contrary, had you invested in stocks during the recent bullish years of mid-1997 to 2000 and 2004 to 2007, when very few people were worried and most were quite willing to invest, your 5 year returns would have been not only poor, but almost solidly negative.

It appears, then, that our feelings of being scared of stocks arising from bear markets and confident of stocks during bullish markets only seems to be warranted by real subsequent returns over the short-term. Based on data going back to 1957, at least, the appearance of a bear market always has turned out to be a good time to consider increasing your investments in stocks. However, given the cyclical nature of stocks ups and downs, whenever stocks have been doing above average for about 5 years (eg 1995-2000; late 2002-late 2007), investors should correctly become apprehensive and begin to reduce their stock commitments.

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Bear markets, above all else, test investors' resolve. It is especially during extended market drops lasting more than one year that investors can succumb to such an extreme level of pessimism that they will likely no longer continue to invest regularly, or continue whatever their prior strategy might have been.

This will likely hurt, rather than help, their returns in the future, assuming they are interested in getting good returns for the long term. Needless to say, bear markets can cause many people to leave the market. And once they do, they may take many years, if ever, to come back.

As a public service provider of free investment advice, our Newsletter has always aimed to share with you recommendations that, when looked back upon, will have proven to be above average. This is especially true during periods of extreme investment anxiety, such as now. While we can't say anything with certainty, what we most often have tried to do is to present data showing how what has happened in the past gives you some idea as to the odds of making good decisions now. This is as opposed to what appears to be merely expressing opinions based on what is sometimes called "the dismal science" of economics, or worse, opinions that do not appear based on any empirical data at all - eg "I think that ..." without indicating what data there is to back it up.

The problem with relying solely on economics is that no matter how astute the analysis, there are so many variables affecting investment performance that, likely, no one can predict how things will turn out. That is why we like to look at investments mainly in terms of higher vs. lower probabilities of favorable outcomes, all within the context of a diversified investment portfolio.

If you are like most people, you are probably avoiding making any decisions about your investments during this time of crisis, if for no other reason than fear and uncertainty. We think this is probably one of the smartest moves the average investor can make at this particular time.

While as of this writing, neither selling nor buying seems to us to be a particularly wise strategy, if we had to come down in favor of one, we think that looking to gradually add to your stock portfolio is the way to go. We are tempered, however, in that we think there will be many better buying opportunities within the next 3 to 6 mos., so there is no rush to be a buyer, any more than anyone should be tempted to rush to sell in the event of even more dire warnings of severe trouble ahead.

"Safe" moves into relatively risk-free investments may indeed be safer than the stock and bond markets for the next year or so. But if you consider the data we present below, and if you are investing for results not just over this period, but for the next 5 years or more, we think that serious consideration should be given to taking advantage of the current crisis to lay the foundation for above average future gains.

While the typical forecast now is for a protracted recession, perhaps lasting for about 2 years, virtually no one whose opinion I respect is calling for a "depression". Even a prolonged recession is hardly unprecedented, and will not lead the average responsible investor, retiree, or homeowner to go broke. However, that's not to say that it won't cause considerable hardship to many. But the economy should eventually emerge healthier, as financial prudence becomes more the order of the day than spending money on things that are not at all necessary and are only available by means of excessive borrowing.

I believe it makes little sense to assume the worst about the state of the economy and your investing in the years ahead, especially if you do not need to tap into the majority of your investments for at least 5 years.

With that in mind, here is how I propose you might consider reacting to the current crisis.

Why Feelings of Apprehension Are A Poor Guide When Making Investment Decisions

During the years 1997-2000 as well as more recently during 2004-2007, many people were convinced it was a good time to invest in stocks. Why? Because when taking into account how well things had been doing over at least the prior year or two, they were induced into a sense of confidence which they projected out into the future. In other words, they were largely swayed by relatively short-term past performance. As a result, they also felt a relatively high level of psychological comfort. And the longer that past performance remained positive, the more seemingly "rational" and comfortable making stock investments appeared.

Right now, though, we have the exact opposite situation. For the last year, one can't help but be aware of the market's almost unprecedented horrendous short-term past performance. And almost all economists are projecting that the situation here in the US, as well as worldwide, will continue to get worse. Thus, the prior relative confidence and psychological comfort level of investors has been decimated; many are scared of remaining invested at all, no less of making any new investments.

Taken together, if one accepts the seeming sensibleness of such thinking and the accompanying emotions of either comfort or fear, it suggests that most people tend to both rationally believe and emotionally experience that the best time to make investments is when the market is doing well. And the worst time is when things are falling apart, like now.

While this belief, and its strong emotional component, seems to make sense - why shouldn't we be normally be guided by our current opinion and sentiment when we are determining how to think, act, and invest - surprisingly, it does not appear to be confirmed as a guide when we look at the market's actual past performance patterns.

As we look back over the last 10+ years, whenever investors thought it relatively a good time to invest, it turned out not to have been so. The following two tables show what happened 5 years after investing in the S&P 500 during consistently preceding psychologically-comfortable investing periods:

Table 1. Poor Results Investing When the Comfort Level Is High (1997-2000)
For Investments Begun on Date Shown ...	... the 1 Year Prior Total Return BEFORE Date ...	... the Resulting 5 Year Annualiz. Total Return AFTER Date
Oct 1, 2000	13.28%	-1.49%
July 1, 2000	7.24	-2.37
Apr 1, 2000	17.94	-3.16
Jan 1, 2000	21.04	-2.3
Oct 1, 1999	27.80	-1.31
July 1, 1999	22.77	-2.2
Apr 1, 1999	18.64	-1.2
Jan 1, 1999	28.72	-0.57
Oct 1, 1998	9.05	+1.0
July 1, 1998	30.15	-1.61
Apr 1, 1998	48.00	-3.77
Jan 1, 1998	33.36	-0.59
Oct 1, 1997	40.44	-1.6
July 1, 1997	34.71	+3.36
	Avr Prior 1 Yr Return = +25.21%	Avr Ann. Return After 5 Yrs. = neg. 1.25%

Table 1 shows long-term investment results made during a long stretch when the prior year's investment results had been good. In fact, investment results had been excellent going back until the early part of 1995. But, no matter when you invested between July '97 and Oct. 2000, the long-term result over the following 5 years was poor although this period might have been good for short-term plays in the market IF you were able to get out in time (most people weren't able to).

Thus, in spite of strong beliefs, positive feelings, and even enthusiasm people had about investing built up over at least a year, returns for investors 5 years after making such investments were consistently poor.

Note: In presenting this article's results for the S&P 500, we are using the Index as a proxy for most stock investments. Of course, there were some categories of fund investments that did do better than the S&P 500, something we have focused on helping investors discover going back to this Newsletter's first issue in 1999.

We can now see that the exact same pattern was repeated beginning in 2004. In spite of being induced into a relatively high degree of psychological confidence by relatively good returns for at least a year prior to investing, we now know that all of investors' long-term efforts made during this period were for apparently for naught: The S&P 500 is significantly lower than it was no matter when you invested during last 4 years. (Of course, over the next few months, or more likely, years, these investments could still recover. That is something that we will have to wait and see. But the general point, which will be shown in Table 3 ahead, is that if possible, it is better to hold off on most new stock investments when prices are relatively high, to await periods when prices are relatively low again.)

Table 2. Repeat Performance: Comfort Level Proved Too High (2004-2007)
For Investments Begun on Date Shown ...	... the 1 Year Prior Total Return BEFORE Date ...	...the S&P 500 on Date Vs. 969 on Oct. 31, 2008
Oct 1, 2007	16.4%	1527
July 1, 2007	20.6	1503
Apr 1, 2007	11.8	1421
Jan 1, 2007	15.8	1418
Oct 1, 2006	10.79	1336
July 1, 2006	8.63	1270
Apr 1, 2006	11.73	1295
Jan 1, 2006	4.91	1248
Oct 1, 2005	12.25	1229
July 1, 2005	6.32	1191
Apr 1, 2005	6.69	1181
Jan 1, 2005	10.88	1212
Oct 1, 2004	13.87	1115
July 1, 2004	19.11	1141
Apr 1, 2004	35.12	1126
Jan 1, 2004	28.68	1112
	Average Prior Return = +14.60%	Average Ann. Return After 5 Yrs. = Unknown

Although we don't know yet what the 5 year return made on these investments will be, we do know that currently the return for each is negative since the S&P now is far lower than the 1112 it was at the start of 2004. The S&P would have to rise considerably for any of these investments to eventually show a good return.

Now contrast the above negative results to the period between 2001 and mid-2003, as shown in Table 3, when investors were last in a period like the current dismal one. These investors were, similar to as they are now, very apprehensive, rather in than their investment "comfort zone". Here you can see that they again were more often wrong than right in their gloomy beliefs and accompanying fears, although the extended length of the bear market did cut into the returns of those who ventured forth in the relatively early stages of the eventual 31 mo. bear market which started its slide in Mar. 2000.

In fact, the investing years that followed those shown in Table 3 were the only 5 year periods during the last 10+ years when it was profitable to invest. But even then, if you assumed the markets were safe just because of your profits over the previous 5 years, you would have been wrong.

Table 3. Good Results Investing When the Comfort Level Is Low (2001-2003)
For Investments Begun on Date Shown	1 Year Prior Total Return BEFORE Date	Resulting 5 Year Annualiz. Total Return AFTER Date
July 1, 2003	+0.25%	7.6%
Apr 1, 2003	-24.76	11.3
Jan 1, 2003	-22.10	12.8
Oct 1, 2002	-20.49	15.5
July 1, 2002	-17.99	10.7
Apr 1, 2002	+0.21	6.3
Jan 1, 2002	-11.87	6.2
Oct 1, 2001	-26.63	6.98
July 1, 2001	-14.83	2.5
Apr 1, 2001	-21.68	3.97
Jan 1, 2001	-9.1	0.54
	Average Prior Return = neg. 15.36%	Average Ann. Return After 5 Yrs. = +7.67%

Investment Results Following the Onset of Each of the 8 Pre-2000 Bear Markets

While the above data can certainly be regarded as a framework with which one can judge how to react to the extremes of bear markets, we felt that just focusing on 5 year results from investing during, and shortly after the last major bear market between 2000 and 2002, could easily be dismissed as "this time (meaning the current bear market) is different." Therefore, we examined the results of investing not long after the start of each of the last 8 bear markets going back over 50 years. In each case, we tested the average yearly performance of the S&P 500 during the 5 calendar years immediately after a bear market drop of 20% of more in the Index had occurred. The following table presents the results:

Table 4. Good Results of Investing After Bear Market Confirmed (1957-1995)
Year During Which 20% Drop Was Reached	1 Yr Tot Return During Yr of 20% Drop	Resulting 5 Yr Ann. Tot Return AFTER Yr of 20% Drop	Length Bear Market/Tot Decline
1990	-3.17%	17.4%	3 mos./-20%
1987	+5.23%	16.7%	3 mos./-34%
1982	+21.41%	16.9%	20 mos./-27%
1973	-14.66%	6.8%	21 mos./-48%
1970	+4.01%	5.9%	18 mos./-36%
1966	-10.06%	9.0%	8 mos./-22%
1962	-8.73%	13.1%	6 mos./-28%
1957	-10.78%	14.8%	15 mos./-22%
	Avr 1 Yr Return During Yr of 20% Drop = neg. 2.1%	Avr 5 Year Ann. Ret. AFTER Yr of Drop = +12.6%	Avr Length Bear Market/Tot Decline = 12 mos./neg. 30%

The data in Table 4, combined with the data on the 2000-2002 bear market (Table 3), show that for the last 9 bear markets, investing back into the market at the start of the new year after an initial 20% bear market occurred consistently produced better than average results for the following 5 years. Note: The 2000-2002 bear market first registered its 20% drop in early 2001, therefore suggesting a good time frame to have increased your investments in the market would have started in Jan. 2002.

In the case of the 3 bear markets that proved to be particularly long and deep (2001, 1973, and 1970), an investor probably would have done even better by waiting longer to put his toes back into the water. Since the current bear market already shows signs of likely being longer and deeper than more shallow bear markets, it may make sense, then, to wait even beyond the start of 2009 to start increasing your commitments to the stock market.

The Bigger Picture

All this appears to demonstrate what I have been writing about since our first Newsletter in mid-1999:

-Success in investing is often counter-intuitive. While the majority of investors comprehend and emotionally react to events in a way that appears commensurate with those events, they are often being fooled. Dramatic plunges in stocks, while wealth destroying in the short run, nearly always present great opportunities for those willing to stop and consider from what historically high point stocks have fallen, and whether or not the fundamentals justify thinking that stocks will not have significantly recovered 5 or 10 years down the road.

Thus, so long as a fund investment is broad and isn't going bankrupt altogether like some individual stocks can, it makes sense to initiate or increase an existing investment after a relatively long period of underperformance such as is apparent now.

-And here is the corollary: While given markets can continue to look good for years and years, once results become "too good", it makes sense to reduce that investment.

In other words, while "buy and hold" can still produce great results over time intervals approaching 20 years, if you cannot adhere to such a long-term discipline, your best bet is to look for entry and exit points which provide the greatest chance of success.

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The Implications for Investors of 28 Years of Declining Interest Rates

One component of any intelligent investment strategy is to understand the likely course of overall interest rates (rates for both long and short term borrowing in the public and private sectors) during the next year and the next decade. Interest rates have a profound impact on the economy as well as the stock and bond markets. The Federal Funds rate (Fed Funds) set by the Federal Reserve (Fed) has been the most important driver of overall interest rates since World War II. During that period, reductions in the Fed Funds rate have been the primary tool used by the government to reverse (“stimulate”) downward trajectories in the general economy. The Fed Funds rate, which is essentially an overnight lending rate has been used to drive down overall interest rates. When the Funds rate falls, the prime bank lending rate falls in tandem, as do a variety of other rates for loans such as credit cards and some adjustable mortgages.

This note will explore the current 28 year megacycle of declining Fed Funds rates and overall interest rates. In my next note, I will explore the likely direction of the Fed Funds rate and overall interest rates over the next year and decade. I will also discuss the changing significance of the Fed Funds rate in light of the alternative radical steps to reduce overall rates that the Fed has recently undertaken and is currently considering.

For the past 28 years, the Fed Funds rate has been in a declining megacycle. In December, 1980, the rate reached 20% (2000 basis points) level. On October 29, 2008, the Federal Reserve lowered the funds rate to 1% (100 basis points). This amounts to a 95% reduction from the peak to its current low point. The decline has not been a straight line trajectory. There have been up and down legs. Over the course of the megacycle, there have been six down legs (including the current down leg) and five up legs. In four of the five prior down legs, the decline in rates has been dramatic – 11.50% between 1980 and 1982, 6% between 1984 and 1986, 6.75% between 1989 and 1992, and 5.50% between 2000 and 2003. In the current down cycle, the funds rate has been lowered thus far by 4.25% to 1.00%. In so far as the Fed Funds cycle is concerned, we are close to the bottom of the tank. In 1981, we had twenty gallons. We now have one gallon.

The 95% reduction in the Fed Funds rate during this quarter century megacycle has been a major stimulant that has driven up stock and home prices.

The simulative impact of ever lower overall interest rates is amply demonstrated by the effects on home owners and home buyers. The rate for 30 year fixed rate loans peaked in 1981 at 16.63% (source: Freddie Mac). It dropped to 5.83% in 2003 and remained at that level for three years. During the interim, each time the mortgage rates fell in tandem with significant down legs in the Fed Funds cycle, home owners were able to refinance their homes at lower rates. In effect, this amounted to a substitute pay raise. Each down leg, up until now, provided another substitute pay raise. The money saved by lower monthly payments could be diverted to other forms of consumption thereby driving up the Gross Domestic Product (GDP).

Lower mortgage rates also made homes more affordable and drove up the price of homes, resulting in (a) increased demand for home construction and (b) increased homeowner net worth. Homeowners used the increased value of their homes as piggy banks to take out loans then buy consumer goods, renovate their homes, take vacations and pay for their children’s education. Homes are far and away the most important asset of most American families.

A further illustration indicates how important progressively lower mortgage rates have been for the overall economy. If the 30 year mortgage rate had remained at 10%, as it was in 1990, instead of the current 6%, the monthly payments of homeowners would be 47% higher and home prices would be far lower.

At some point the megacycle decline in both the Fed Funds rates and overall interest rates will bottom out. In my opinion, there is a widespread failure to recognize that these cycles will and must bottom out. When they do so, there will be profound impacts on the GDP as well as the stock and bond markets. Put bluntly most investors have their heads in the sand concerning this inevitable outcome.

The Fed now appears determined to bring overall interest rates, and especially long term rates, to a new megacycle low and thereby stimulate the economy into another up cycle. Will we see 30 year fixed rate mortgages at 4% or 4.5%? The likelihood of the Fed’s success in bringing down long term rates will be discussed in a subsequent note. If they fail to do so, it is more likely that we will enter a period of very slow growth or continued decline.

Our thinking about the economy and markets is overwhelming framed by the past 28 years of declining Fed Funds and overall interest rates. Economic and markets models are premised on that backdrop. Try as we may, it is hard to get beyond that framing but it is critical that we do so by acknowledging that megacycles can and do come to an end.

In December, I will discuss the likely direction of the Fed Funds rate over the next 5 years.

Publisher's Note: Steve has been an astute observer of the big economic picture for many years now. He correctly foresaw that a housing/subprime crisis was coming as early as 2005, at least two years ahead of most investment professionals and government experts. Steve has a law degree from Stanford University and has worked as Chief Assistant U.S. Attorney for Northern California. He currently is engaged in a variety of worthwhile activities.

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