Last week I posted two articles discussing the potential of a 30% increase in the markets over the next two years, as proposed by Jeremy Grantham, due to the ongoing monetary interventions by the Federal Reserve. Specifically, I stated:
“The primary reason that stocks are likely to climb 30% higher from current levels, over the next 24-months, is because that is what happens during the ‘mania’ phase of a bull market cycle...At the current rate of [the Federal Reserve’s] balance sheet expansion, and assuming that correlations remain, the markets could well rise to 2329 by the end of 2015.”
Those two articles, and a subsequent discussion on the daily “Real Investment Hour” radio broadcast, sparked the following question from one of my listeners:
“It sounds as if everyone agrees the market will crash probably not this year but likely in 2014 or maybe in 2015. Yet, now it looks like the market may run up another 30%. So what’s the risk in being in the market now if the aforementioned scenario happens? If the market corrects 20% it would still be up 10% from today.”
One of the primary tenants of investing, other than “buy low and sell high,” is always analyzing BOTH sides of every argument to avoid confirmation bias. Therefore, while the articles last week made the case for being invested in the market due to the ongoing liquidity ramp – the question above got me to thinking about the other side of the argument: the case for going to cash.
With the S&P 500 rapidly approaching a 30% gain for 2013 (assuming a year-end target of 1850), the case for going to cash is comprised of three primary issues: 1) the impact of reversions, 2) historical length of economic recoveries, and; 3) historical returns following years of 30% market returns.
The Impact Of Reversions
There have been numerous studies and discussion on the historical impact to returns due to “reversions to the mean.” However, the impact of reversions remains lost on most individuals as the emotion of “greed” overtakes rationality during strong market advances. There are two critically important points in the question above. The first is that he believes there is “no risk” of staying invested even if the market declines by 20%. The second thing you should know is that the math is wrong.
One of the biggest mistakes that individuals make when investing is “not doing the math” which is clearly demonstrated in the question above. Let’s assume that the S&P 500 is trading at 1800. If the market advances 30% it would then be trading at 2340. However, the “risk,” and inherently the reality for the majority of investors, is that individuals would not “sell out” of their portfolios at the next market peak and would suffer the next 20% decline. The flaw in “the math” is that a 20% decline, following a 30% advance, does not leave you holding a 10% gain. In reality, the 30% gain is reduced to just 4% as the market reverts back to 1872.
In other words, if you went to cash today, and a 20% correction occurs at any point in the next two years, your net return would effectively be the same or greater than remaining invested. The impact of reversions are devastating to long term portfolio returns particularly when individuals, as opposed to financial markets, have a finite time span within which to save and invest before needing those savings for retirement.
Economic Recoveries & Subsequent Market Returns
However, the real issue is that the market is unlikely to correct “just 20%.” The next major market correction will very likely coincide with the next economic recession. Of course, by simply writing the “R” word this article will be summarily dismissed by the “financial illuminati” who continue to marvel at the day to day levitations of the markets with the inherent belief “trees can grow to the sky”. Ultimately, all economic recoveries will eventually contract. The chart below shows every post recession economic recovery from 1879 to present.
The statistics are quite interesting:
- Number of economic recoveries = 29
- Average number of months per recovery = 39
- Current economic recovery = 53 months
- Number of economic recoveries that lasted longer than current = 6
- Percentage of economic recoveries lasting 53 months or longer = 24.14%
Think about this for a moment. We are currently experiencing the 7th longest economic recovery in history with most analysts and economists giving no consideration for a recession in the near future. This is important because, as stated above, major market corrections occur during economic recessions and those “reversions” tend to be much larger than 20%. The chart shows each of the historical economic recoveries and the subsequent market correction during the inevitable contraction.
The statistics are equally interesting:
- Average number of months of contraction: 14
- Average market declines during all contractions: -29.13%
- Average market decline following top seven economic recoveries: -36%
With these statistics, it is somewhat easy to assess the risk/reward of remaining invested in the markets currently in hopes of further advances. If we assume that the markets reach the target of 2340 before the onset of the next economic contraction; the resulting decline, using the historical average of -36%, would push the markets back down to 1498.
Pay attention here. A decline of that magnitude would result in a 16.7% loss from the current value of 1800. Such a decline would almost entirely erase all the gains from 2013. Therefore, even if you enjoy the next 30% increase by staying invested in the market today, you could potentially wind up losing all of that gain PLUS everything from 2013. Ouch!
30% Gains And Sideways Markets
The last piece of the case for going to cash today is shown in the chart below. I calculated the annual returns (capital appreciation only) using monthly data for the S&P 500. I then showed just the first year in which a 30% or greater increase in the S&P 500 occurred and the subsequent years following that 30% gain.
Here are the statistics:
- Number of years the market gained 30% or more: 10
- Average return of 10 markets: 36%
- Average return following a 30% year: 6.12%
I have also notated that each 30% return year was also the beginning of a period of both declining rates of annualized returns and typically sideways markets. It is also important to notice that some of the biggest negative annual returns eventually followed 30% up years. If the markets rise to 1850 by the end of 2013, which I believe is entirely possible as managers chase performance, it will mark the 11th time in history the markets have attained that goal.
While it is entirely possible that the markets could “melt up” another 30% from current levels due to the ongoing monetary interventions; history suggests that forward returns not only decline, but bad things have eventually happened.
Go To Cash Now?
I want to be clear that I am not advocating that anyone should go to cash today. The problem with this analysis, unfortunately, is that while individuals are just as unlikely to sell at the top of the market; they will not buy at the bottom. History is replete with market booms and busts and the devastation of individuals along the way.
This is why chasing an all equity benchmark is inherently flawed. Benchmark indexes are riddled with issues that you can not replicate in your portfolio which I discussed in detail in “Why Benchmarking Is A Losing Bet.”
“While Wall Street wants you to compare your portfolio to the ‘index’ so that you will continue to keep money in motion, which creates fees for Wall Street, the reality is that you can NEVER beat a ‘benchmark index’ over a long period. This is due to the following reasons:
1) The index contains no cash
2) It has no life expectancy requirements – but you do.
3) It does not have to compensate for distributions to meet living requirements – but you do.
4) It requires you to take on excess risk (potential for loss) in order to obtain equivalent performance – this is fine on the way up, but not on the way down.
5) It has no taxes, costs or other expenses associated with it – but you do.
6) It has the ability to substitute at no penalty – but you don’t.
7) It benefits from share buybacks – but you don’t.”
In order to win the long term investing game, your portfolio should be built around the things that matter most to you.
* Capital preservation (A lost opportunity is more easily replaced than lost capital)
* A rate of return sufficient to keep pace with the rate of inflation.
* Expectations based on realistic objectives. (The market does not compound at 8%, 6% or 4%. Losses destroy the effects of compounding returns)
* Higher rates of return require an exponential increase in the underlying risk profile. This tends not to work out well.
* You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.
* Portfolios are time-frame specific. If you have 5-years to retirement, but build a portfolio with a 20-year time horizon (taking on more risk), the results will likely be disastrous.
The index is a mythical creature, like the Unicorn, and chasing it takes your focus off of what is most important – your money and your specific goals. Investing is not a competition and, as history shows, there are horrid consequences for treating it as such. It is important to step away from day to day gyrations of the market and focus instead on matching your portfolio to your own personal goals, objectives, and time frames. Building an asset allocation model that can hedge volatility risk, produce income and protect capital are critical to surviving the “long game.” In the end, you may not “beat the index;” but you will substantially increase the odds of achieving your own personal goals which is why you started investing your “hard earned savings” in the first place.
Lance Roberts is a Chief Portfolio Strategist/Economist for RIA Advisors. He is also the host of “The Lance Roberts Podcast” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, Linked-In and YouTube