Imagine this: The Dow Jones industrial average travels 15,000 points, and you have nothing to show for it. Same for the S&P 500-stock index, a full 1,800 points, and the net gains are zero, nada, zilch.
How did this happen? If you employ a buy-and-hold strategy, the round trip in the equity markets is simple math. Dow 14,000 down to 6,500 and back again equals about 15,000 points. Any stocks bought in late 2007 are just now, after six long and tumultuous years, returning to break even, even as stocks mark new all-time highs.
What does this mean for investors? Let’s look at alternative investing approaches, including what you could do to avoid this. A few strategies you can easily deploy will make the next round trip — and, yes, there will be one — much more profitable.
First, a few words about new all-time highs.
Ned Davis Research did a study (brought to my attention by Mark Hulbert) that looked at what happened when the S&P 500 made a new market high after a bear market. Since the 1950s, there were 13 such instances. The mean bull market “continued for another 644 days — nearly two years — and, in the process, gained an additional 40.3 percent.” The median case was less impressive — the bull ran for one more year and gained more than 18 percent.
The weakest example was 2007, with the inflection point coming less than six months later and under 3 percent higher following new highs.
Why is this noteworthy? Mostly because so many investors have fought this rally the entire way up. I suspect the recency effect is to blame — the residual psychological trauma caused by the 2008-09 crash is still so fresh in people’s minds that they have become fearful of risk. Aversion to losses has investors so focused on avoiding any drawdown that they end up missing what turns out to be the best rally in a generation. New highs raise the fear of yet another market top.
This is an emotional reaction. Rather than give in to your ancient lizard brain, let’s put that big ole underutilized neocortex to work. To do that, we have to consider a few standard market metrics and see whether they tell us anything.
Valuation: Markets today are not cheap or expensive. Despite doubling since the market lows, the S&P 500 trades at 15.4 times earnings. The average for all bull markets since 1962, according to Bloomberg, is just under 20 times earnings. From a valuation perspective, markets are not unreasonably priced.
Market internals: Healthy markets can be described as having a strong trend, good leadership and, especially, good breadth. What that last term means is that many stocks are participating in the overall market trend. We track this through the advance-decline (A/D) line, a measure of how many stocks are rising versus falling. During market tops, we tend to see new highs made even as the A/D line diverges. This happens because major market tops are usually preceded by signs of increasingly selective buying. Think of the Nifty Fifty in the 1970s or the four horsemen of the Internet in the late 1990s. I also watch how many new 52-week highs are being made versus new lows. When this diverges from prices, it can be a warning sign.
Global markets: The internals in the United States remain fairly robust. And in Britain, markets have been reasonably strong. We also have seen a big rally in Japan.
The same is not true for the rest of the world. The Shanghai index has had troubles for two years. India, Hong Kong and Australia also have seen a rough patch. South Korea and Taiwan have been deteriorating. And while everyone knows that Spain and Italy have been a mess, we are starting to see signs of weakness in the market conditions in France and Germany.
Overbought markets: A gain of 10 percent usually makes for a decent year — and the United States achieved that in three months. Markets may have gone too far too fast, becoming what traders like to call “overbought.” The way overbought markets work off these excesses is through consolidation. It may take a few weeks or even months for the market to digest these gains and for earnings to catch up to prices.
These factors suggest that the bull market is not yet over, but we could start to see some choppy waters. Eventually, this bull market will come to its natural end, as every one does.
Instead of just buying and holding, there are a few strategies to take advantage of any market volatility:
●Dollar cost averaging: The simplest and, for many people, the best option. Each month, you contribute a fixed dollar amount to a handful of broad indices via ETFs. When stocks are cheap, you are buying more shares of them. When things get expensive, you are buying less.
Think about what this would have looked like over the course of a round-trip cycle like 2007-13. As markets fell, you kept making equity purchases. As they bottomed, you bought more shares; as market rallied to new highs, you bought increasingly fewer shares. This makes your weighted average purchase price closer to the lows than the highs. Had you been doing this last cycle, you would be very happy today.
Note: This works best when you can set it on autopilot. Online brokers can help you automate this process.
●Portfolio rebalancing: This two-step process is a little more complex and involves more planning. The first step is to set up an asset-allocation model, which is not nearly as complicated as it sounds. Decide on a portfolio of various asset classes, including stocks, bonds, real estate and commodities. Let’s make your hypothetical allocation 60 percent equities, 30 percent bonds, 6 percent real estate and 4 percent commodities (60/30/6/4).
Depending upon what markets do, different parts of your portfolio will eventually move away from your original percentage allocations. Over time, your allocation has morphed into 62/28/7/3. On a regular basis, you sell a little of what has become overweighted and buy a little of what is underweighted to restore your portfolio to its original allocation. To keep costs down, do this less frequently for smaller portfolios (annually) and more frequently for larger portfolios (quarterly).
You can break down asset classes further: equities into classes such as domestic, international, dividend, growth, small cap, etc.; bonds into Treasurys, corporates, munis, TIPs.
Rebalancing works thanks to mean reversion. Asset classes that get ahead of themselves tend to revert back to more typical valuations eventually. Rebalancing means you are selling a little of what is pricey and buying a little of what is cheap. Reams of academic research shows that rebalancing creates risk-free gains over longer periods. It is one of the few free lunches on Wall Street.
Like dollar cost averaging, this strategy works only if you have the discipline to follow it. (Rebalancing as equities crash is more difficult than it sounds). To overcome the emotional elements, work with an online broker who can help you automate the process.
●Asset allocation tilt: “Tilting,” which is more complex than simple rebalancing, means shifting your allocation in more defensive or aggressive directions based on very specific predefined factors. These could be economic, valuation or even market-based. For example, you could tilt your portfolio into a greater equity exposure after a market falls a specific amount. A 60/40 portfolio might become 65/35 after equity markets fall 30 percent. An aggressive allocator would add 5 percent at levels of 40 percent and 50 percent off of highs. (Easier said than done, I know). One could tilt a portfolio more defensively as valuation levels rise above specific levels, i.e., 22 P/E for the S&P 500.
●Market timing: The granddaddy of the big cycle, the holy grail for traders. Market timers face two challenges: They have to identify when markets are topping and have the emotional fortitude to leave the party just as it really is getting going. Selling when things are doing well is much harder than it looks.
Then they have to do the same thing at the other end: They have to identify when markets are bottoming. This typically occurs when it looks as if the world is going to hell. Despite every instinct in their bodies, timers then must be able to jump back in.
Market tops are long-drawn-out processes; bottoms are emotional, panic-filled events. Very, very few people can call either on a timely basis. You are not one of those people.
You have alternatives to simply throwing money at your portfolio and hoping for the best. Dollar cost averaging and portfolio rebalancing are strategies that will improve your returns — assuming you have the discipline to stay with them.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. On Twitter: @Ritholtz.