Why Not Just Sell And Wait For Rosier Days?

I was emailing with a client yesterday and during the course of the conversation he asked the following:

“Are you overloaded these days? It seems to me that right now all we can do and should do is wait….there’s still more downhill. I understand your investment philosophy does not concern itself with short term events, but still…shouldn’t there be an exception if you have reasonable expectations that the market will sink more before it bounces?”

Since it is a good question, and one others may be wondering about, I thought I would elaborate here rather than just respond privately.

This client is right, I am not a market timer and do not base investment decisions on what the stock market may, or may not, do over the short term. If the market’s short-term direction merely correlated with economic activity this would not be a wise philosophy. We would all simply sell our stocks when the recession began and wait until it ended before getting back into the market.

The reason why market timing is so difficult (and why I choose not to partake in it) is because the stock market is not a proxy for the economy over the short-term. The Dow didn’t drop 300 points on Monday because the economy got worse, and the next time it goes up 300 points it will not be because the economy got better. There are so many crosscurrents that affect day-to-day stock market movements that it makes it very hard to guess which way things will go, even during a severe recession.

As an example, consider the last three months. If you asked economists and market watchers how the economy did over the last three months, there would be a consensus view that it has been bad and is getting worse. As a result, one might conclude that stocks would simply drift lower day after day, week after week, month after month, because there is no evidence that the economy is improving.

If we look at market data, however, we see that the S&P 500 rose by 27% between the lows made on November 21st (741) to the highs made on January 6th (943). Did the economy improve during that time? No, it got worse.

Since January 6th the S&P 500 has dropped from 943 to 700, a loss of 26%. What explains this move down? A bad economy? Probably not entirely, given that it has been bad the entire time despite two dramatic (and equally substantial) market moves in opposite directions.

We could make a list of at least a dozen reasons why the market rose 27% over a six week period, only to fall 26% over the next eight. All of those factors combined determine the short-term movements in the market and personally, I find them oftentimes irrational and highly difficult to predict.

To further illustrate the point that markets and economies don’t always move in tandem, consider the last recessionary period of this magnitude that our country faced, 1980-1982. Look at how the stock market fared during this three-year period compared with key economic figures such as GDP growth and unemployment:

Does the above data make any sense on its own? Not really. After all, the market rose significantly in the years the economy declined and fell during the year it rebounded temporarily. Joblessness rose consistently over the entire period. Simply assuming that the market will stay bad if the economy stays bad is too simpleminded for such a complex marketplace. There are so many variables that play into it, it could give you a headache trying to make sense of it all.

As a result, I choose to simply focus my time on researching individual companies, their long term prospects, and their share price valuations. There are plenty of people who prefer to focus on other things, and that’s fine, that is what makes the market. We are all looking at the exact same data and still come to many different conclusions or choose to focus on different data points entirely.

As a long term investor, I am investing in a world where the stock market rises in any given year about 75% of the time. Not only that, but sometimes it goes up dramatically even when the economy sucks (as the data above shows). Over the long term, historical data has shown that there is a direct, inverse correlation between current share price valuation and future share price returns. Over the short term, stock prices are dictated by any number of factors and the near-term movements are anyone’s guess quite frankly.

I prefer to stick to one aspect of stock market analysis. That is just my preference, it doesn’t make it right or wrong, it’s just what I am good at and have confidence in. Other market participants prefer to ignore the things I look at and focus on those that I ignore. Thank goodness for that, because without that discord, there would be no market for us to participate in, and it certainly would not be inefficient enough to present compelling investment opportunities for all of us to try and profit from.