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Twists And Turns

Posted by: Brian Dennehy
Membership level: Free
 
No, not a new dance. With the 10th anniversary of the 2018 crash just ahead, the Great Financial Crisis, I would like to build a picture of where we are today. This will be over a small number of blogs and today focusses on the anatomy of a bull market, and the twists and turns along the way.
 
When markets keep going up and up for prolonged periods (despite getting more and more expensive) it’s easy for investors to get complacent.  Memories of the last correction fade and the belief that “this time is different” takes hold.
 
It has certainly been a while since we had a decent downturn. The pivotal US stock market, which both propels the UK market up and will pull it down, is now officially a record bull market - this from last week’s blog:
 
“This week the US market was lauded because it is now officially the longest bull market in history.
 
The analysts typically call a bull market one which hasn’t been interrupted by a 20% correction. I’m not sure it is a terribly useful definition. But it does give a sense that we are much nearer the end than the beginning.
 
3,453 days without a 20% correction. On 22nd August 2018 the bull run which emerged from the ashes of the Great Financial Crisis edged past the 1990-2000 uptrend, which itself was followed by the technology-led Crash, when the mainstream market fell 50% over three years.”
 
Here’s a refresher on what a downturn looks like.
 
You already know that investing in funds is a great idea, they give all of us the opportunity to participate in the dynamism and profitability not just of our own economy, but in exciting opportunities around the globe.
That is why for many people investment funds probably play a significant role - in your savings, your investment portfolio, SIPPs, and ISAs.
 
Based on over 100 years of data, if you stay invested in the UK stock market for 10 years there was a 91% likelihood that you would have achieved a better return than leaving your money on deposit.
91% probability not good enough?
 
Then if you left it invested for 18 years the odds increased to 99%.
 
History clearly suggests that if you stick with this journey long enough there is a high probability that you will make decent money - but there is no certainty as to what you will get back or when. Plus, over that 18 years, the road had many twists and turns – this is volatility. Your investment journey if you like.
 
This is how we define those “twists and turns”:
 
A correction is in the range of 10-20%.  It will generate twitchy headlines.  Be patient and it will go as soon as it arrived. We barely encountered one of these with “the February wobble” earlier in 2018.
 
A bear market.  Falls in the range of 20-50%. Yes, it can be scary.  Three since 2000 but patience and steady nerves or a good adviser got you through them. Oh and some luck, but I’ll return to that.
 
A secular bear market, a multi-year downturn following a huge investment bubble.  You should expect falls in excess of 50%.
 
You can factor in occasional years of weakness such as the first two categories. But very occasionally it can get somewhat worse. Before exploring the latter in the context of 2008 and today, let’s look at how we get into these messes.
 
The Confidence Trick
 
Confidence lubricates our day-to-day life, and also builds bull markets, those long term uptrends for stock markets which we love so much
 
There is a ridiculous idea in some quarters (and not just in academia) that we are all rational. That we all have access to the same information at the same time, and all respond in exactly the same way. Among other things this is one of the fundamental excuses for index trackers – no one has any special knowledge which can give them an edge, so you can do no better than buy an index tracker. We have proved this wrong so many times I will not bore you with that again – though the curious might begin here.
 
As a matter of fact, not theory, we can state that confidence does not build uniformly across all investors.
 
A relatively sedate upward trend in the stock market is fed by a stream of new buyers over time. People join the herd of investors at different times. This is self-evident from the steady incline of the chart from 1988 to 1998.
 

 
That upward trend will grow gradually most of the time. An exception occurs towards the end of some upward trends as confidence morphs to over-confidence and then out-and-out greed. The technology bubble of the 1990s is a great example, which you can also see clearly on the right hand side of the same chart.
 
The herd of investors is a very mixed group. It is made up of powerful institutions and hedge funds (the so-called smart money) as well as retail investors. This herd is very powerful, fuelling bull markets that can go on for years. It is the retail investors who tend to get to the party late in the day, when the upward trend is long established and the easy money has been made.
 
Herd Too Late
 
In particular, it is those who are least-well-informed and ordinarily least-confident who will tend to join the herd late in the day. This is ironic because the higher the market goes, the more over-valued it becomes, and the greater the risks. But those late-in-the-day do not see this – they just take comfort from the safety of the herd – a caveman instinct, wholly inappropriate when investing.
 
In the Credit Suisse Investment Returns Yearbook 2014. They noted that, in the 20 years ending in 2013, the return of individual investors was roughly 60-80% of that achieved by the market.
 
Perhaps rather unkindly they call it the “dumb money effect” and tell us:
 
“The root of the problem is bad timing… When markets are down investors are fearful and withdraw their cash. When markets are up they are greedy and add more cash”
 
The ordinary investing public join the herd far too late – buying high, selling low. It isn’t because these investors were trying to be clever – but rather they lacked sufficient confidence to buy earlier. Once the herd has grown substantially, and the market is already a long way ahead, only then will many investors jump on board.
 
But the potential problem is far greater than late-to-the-party investors underperforming the stock market as a whole. A multi-year downturn, secular bear market, can destroy a large part of your invested capital for a prolonged period and have very serious consequences in the wider economy.
 
History suggests that such a secular bear market is preceded by an investment bubble. So in the next blog in this series I look at the anatomy of a bubble and bust.
 
FURTHER READING
Topic: Market commentary


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