| Lummer's Logic |
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| Bear Market Project II - Book of Shadows
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By Scott Lummer
Chief Investment Officer, mPower |
April 17, 2001
At the suggestion of one of my colleagues, this week's
column includes a rerun of a piece I wrote in November 1999. At the time, The Blair
Witch Project was thrilling (or nauseating) theatergoers across the country, and the
average investor was expecting returns of more than 20 percent for the foreseeable future.
I felt such a belief was outrageous, so I presented a kind of counter-myth a la
Oliver Stone.
The story was not intended to be a prediction, just a
warning of what might occur in the future. But it's kind of eerie to read it again now.
Here it is:
The Bear Market Project
Many young investors have heard tales of the "Bear
Market." Since they have never seen it for themselves, they think it is a myth. But
it's not, as the following column shows. (The column is set a few years in the future.
Since my time machine occasionally malfunctions, this column is an illustrative example
and does not attempt to portray market events exactly as they will happen. Also, it is
extremely scary, so read it at your own risk.)
***
This column depicts an event that took place outside a
small investment advisor's office in Maryland.
The time is April 2003. Two years ago, three young cynical
analysts (we'll call them Brian, Heather and Greg) set out to prove that the legendary
"Bear Market" did not exist. Although they have heard tales of the Bear Market
gobbling up investors' portfolios in the past, their vast experience (after all, they have
been investing for 10 years) convinced them that the Bear Market was either purely
fictional, or had long since died off.
It's true, over the past two decades there have been
occasional phenomena suggesting that the Bear Market was indeed up to its old tricks.
There was the time back in 1994 when little Evan Robinson went wandering into the
exchanges, and his portfolio completely disappeared. However, the three young analysts
convinced themselves that this event was so minor as to be trivial.
Before that, there was the mysterious "Black
Monday" of 1987, when thousands of investors reported being harmed by the Bear
Market. Our three brave analysts were troubled by that event, but noted that it was
short-lived, and pointed out that the investors who had sufficient provisions to remain in
the exchanges came out unscathed. Emboldened by such research, the bullish threesome were
determined not to be swayed by the myth of the Bear Market, and started investing
aggressively in early 2001.
Heather, Brian and Greg did not begin their search for
investments completely unprepared. They were ready to accept some losses, and felt that
they might be able to withstand a short-term hit of as much as 25 percent. Initially, even
this seemed unnecessary, since their portfolio earned money during the first quarter.
Supported by their initial findings, they became reckless,
eschewing the traditional benefits of a diversified portfolio and wandering into the area
where the Bear Market poses the greatest threat -- high price-to-earning ratio (growth)
stocks. Only Greg, the least convinced of the three, was shaken by a 10 percent decline in
stocks during a single week in May 2001. He stayed in the field after being chastised by
the leader, Heather. She seemed to be proven right when stocks recovered during June and
the group's portfolio was up by a large amount for the year.
Then weird things started to happen. Productivity, which
had been steadily improving since the early 1990s, began to level off. Signs of inflation
began showing up. The growth of the Internet and computer sectors started to creep
downward, into single digits. And for the first time in a decade, Microsoft announced
earnings below expectations. For the year 2001, stocks in general were down by 9 percent
-- their first decline in seven years.
Our intrepid trio still held fast to their belief that
these were natural occurrences and that the Bear Market did not really exist. However, in
May 2002, the Fed raised interest rates for the third time in less than a year, and the
market fell another 8 percent. Moreover, although stocks as a whole were down 17 percent,
our heroes' portfolio had fallen by 24 percent.
At this point, Greg disappeared. No one knows where he
went, but remnants of his brokerage statements were found near a bank selling certificates
of deposit.
Brian and Heather, although shaken by Greg's disappearance,
vowed to continue on. But the market free fall did not stop. In November, economic figures
showed that inflation was on the rise while employment was falling. Major companies
announced layoffs, and consumer confidence fell to its lowest level in 20 years. By the
end of the year their stocks had fallen an aggregate 38 percent, and Brian and Heather has
lost 52 percent.
Heather lost track of Brian and was forced to weather the
storm alone. In an emotional note to her family, she apologized for losing so much of
their money. Then, although there were some signs of stability from international and
basic manufacturing stocks, Heather stopped accessing her online portfolio tracker. In the
end, she had lost nearly 60 percent, and, apparently, her will to continue.
***
Back to 1999.
O.K., so that was a bit melodramatic. But my concern is
that many investors are substantially underestimating the potential volatility of the
stock market. Moreover, they are increasing their risk by taking large positions in
particular sectors. Some investors may be unaware of how far a market can drop while
others may feel that risks are lower in today's market. Well, everyone is entitled to his
or her opinion, but I see no evidence that stocks are any more stable now than they were
in the 1970s.
I am not literally predicting that there will be a huge
market downturn in the next few years. Nor am I suggesting that investors should get out
of the stock market -- in fact, all of my money is in equities. However, it is vital to be
broadly diversified across various sectors, and to be aware of the risks you are taking.
The problem with underestimating stock market volatility is that a sustained downward move
for which you are not prepared could cause you to pull out of stocks at the worst possible
time -- the bottom of the market.
Now if you'll excuse me, I've got to get back to work on my
column based on "Boogie Nights."
***
Back to 2001: Little League Lessons
Why retell the tale now? Because it shows the importance of
building appropriate expectations. This is what I try to do when coaching my son's Little
League team. It's important for players to have goals of doing well, but also to realize
that even the best players occasionally strike out. That way, when the kids swing and miss
they won't be overly disappointed and they'll keep a positive attitude during their next
time at bat.
The same thing holds true for investing. The main reason I
wrote the original article was that although a decline was possible, it was not
necessarily expected. That's important to recognize now. As uncomfortable as the recent
market performance has been, it should not have come as a shock. We should have been
prepared for it, and the fact that it occurred should not alter our investment course.
That's why we at mPower are suggesting that the majority of investors stick to a generous
allocation to stocks if that's the appropriate allocation for them.
All of us who have been equity investors have incurred a
big strikeout. However, we have a lot more at-bats left and the game is far from over.
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