November 3, 2008
Past the Tipping Point?
Since the early 1970s, investment professionals and academics have debated amongst themselves about whether the world's securities markets, in their role as real-time information discounting forums, are wholly efficient. Those arguing the affirmative case assert that at any given moment the price of a stock, bond or marketable financial instrument reflects the sum total of all information about the vehicle and that individuals in possession of such knowledge collectively act rationally in their own self interest. Further, they assert that since we now have instantaneous global information transfer, the markets, therefore, are continually up-to-date and auction prices reflect the ebb and flow of such intelligence. As an assumption underlying strategy for long-term investors, the statistical evidence tends to support the general framework of the efficient market hypothesis. However, as has become evident under the extreme stress of recent months, the expectation that investors act rationally breaks down.
The Perils of "Group Think"
Individuals, on their own and in possession of reliable information, are probably capable of acting rationally in their own self-interest. But in a crowd, as intuitively we all know, we have difficulty making independent, carefully, reasoned decisions.
Charles Mackay in his 1841 classic account Extraordinary Popular Delusions and the Madness of Crowds (PDF), describes a number of then past manias which when compared with what we are experiencing today sound frighteningly familiar. The craze most often cited, of course, is the 1630s tulip bulb bubble in Holland, during which in the extreme some exchanged their principal residence for a single root. The behavior patterns exhibited then, and those of the recent few years, and the situation we are faced with today, are so strikingly similar that it would seem useful to revisit Mackay's analysis. The attached excerpt from Andrew Tobias' 1980 revival of Mackay's work makes the point. You will find it easy to substitute today's cast of characters (e.g., the housing market for tulips, hedge funds for "stock-jobbers," mortgage brokers for "tulip-notaries," the use of leverage to enhance at a great risk the sellers' profit, etc.).
The point to be made here, is that in a crowd (today magnified by the influence of a sadly uninformed media) extremes of behavior driven by the urge to conform, or greed, and/or currently fear, can produce out-of-sample results. What we have just been through in the month of October (and more could still be ahead) has mostly to do with psychology rather than fundamental investment values, or the direction of the economy.
Bull and Bear Market Cycles
The tulipmania cycle related by Mackay also serves as a reminder that such a craze builds gradually, but unwinds precipitously once reality returns and panic sets in. This is no less evident in a look back over U.S. equity bull and bear market cycle history (view "Bull and Bear Markets, S&P 500 Index 1926 - September 30, 2008, Monthly Returns (PDF)"). In this graphic, supplied by Dimensional Fund Advisors (DFA), you can see that historically something like 70-75% of the time, as measured in months, the stock market is building value and on a positive trend line. Full-fledged bear markets, on the other hand, tend to be sharp and short in duration, averaging less than 18 months. Also, note that if you extend the latest bear market trend line, plotted lower far right on the attachment to the October 10th intra-day low, the S&P 500 was down 46%. With history as no more than a guide, this October low compares in severity with only two other post-WWII declines.
Refocusing on the Longer-Term
As painful as the current erosion in equity prices has been for all investors, such declines have been experienced before and are usually followed by rebounds to levels of long-term intrinsic value. No predictions as to when this reversal will occur, and it will no doubt be delayed as hedge funds continue to deleverage and tax-loss selling exhausts itself, but as the New Year approaches relief could be on the horizon. Given time, the equity market's response to financial crises such as these has generally been restorative (view "The Market's Reponse to Financial Crisis (PDF)." Source DFA). In the interim, we will begin shortly to implement our tax-loss realization and equity rebalancing programs.
Thanks to all of you, who have responded so positively to these recent e-mails. Your comments and suggestions are appreciated by all of us. If you have been unable to open and/or print either of these attachments, please let us know. We would be happy to mail them to you.
As always, your thoughts, comments and questions are most welcome. Please contact us via email at tfc@tfcfinancial.com or call us at 617-210-6700.
James L. Joslin
Chairman & CEO