Bulls are back in voguebut don’t believe the hype

It should come as no surprise that the uber-bulls have forced their way into the spotlight. After all, stock market averages continue their assault on the all-time nominal highs registered just as the financial crisis gathered momentum during the autumn of 2007.

Caution is now a dirty word and bears have gone into hibernation. Bullish opinion is in vogue and virtually certain to capture the public’s imagination – and a sizable share of their hard-earned savings. However, savers need to be aware that the positive commentary is often misguided, and occasionally downright dangerous.

The latest opinion piece to catch the eye was by James Glassman, who co-authored the infamous 1999 investment book Dow 36,000 , in which he and economist Kevin Hassett argued that the stock market index could reach the headline number within three to five years.

Unfortunately for the authors, the powerful bull market that began almost two decades earlier in the autumn of 1982, came to an end just months after the book’s publication, and the Dow Jones Industrial Average registered a percentage point decline of close to 40 per cent over the 33 months that followed the equity index’s secular peak. Stocks continued their upward trajectory over the next five years, but the financial crisis pushed the index down to 6,547 by the spring of 2009 – a level that was more than 80 per cent below the book’s catchy title.

Glassman is undeterred, and believes that the original forecast is within reach. He writes: "From its low of 6,547 on March 9th, 2009, the Dow has risen 117 per cent. Another 117 per cent in four years would put it at 31,022, just 16 percentage points shy of the magic number."

Misleading argument
It is important to remember that Glassman's original thesis was premised on the belief that, "investors had mistakenly judged the risk in stocks to be greater than it really was". The authors argued that the stock market deserved a higher valuation multiple, since the historical data demonstrated that, "over long periods, stocks were no more volatile, or risky than bonds".

The idea is that time washes away all sins and stocks are a safe asset for investors with long investment horizons. Known as time diversification, the contention rests on the use of the standard deviation of annualised returns as the appropriate risk measure which, as a matter of basic statistical fact, decreases as the time horizon increases.

The argument is totally misleading, because it is the terminal portfolio value that matters to investors. In this regard, it is the standard deviation of total returns that is the appropriate risk measure. It may be true that the standard deviation of annualised returns decreases in proportion to the square root of time, but the standard deviation of total returns does the opposite. In other words, a 25-year investment is five times as risky as a one-year investment – the dispersion of potential terminal portfolio values grows ever larger as the time horizon increases.

The idea that stock market investments are safe in the long run rests not only upon the standard deviation argument, but also upon the observation that the probability of loss decreases with time. The problem with this line of reasoning is that losses of different magnitudes are treated the same. Is a 30 per cent loss on a $1 million retirement fund in year 30 really equivalent to a 30 per cent loss in year one?

Not only does the magnitude of losses increase with time, so too does the risk of catastrophic losses. For example, incurring a loss of 40 per cent is 10 times more likely after three years than after one year. It is clear that the risk in stock investing is very real as the time horizon grows.

Consider the words of Professor Zvi Bodie: “If it were true that stocks are less risky in the long run, then the cost of insuring against earning less than the risk-free rate of interest should decline as the length of the investment horizon increases. But the opposite is true.”

In this regard, the verdict is against the uber-bulls and believers in Dow 36,000 , as valuation indicators with statistically significant, predictive ability call for minimal investment in stocks right now.

It is a sign of the times that the champions of time diversification are back in the spotlight, but investors should be aware that the advice could prove hazardous to their financial health. The arguments were bogus when Dow 36,000 was first published, and they remain bogus today.
charliefell.com