What Is a Bear Market and What Is a Bull Market?

Answer #1 to the Question What Is a Bear Market and What Is a Bull Market? — They Are NOT Short-Term Ups and Downs in Stock Prices

The New Depression

Much confusion about what is a bear market and what is a bull market is caused by a failure to distinguish short-term price movements from long-term upward or downward trends. The U.S. stock market has been in a bear market since January 2000. That means that stock prices have been working their way downward for ten years now and will likely continue working their way downward for some time to come (this article was posted in March 2010). However, prices have moved upward since March 2009. The latter phenomenon is often referred to as “a bull market” but it really should be given a different label since it has nothing in common with the true bull market that we experienced from 1975 through 2000.

Some stock price changes have long-term significance and some do not. The general rule that you must focus on is that stock prices are always headed on a long-term basis in the direction of fair value. Thus, you should set your stock allocation with an expectation that prices will be headed downward if they are high and upward if they are low. In contrast, short-term moves upward or downward are insignificant and should be ignored. The smart investor tunes out short-term price changes and sets his stock allocation by making reference to long-term trends. So it is a mistake to think of short-term bull or bear moves as being similar to genuine (long-term) bull or bear moves. These are very different phenomena.

Many stock investors who lost money in the stock crash of September 2008 are taking comfort in the fact that prices have traveled upward since then. This is a mistake. We are still in a long-term bear (often referred to as “a secular bear market”). Thus, the effect of any temporary move upward is likely to be canceled out by larger downward price movements that will be taking place in future days. In fact, the more that prices go up, the greater will be the pressure created for stronger and deeper price drops. Today’s stock investors are hurting themselves by cheering on upward price movements and should instead be seeking a stabilization in prices or even modest price drops, which would diminish the risks of further crashes.

If you would like to review the historical data for yourself to come to a better understanding of how the bull/bear cycle works and of what is a bear market, please check out the “Stock Market Data” section of Robert Shiller’s web site.

Answer #2 to the Question What Is a Bear Market or a Bull Market? — They Are Both Dangerous Self-Accelerating Phenomena

What Is a Bear Market?

Many investors cheer on bull markets because they cause temporary gains in portfolio values. This is a mistake. Bull markets are caused by investor emotion. Thus, it is almost impossible to control a bull market. Unjustified price increases cause investors to become even more emotional and the added emotion then causes even more unjustified price increases. When a market enters a bull stage, it has given up much of its rationality, and the tendency of a market that has lost much of its rationality is to lose even more of its rationality. Any bull move (that is, any price increase not justified by the economic realities) causes further bull moves.

The same is true with bear markets. It is also emotion that causes prices to drop below fair value. And, again, emotional price drops cause investors to become depressed, which causes even more emotional price drops. Bear markets are also dangerous, just in a different way than bull markets.

Answer #3 to the Question What Is a Bear Market or a Bull Market? — Both are Self-Cancelling Phenomena

This gets tricky. Bull markets cause even greater bull markets. And bear markets cause even greater bear markets. Until they don’t.

Out-of-control bull markets cause bear markets. And out-of-control bear markets cause bull markets.

Yes, it is a bit confusing. But it does make sense if you think over for a moment the implications of the reality that both bull markets and bear markets are entirely emotional phenomena.

Say that you are a moderate drinker. You drink perhaps a glass or two of beer a week or perhaps a glass or two of wine. What sort of drinker are you likely to be a year from today? The odds are that you will remain a moderate drinker. So long as your drinking habit is a moderate one, it is likely to remain more or less what it has long been.

Bear Markets and Depressions

Now imagine that you are an alcoholic, that you drink a six-pack every night after work. Now what sort of drinker are you likely to be a year from today? Someone who drinks a six-pack a day is on the road to becoming an alcoholic and is likely to be moving farther down that road as time passes. The heavy drinker is likely to be an even heavier drinker after the passage of some time. Like a bull market, heavy drinking is self-accelerating.

But drinking cannot continue becoming heavier and heavier indefinitely. At some point, the alcoholism causes such problems that the drinker is faced with a choice of either killing himself with drink or giving up drink altogether. Excessive drinking increases to the point at which it can no longer increase and then leads to adoption of a drinking habit just as extreme but in the opposite direction. Heavy drinkers usually have to give up drink altogether because the out-of-control nature of their habit rules out the possibility of moderation of the habit.

So it is with bull markets. Bull markets push stock prices to more and more and more insane levels and then cause crashes. It is not possible for insane markets to moderate themselves. Why? Because bull markets are fueled by investor emotions and intensely emotional investors are not open to the consideration of reason, which is a necessary part of any move to moderate prices. Out-of-control bull markets almost always lead to out-of-control bear markets. It would be fair to say that out-of-control bull markets are the cause of out-of-control bear markets.

Answer #4 to the Question What Is a Bear Market and What Is a Bull Market? — Both Are Entirely Emotional Phenomena

The fair-value price for stocks is the discounted value of the future earnings stream generated by the underlying companies. Going back as far as we have records, the average long-term return for U.S. stocks has been 6.5 percent real. So stock prices need to increase 6.5 percent real each year to cover the productivity gains for the year.

Any gains beyond that amount are the product of investor emotion and unsustainable in the long term. Investors should not be cheered by excess gains. They need to be paid back in future years. An investor counting his bear market stock gains as real is like a debtor getting excited because of his additional “earnings” in a year when he took on a lot of credit-card debt. Borrowed money is not real wealth and neither are bull-market stock gains.

The same is of course true of bear market losses. Just as excessively high stock prices must fall to fair value, excessively low stock prices must rise to fair value. So bear market losses are no more real than bull market gains.

Stock Crashes and Recessions

Don’t count the money you “earn” in a bull market (above that reflecting the economic realities) as real. And don’t count the money you “lose” in a bear market as real. What investor emotion gives in a bull market it takes back in the bear market that inevitably follows.

Answer #5 to the Question What Is a Bear Market and What Is a Bull Market? — They Both Compromise the Free Market

Free markets are wonderful. But markets do not yield their benefits by magic. There are preconditions to the effective functioning of a free market. One essential precondition is that participants in the market be sufficiently informed as to what is in their best interest to make effective financial decisions. That becomes impossible both in bull markets and in bear markets.

Say that an investor is at an age where be needs $200,000 in savings to be on track with his retirement plan and that his stock portfolio is nominally valued at $300,000. This investor would be tempted to believe that he is able to afford to buy a bigger house or a newer car or to go on a more expensive vacation than those he has gone on in the past. Now say that stocks are at the time priced at three times fair value (as they were at the top of the bull market of the 1990s). This investor’s portfolio is really comprised of $100,000 of real lasting wealth and $200,000 of cotton-candy nothingness fated to be blown away in the wind during the coming bear market. He is not far ahead in his efforts to finance his retirement but far behind.

Economic Recovery

This investor hurts not only himself when he spends money that he cannot afford to spend. He also undermines the functioning of the free-market economy. The purpose of the free market is to allocate resources to businesses that are doing a good job of satisfying consumer needs. But investors who are prompted by bull market prices to spend excessively cause rewards to be delivered to companies selling luxury goods at the expense of companies selling lower-priced goods. A functioning market would reward the companies responding to the real needs of consumers but the phony bull-market wealth causes funds to be misdirected to companies that properly would thrive only in an economy in which real incomes were higher.

Answer #6 to the Question What Is a Bear Market and What Is a Bull Market? — They Are Both Wealth Destroyers

Bull markets are wealth destroyers. They cause people to spend money that they do not possess in any real sense. Then when the phony bull-market funds disappear in the bear market that always follows a bull market, they cause the overspenders to become worried about their financial futures and thus reduce spending to lower-than-proper levels. Both overspending and underspending do harm to the economy and thereby destroy wealth.

A simple answer to the question “What is a bear market and what is a bull market?” is “Both are no darn good!”

Answer #7 to the Question What Is a Bear Market and What Is a Bull Market? — They Are Both Evidence That Buy-and-Hold Investing Can Never Work for the Long-Term Investor

The Buy-and-Hold Model for understanding how stock investing works is rooted in a belief that investing is a rational endeavor. If stocks could become overvalued, it would not make sense for investors to remain at the same stock allocation at all times (since the long-term value proposition of owning stocks is obviously less at times of overvaluation). Buy-and-Hold posits that overvaluation is impossible because it is not rational. Investors should value stocks properly, Buy-and-Hold advocates argue.

Investors should indeed value stocks properly. That much really is so. What Buy-and-Holders ignore is that investing is done by humans and humans are as much emotional as they are rational. Many investors do not want to invest rationally despite the financial penalties that follow from failing to do so. So during bull markets social taboos against reporting on the realities of stock investing are adopted to prevent those engaging in emotional investing from having to come to terms with their emotional investing decisions.

Answer #8 to the Question What Is a Bear Market and What Is a Bull Market? — Neither Are Required, Both Are Choices

Hope for Better Economic Times

Bull markets and bear markets don’t just happen. Bull markets happen because investors like the idea of voting themselves raises and elect to push stock prices up to unsustainable levels. Bear markets happen because prices must drop once they reach insanely high levels and the price drop depresses investors, causing the drops to be deeper than is necessary. There are no economic forces that require us to endure bull markets or bear markets.

Markets function best when participants are well-informed as to the pros and cons of the choices available to them. We could end both bull markets and bear markets by providing investors with tools that teach them the realities of stock investing. For example, if we explained to investors that “Staying the Course” in a meaningful sense requires an investor to lower his stock allocation when stock prices reach insanely dangerous levels, bull moves would cause stock sales, which would bring prices back down to reasonable levels. Stock prices are self-correcting for so long as investors are warned of the danger of giving in to their Get Rich Quick impulses and permitting bull markets to get out of control.

We all would be better off if there were no bull markets or bear markets, if stock prices increased by the 6.5 percent real justified by the economic realities. In that world, we would obtain the good of stock investing (high returns) without having to endure the bad (price volatility). All that we would have to do is to permit (and encourage!) investors to learn what they need to learn to invest effectively for the long run. That is, we would need to discourage the promotion of Buy-and-Hold, the investing philosophy that encourages investors to give in to their Get Rich Quick impulses and make no allocation shifts even when stock prices rise to insanely dangerous levels.

The great irony is that Buy-and-Hold assumes investor rationality while making investor rationality impossible (by discouraging investors from changing their stock allocations in response to big price changes). We can bring the bull/bear cycle to an end by encouraging our fellow investors to take stock prices into consideration when setting their stock allocations.

Answer #9 to the Question What Is a Bear Market and What Is a Bull Market? — Both Cause Economic Crises

Each of the four bull markets experienced from 1900 forward caused an economic crisis. We have never experienced an economic crisis during that time that was not preceded by a bull market. The bull market causes the crash that causes the bear market that eats up even more middle-class wealth and reduces spending to a point at which the economy can no longer function.

Answer #10 to the Question What Is a Bear Market and What Is a Bull Market? — They Are Change Agents

Cause of the Great Depression
The economic crises brought on by the bull market/bear market cycle force the societies enduring them to change in fundamental ways. The bull market of the 1920s brought on The Great Depression, which led to adoption of the New Deal. The bull market of the 1960s brought on the stagflation of the 1970s, which led to Reaganomics.

The bull market of the 1990s led to today’s economic crisis, which has so far brought us the Tea Party Movement and which I believe in coming days may lead to a shift from the Buy-and-Hold Model for understanding how stock investing works to the Rational Investing Model (the Rational Model posits that investors must change their stock allocations in response to big price changes in an effort to keep their risk profiles roughly constant). A shift to Rational Investing strategies would greatly diminish the risks of stock investing and permit the free market to do a far more effective job of properly allocating capital, possibly ushering in a time of great economic growth and the Golden Age of Middle-Class Investing. That’s if we can survive the additional stock crashes that may be needed to persuade Buy-and-Hold advocates to admit the mistake they made in thinking that the market is immediately efficient rather than gradually so. Let’s all say a prayer!

The New Great Depression Will Not Last Long

It has taken me nine years to work up the courage to write an article about the new great depression. I’m like everyone else. Talking about the next great depression scares me. But things have gotten bad enough (this article was posted in June 2012) that I believe these words must be put forward.
The New Great DepressionThe first thing I want to do is to reassure you. There really is going to be a second great depression. Pretending otherwise makes things worse. I have a reputation for talking plainly about difficult financial subjects. I am going to do that here. But my aim is not to scare you into buying some doom-and-gloom book. So I am going to tell the full story, both the true bad story and the true good story. We are today headed into the next great depression. And then not too long afterwards we will be headed into the greatest times of economic growth we have ever seen.

Reality #1 About the New Great Depression: You Cannot Trust the Conventional Economics Experts to Tell You the Straight Story

You cannot trust anything the expert economists say. They are the ones who got us into this mess! If they knew what they were doing, we wouldn’t be headed into a second great depression. Please ignore anything that the conventional economic experts say.

Reality #2 About the New Great Depression: There is One Group of Economists Who Warned Us About the Economic Crisis Before It Hit

To make any sense of our economic crisis, we need to turn to a group of economists that do not make their living parroting the mainstream ideas. The leader of this group is Yale Economics Professor Robert Shiller, author of the book Irrational Exuberance. Here are some words from Shiller’s book, published in March 2000:

If over some interval in the first decade or so of the twenty-first century the U.S. stock market is going to follow an uneven course down, as well it might — back, let us say, to its levels in the mid-1990s or even lower — then individuals, foundations, college endowments, and other beneficiaries of the market are going to find themselves poorer, in the aggregate by trillions of dollars. The real losses could be comparable to the total destruction of all the schools in the country, or all the farms in the country, or possibly even all the homes in the country.

So there were people who saw where we were headed back at a time when we could have done something to stop it from happening. Those are the people we should be listening to when trying to find a way out of this mess.

Reality #3 About the New Great Depression:: It is Very Easy to Understand Intellectually Why Our Economy Collapsed

Stock prices rose to insane levels in the late 1990s. At the top of the bubble, U.S. stocks were priced at three times fair value; they were priced at $12 trillion more than they were worth. Stock prices always return to fair value after 10 years or so; there is not one exception in the historical record. So anyone paying attention to stock prices knew in 2000 that over the next 10 years we would be seeing about $12 trillion in spending power disappear from the U.S. economy.

The Next Depression

It is not hard to understand why we are all so afraid to spend money today. We had hoped by this time to be much farther along in our efforts to finance our retirements. We are trying to make up for lost time by cutting back on nonessentials and saving more than we ever have before. Our unwillingness to spend has caused tens of thousands of businesses to fail and millions of workers to be thrown out of work. But government stimulus programs and exhortations to spend do not change anything. We are scared about our financial futures. So we are not about to begin spending freely again.

The insane bull market of the late 1990s caused the economic crisis. We were borrowing the money to finance those inflated portfolio values from future investors. We are those future investors! Paying off a credit card debt is a lot less fun than running it up. We have behaved foolishly and caused ourselves great pain. There’s nothing complicated or hard to understand about it.

Reality #4 About the New Great Depression: It Is Very Hard to Accept Emotionally Why Our Economy Collapsed

The cause of the economic crisis is obvious: It is the heavy promotion of Buy-and-Hold/Get Rich Quick investing strategies that did it. The trouble is that this obvious explanation is very hard to accept emotionally. We all feel like fools. This is the fourth time in U.S. history that an out-of-control bull market caused an economic crisis (there has never since 1900 been an economic crisis that was not preceded by an out-of-control bull market). We like to think of ourselves as responsible people. We don’t want to admit that we did this to ourselves.

So we have become defensive about the dangers of Buy-and-Hold. We spend whatever mental energies we direct to consideration of the economic crisis to coming up with rationalizations for it. We blame the government. We blame the big, bad bankers. We blame anything but the marketing pitches that told us that there was no need for us to lower our stock allocations when stock prices reached insanely dangerous levels, that there was some sort of magic blue pixie dust that was going to cause it all to turn out different this time.

Reality #5 About the New Great Depression: We Are Slowly But Surely Coming to Terms With these Realities

I’ve been writing on the internet about the dangers of Buy-and-Hold Investing since May 2002. I’have seen it all. I’ve had old friends of mine threaten to kill my wife and children. I’ve seen web sites set up for the sole purpose of ridiculing me and intimidating me. I’ve been banned from discussion boards and blogs where I had been a widely praised and widely loved community members for years before I started posting about the dangers of Get Rich Quick investing strategies. I’ve had my means of making a living taken away from me because I dared to accurately report the numbers that people use to plan their retirements. I’ve had big-name experts in the field tell me that they love my work but then add that they don’t want to be associated with me in any way because they have seen the intensity of the hate directed at those who speak honestly about the realities of stock investing. I think it would be fair to say that I am the world’s leading expert on the emotional pain felt by Buy-and-Hold investors in the process of coming to terms with the long-term consequences of their many acts of financial self-destruction.

Depression 2012

As the world’s leading authority on this sad matter, I have some good news to impart: It’s getting better!

I haven’t been banned at a new board or blog for six months now. That’s never happened before! I have recently been invited by several bloggers to write Guest Blog Entries for them. That’s never happened before! I occasionally today see reasonably long comment threads appear at the three weekly columns I write on the dangers of Buy-and-Hold. That’s never happened before!

Things are changing.

Why? Because that’s the way it goes with the humans. We have a hard time letting in painful information. But eventually we get around to it. This is the fourth economic crisis that was caused by the widespread promotion of Get Rich Quick strategies. We didn’t come to terms with our mistakes quickly on the first, second or third times either. But we did eventually. We will come to terms this time too. It’s always darkest before the dawn. That’s because it is the darkness that scares us into doing what we need to do to bring on the light.

Reality #6 About the New Great Depression: Things Cannot Change Until They Get a Lot Worse

Buy-and-Hold is not just an investing strategy. It is an industry.

There are rich and powerful people who who have written books promoting Buy-and-Hold. They very, very, very much do not want to get about the business of correcting those books.

There are rich and powerful people who have developed calculators rooted in Buy-and-Hold. They very, very, very much do not want to get about the business of correcting those calculators.

There are rich and powerful people who have built web sites that promote Buy-and-Hold. They very, very, very much do not want to get about the business of acknowledging the financial distress they have caused their readers.

We need to change. We need to begin telling people the realities of stock investing as revealed to us by the academic research produced after Buy-and-Hold was developed. But it’s going to be hard to pull that off.

The consequences of not doing what we need to do must become very dire before we will be willing to take on this hard task. The economic destruction we face today is not nearly bad enough to spur us on.

But it’s getting there. And there are signs that the next great depression is no longer all that far off in the future. If stocks perform in the future anything at all as they have always performed in the past, we will be seeing the second great depression begin sometime within the next two or three years.

Reality #7 About the New Great Depression: We Know How to End the Next Great Depression Once It Comes

The first great depression was caused by insane stock valuations too. But we didn’t know that at the time. So it took some time to bring that one to an end. There is no reason to believe that the second great depression will last even nearly as long.

Depression 2011

It’s not possible today to inform middle-class people about the dangers of Buy-and-Hold. Honest posting on these matters is banned at all the major sites. Shiller’s book was a widely praised bestseller. But even Shiller has acknowledged that he has never gone public with all he knows about how stock investing works because he would be viewed as “unprofessional” if he did so.

All that will change with the coming of the next great depression. Once the second great depression is not something we are speculating about but something we are struggling to overcome, the Ban on Honest Posting will be lifted throughout the internet and we will be able to use this wonderful new internet technology to fill people in on what they need to know to invest effectively and thereby to bring the new great depression to an end

Reality #8 About the New Great Depression: We Will All Live Richer Lives on the Other Side of the Second Great Depression

Investing was not a subject of sustained academic study until the 1960s. And the first model that was developed was the now discredited Buy-and-Hold Model. So there has never been a time when middle-class investors have been able to tap into the benefits of stock investing in an effective way.

All that is about to change with the start of next great depression. We know more about how stock investing works today than any group of people has ever known before. We are blessed. We just need to work up the courage to take on the powerful people who do not want others to learn about the mistakes they have made. We’re almost there.

Another Depression

It’s a strange paradox. But the new great depression might end up bringing on the greatest period of economic growth in our nation’s history. I’m scared. I am sure that you are too. But I want you to know that this is not a scary time that we will be going through for no good purpose. Sometimes we need to go through scary times to achieve great jumps forwards. The experiences that I have seen doing the work I have been doing in this field for the past nine years tells me that this is one of those times.

The new great depression is coming soon.

That’s not necessarily such a bad thing.

The True Cause of the Current Financial Crisis is Buy-and-Hold Investing

Question #1 Re The True Cause of the Current Financial Crisis: Why Did the Economy Collapse in Late 2008?

The economy collapsed because of the reckless promotion of Buy-and-Hold Investing for 28 years after the academic research showed that there is zero chance that this strategy can work for the long-term investor.

True Cause of Financial Crisis
Question #2 Re The True Cause of the Current Financial Crisis: But Isn’t Buy-and-Hold Investing the Responsible Way to Invest for the Long Term?

That’s what most people think. That’s the problem. When a majority of investors come to view the most reckless way to invest as a safe way to invest, many people come to suffer very large financial losses. Our economic system is imperiled as a result.

Question #3 Re The True Cause of the Current Financial Crisis: What’s Not Safe About Buy-and-Hold Investing?

Like all assets that can be bought and sold, stocks offer a great value proposition at some prices and a poor value proposition at other prices. Buy-and-Hold Investors (they are often referred to as Passive Investors) do not change their stock allocations when prices change. That is, they direct just as much of their money to stocks when stocks offer a strong value proposition as they do when stocks offer a poor value proposition. When most investors become Buy-and-Hold Investors (or Passive Investors), price discipline disappears from the market. When price discipline disappears, the market becomes unstable and price crashes follow.

Question #4 Re The True Cause of the Current Financial Crisis: Why?

The purpose of a market is to set prices properly. When prices get pulled too far from fair value, they must be pulled back to fair value or the market will collapse. When we leave the market no other means of restoring prices to fair value, we force a crash. When we invest passively, we leave the market no other means of restoring prices to fair value. It is the buy-and-hold concept and the millions of investors who bought into it that caused the crash.

Question #5 Re The True Cause of the Current Financial Crisis: If the Purpose of the Market Is to Set Prices Properly, Why Did It Permit Stocks to Become So Insanely Overvalued in the First Place?

We are the market. In the short term, we have the power to set prices wherever we want to set them. We naturally feel a temptation to set prices above fair value because doing so appears for a time to be a way of voting ourselves big raises.

Question #6 Re The True Cause of the Current Financial Crisis: You’re Saying That We Like to Set Prices High But that We Also Like Fair-Value Prices. Which Is It?

True Cause of Economic Crisis

It’s both. We feel a great short-term temptation to set prices insanely high. But we ultimately are governed by the long-term economic necessity that prices reflect fair value. It’s the tension between the short-term desire for high prices and the long-term requirement of fair-value prices that causes all stock crashes. If prices never get too out of control, the tension can be resolved through modest price drops. But when the idea that price doesn’t matter (Buy-and-Hold Investing or Passive Investing) catches on, prices go so high that a crash becomes an inevitability.

Question #7 Re The True Cause of the Current Financial Crisis: Why Do You Say that Buy-and-Hold Investors Believe that Price Doesn’t Matter? The Believe in Rebalancing, Don’t They?

Rebalancing doesn’t solve the mispricing problem. The goal of rebalancing is for the investor to remain at the same stock allocation at all valuation levels. That’s not a rational response to mispricing. The rational response to mispricing is a lowering of one’s stock allocation. It makes no sense for an investor to maintain his stock allocation when returns have been reduced and risks have been increased.

The historical stock-return data shows that the most likely 10-year annualized return on stocks when they are priced as they were in the early 1980s is 15 percent real. The most likely 10-year annualized return on stocks when they are priced as they were in January 2000 is a negative 1 percent real. There is no one stock allocation that makes sense at both price levels. An 80 percent stock allocation makes sense when the most likely long-term return is 15 percent real but not when it is a negative 1 percent real. A 20 percent stock allocation makes sense when the most likely long-term return is a negative 1 percent real but not when it is 15 percent real.

Question #8 Re The True Cause of the Current Financial Crisis: Aren’t Stocks Always the Best Choice for the Long Run?

It depends on what you mean by the phrase “the long run.” It is true that stocks are almost certain to provide a great return after 30 years regardless of the price at which they are purchased. However, this is not so at 10 years or 15 years or 20 years or even in some cases 25 years. Someone buying stocks at the prices that applied from January 1996 through September 2008 might not see a return better than what he could have obtained from far safer asset classes for as long as 25 years. It is possible that those who purchased stocks at the top of the bubble will not be able to equal the returns that were available at the time from Treasury Inflation-Protected Securities (TIPS) for 60 years! That’s a long, long, long “long-term.”

Question #9 Re The True Cause of the Current Financial Crisis: Are You Recommending Market Timing?

Debt BombI agree with those who say that short-term market timing (changing your stock allocation with the expectation of seeing a benefit for doing so within a year or so) is a bad idea. However, I also say that long-term timing (changing your stock allocation in response to big price changes with the understanding that you may not see a benefit for doing so for as long as 10 years) is a good idea. It is common sense to take the price at which stocks are being sold into consideration when deciding how much of your money to put into stocks. The historical record shows that long-term timing always works. In fact, it shows that those who fail to engage in long-term timing cannot achieve investing success in the long term.

Question #10 Re The True Cause of the Current Financial Crisis: Didn’t Many Buy-and-Hold Investors Do Well for a Long Time?

All investors heavily invested in stocks did well from 1975 through 1995. They didn’t do well because they invested passively. They did well because stocks were priced to provide strong long-term returns. By January 1996, prices had risen high enough that that was no longer so. It was only from 1996 through 1999 that Buy-and-Hold Investors did well because they invested passively (that is, because they failed to follow the common-sense inclination to lower their stock allocations in response to insanely high stock prices). Rational Investors (those who take price into consideration) have done better since January 2000. Rational Investors are now ahead on an overall basis and that differential will grow over time because of the compounding returns phenomenon.

Question #11 Re The True Cause of the Current Financial Crisis: How Much Does That One Case Prove?

It’s not only the one case. The P/E10 value (P/E10 is the price of the S&P Index over the average of the last 10 years) has gone over 25 four times in U.S. history. On those four occasions, stock investors suffered an average loss of 68 percent real. On each of those occasions, we experienced an economic crisis. We have not once since 1900 experienced an economic crisis that was not preceded by a P/E10 value exceeding 25. It is insanely dangerous stock prices that are the primary cause of economic crises.

It is not hard to understand why. Once we get to insanely high stock prices, stocks must crash if the market is to continue to function. Stock crashes cause massive losses of wealth. Massive losses of wealth cause consumers to cut back their spending dramatically. Dramatic spending cutbacks cause businesses to fail. Business failures cause millions to lose their jobs.

Teaching investors to ignore the prices of the stocks they buy sets in motion a chain of events that sooner or later inevitably produces an economic crisis. Persuading millions to follow a buy-and-hold strategy is the financial-world equivalent of persuading millions to remove the brakes from their cars. Cars without brakes always crash sooner or later. So do economies in which all price discipline has been removed from the stock market.

Question #12 Re The True Cause of the Current Financial Crisis: It Sounds As If You Are Saying That Long-Term Stock Returns Are Predictable. That Would Be a Little Bit Too Good To Be True, Wouldn’t It?

How so? If you think a moment about where it is that stock returns come from, I think you will see that it should come as no surprise to us to learn that stock returns are highly predictable. Stock returns are not set by a Random Number Generator in the Sky. When you buy a share in a broad U.S. stock index, you are buying a share in U.S. productivity. U.S. productivity has been strong enough to finance an average annual stock return of something in the neighborhood of 6.5 percent real for many, many years. It certainly is possible that that number could drop to 6 percent or rise to 7 percent. But it seems unlikely that we will see dramatic changes. So why would anyone think that long-term stock returns would not be at least to a large extent predictable?

Question #13 Re The True Cause of the Current Financial Crisis: Are There Any Experts Who Agree With You That Long-Term Returns Are At Least Somewhat Predictable?

Second Great DepressionYes, there are a good number of them. The list includes: (1) Robert Shiller; (2) John Walter Russell; (3) Rob Arnott; (4) Warren Buffett; (5) William Bernstein; (6) John Bogle; (7) Cliff Asness; (8) Ed Easterling; (9) Scott Burns; (10) Andrew Smithers; (11) Michael Kitces; and (12) Jeremy Grantham. Even many Passive Investing advocates acknowledge that long-term returns are at least somewhat predictable.

Question #14 Re The True Cause of the Current Financial Crisis: If A Good Number of Experts Agree That Long-Term Returns Are At Least Somewhat Predictable, Why Are We Told So Often to Invest Passively?

Most of those cited as “experts” on investing have ties to The Stock-Selling Industry. All industries like to see their customers buy as much of their product as possible and at all times and prices. Buy-and-Hold Investing has brought in millions to The Stock-Selling Industry.

Question #15 Re The True Cause of the Current Financial Crisis: Are You Saying That Most of Today’s Investment Experts Are Corrupt?

No. I don’t believe that. I believe that most of today’s investment experts are smart and good and hardworking people who want to serve their clients effectively. I also believe that most of today’s investment experts arecompromised.

There was a time when the academic research really did support Buy-and-Hold Investing. My sense is that, as the evidence came in that big mistakes had been made in the first formulation of the Buy-and-Hold model, cognitive dissonance kicked in and the “experts” used their high-octane brains to develop ever-more-convoluted rationalizations for ignoring the evidence that valuations affect long-term returns and the implications of that reality. Stock prices continued to go up until 2000, so for years the was little pressure from investors to fix the holes that had been revealed in the theory. After the 2008 crash, investors have become more restless. But now the embarrassment that comes with acknowledging the mistakes that were made for years is greater than ever.

The financial pressures not to question Buy-and-Hold Investing are enormous. An investing expert who finds fault with Buy-and-Hold Investing courts social ostracism and perhaps the loss of a career that is highly rewarding and that pays very, very well. It is human nature in such circumstances not to look too closely at ideas that would rock a happy boat. The psychological literature tells us that in these circumstances it is possible for large numbers of “experts” to feel such reluctance to share the realities as to hold back from learning what they need to learn to appreciate the realities themselves. Today’s investment experts are highly incentivized to know as little about how stock investing really works as possible. Achieving true expert status is a career limiting move.

Even among personal finance bloggers (who obviously do not face the same financial pressures), we have seen a great reluctance to acknowledge mistakes. We are suffering from what the economists call a “Tragedy of the Commons” problem. No one benefits from our failure to inform investors of what really works. The economic crisis hurts us all. But each individual blogger fears that he will lose links and annoy those of his readers who still believe in Buy-and-Hold Investing if he points out that the experts have been giving wildly dangerous advice for years now, and each “expert” fears that he will lose the confidence of his clients if he “tells.”

Dangers of Buy-and-Hold Investing

We need to persuade a few leaders to step forward. My sense is that thousands of others will happily get with the program once they come to feel that it is “safe” to do so, that they will not be violating a social taboo to let their clients know the realities of stock investing as revealed by the academic research of the past three decades.

Question #16 Re The True Cause of the Current Financial Crisis: You Are Saying that the Evidence That Buy-and-Hold Doesn’t Work Is Strong And Yet That the Experts Who For a Long Time Have Been Promoted It Heavily Are Not Corrupt. Isn’t That a Contradiction?

It’s a contradiction. I once recorded a podcast (RobCast #73) entitled “It’s Not a Conspiracy, It’s Cognitive Dissonance.” It tells the story of two academic researchers who joined a cult to learn what makes cult members tick. The members of the cult had given up their marriages and their jobs and their live savings to be a part of a cult that believed that the world was coming to an end on a specified date. When the date came and the world did not end, the researchers watched to see the cult members turn on their leader. The leader said that he would need to check with the aliens who had earlier revealed to him that the end of the world was approaching as to what had happened. He came back to report the happy news that the cult’s strong belief had persuaded the aliens that it was not necessary to bring the world to an end just yet. He congratulated the cult members for the important mission they had accomplished through their many sacrifices. The failure of the world to come to an end on schedule was interpreted by the cult members as confirmation that they were doing the right thing to devote their lives to this cause.


Like it or not, that’s how we operate. I have seen Buy-and-Hold dogmatics threaten to kill those who post accurate reports of what the academic research has been saying for 30 years now. I think it would be fair to characterize such behavior as highly defensive. Yet I can also report that the same community members who feel an intense desire to block honest posting on the flaws in Buy-and-Hold Investing themselves follow it. We cannot say that just because people show that they are aware of the weak points of the Buy-and-Hold concept it is clear that they themselves have lost faith in the idea. My sense is that the vast majority of Passive Investing advocates believe that it works (while also feeling doubts that make them intensely defensive when questioned as to why they believe).

Question #17 Re The True Cause of the Current Financial Crisis: You Said Above That There Was a Mistake Made in the Formulation of the First Draft Version of the Buy-and-Hold Approach. What Was This Mistake?

The academic researchers learned in the 1960s that short-term timing does not work; that is, it is not possible to predict effectively what the stock return will be over the next year or so. There are two possible explanations for this reality. One is that the market does such a good job at setting prices that it is not possible for any investor to reliably do a better job. The second is that the market does such a poor job at setting prices, at least in the short term, that the best that any investor engaged in short-term timing can do is take guesses as to where prices will be in the next year or so.

The academic researchers took a guess that the first explanation was the one that applied. All of today’s conventional investing wisdom is rooted in a belief in the accuracy of this guess. It is because most experts believe that the market does a good job of setting prices that you are told that you cannot beat the market, and that timing never works, and that stocks are always the best investment choice for the long run.

Stock Crash of 2008

Yale Professor Robert Shiller published research in 1981 showing that it was not the first explanation but the second explanation that actually applies. Shiller showed that valuations affect long-term returns; that is, stocks provide higher returns starting from times of good prices than they do starting from times of bad prices. If the first explanation (that the market does a good job of setting prices) applied, there could never be any significant amount of overpricing (overpricing is mispricing, not accurate pricing).

However, Shiller’s findings are entirely consistent with the second explanation. Shiller showed that valuations affect long-term returns. If the market does a poor job of setting prices in the short-term but a good job of setting prices in the long term, it would follow that returns would be poor starting from times of high valuations and that returns would be good starting from times of low valuations.

Prices can go just about anywhere in the short term. But they are always in the process of moving to fair value. When prices are insanely high, they are fated in not too long a time to crash. When prices are insanely low, they are fated in not too long a time to shoot upward. The market is not immediately efficient but only gradually so.

Shiller’s findings have been confirmed by dozens of studies published over the past three decades. There has never been a credible study published supporting a claim that long-term timing doesn’t work. The often-repeated claim that “timing doesn’t work” is a falsehood. The reality (as revealed by the historical stock-return data) is that timing always works and is required for those investors hoping to have a reasonable chance of achieving long-term investing success. Oops!

Question #18 Re The True Cause of the Current Financial Crisis: Can We Be Absolutely Sure That Long-Term Timing Will Continue to Work?

I don’t think we can be absolutely sure.

Common sense tells us that long-term timing must work. For there to be a time when long-term timing did not work, there would have to be a time when the price we paid for stocks had no effect on the value proposition obtained from them. I think it would be fair to describe that as a logical impossibility.

And the historical stock-return data confirms that what our common sense tells us must be so in fact always has been so in the real world.

I don’t think we can say more than that. There are no guaranties. Many were surprised by Shiller’s findings. It may be that we will be surprised again in coming days by findings that few anticipate today. The future is unknown.

That said, I think it would be fair to say that the prudent way to invest is to assume that stocks will perform in the future at least somewhat as they always have in the past. Buy-and-Hold Investing is the longest of long shots. We should not be advising millions of middle-class investors to take the longest of long shots with their retirement money, in my assessment. At the very least, we should be cautioning those who elect to invest passively that the historical data offers little support for their choice.

Next Stock Crash

Question #19 Re The True Cause of the Current Financial Crisis: The Experts Who Promote Buy-and-Hold Investing Have Studied Investing Far More Than You Have and Many Manage Large Funds. Do You Really Think It Is Possible That You Know More About This Than They Do?

I do. The “experts” are smarter in an intellectual sense. The problem here is not intellectual in nature. The problem is emotional in nature. The experts very much want to believe in Buy-and-Hold Investing and the millions of middle-class investors who follow this strategy very much want to believe in it. I am not emotionally attached in this strategy. On this one issue, I believe that I am right not despite my lack of a background in this field but becauseof it. The experts have too much to lose (or at least see themselves as having too much to lose) by acknowledging how strong the case is that Buy-and-Hold Investing does not work and that their promotion of this approach caused the current financial crisis to accept clearly established (in my view!) realities.

Question #20 Re The True Cause of the Current Financial Crisis: Do You Acknowledge That This Is An Incredible Claim?

Yes. It is also the best explanation that my mind is able to come up with to explain an exceedingly strange series of events. On the morning of May 13, 2002, I reported to a Motley Fool discussion board that the studies that financial planners use to help us plan our retirements (these studies are called “safe withdrawal rate” studies) fail to account for the effect of the valuation level that applies on the day the retirement begins and thus get all the numbers wildly wrong. My findings have been confirmed by numerous experts. Yet not one of the discredited studies has been corrected in the seven years since. Instead honest posting on safe withdrawal rates has been banned at numerous discussion boards and blogs. If you are able to come up with a better explanation of this verifiable reality than widespread cognitive dissonance among those who advocate Buy-and-Hold Investing, I would be grateful if you would share it with me.

Question #21 Re The True Cause of the Current Financial Crisis: Are You Saying That 90 Percent of Today’s Investing Experts Are Certifiably Nuts?

I’ve learned wonderful things from a good number of the experts who promote Passive Investing strongly. I feel a good bit of respect and affection for these people. I believe that they are good and smart and hardworking people who fell into a trap when they came to believe in Buy-and-Hold Investing. I believe that they have caused great human misery through their advocacy of this dangerous idea.

Are they nuts? Kinda, sorta. I believe that the wisdom of the television commercial for the Mounds and Almond Joy candy bars applies here: “Sometimes you feel like a nut — and sometimes you don’t!”

We all are kinda sorta nuts re certain issue at certain times and in certain circumstances, are we not? Think of the Passive Investing Era as the time-period when the majority of investing experts drove drunk or got addicted to cigarettes or dated people obviously not right for them. We need to put aside the idea that there is a rational explanation for all human behavior. It’s not so. It’s holding us back. It’s become dangerous for us to continue to entertain this excessively rationalistic (and not even a little bit rational!) fantasy.

John Bogle is a whole big bunch smarter than Rob Bennett in an I.Q. sense. But Rob Bennett has been placed in circumstances that have permitted him to zoom past John Bogle in his understanding of what works in stock investing. I didn’t ask for this to happen. It happened. Given the circumstances in which we find ourselves, I do not think that it would be responsible for me to pretend that I believe that John Bogle is incapable of making mistakes. I am personally aware of a number of very important mistakes that he has made. I would like to help him come to understand where he got on the wrong track and thereby help him to become once again a leading figure in helping middle-class investors to invest effectively.

Overcoming Economic Crisis

I don’t blame Bogle or any other Passive Investing advocate for the mistakes that have been made. But I see it as my job to press as hard as possible for correction of the mistakes. For the mistakes to remain uncorrected puts us all (including the Passive Investing advocates) at great risk.

I wish that we all could get past the temptation to play the blame game and get about the business of repairing the damage done to our economic and political systems through the reckless promotion of Buy-and-Hold Investing for 30 years since it was revealed to be an unworkable idea. Once we do that, I believe that we will find ourselves on a path that takes us up, up, up, rather than on the one that for a long time now has been taking us down, down, down.

Question #22 Re The True Cause of the Current Financial Crisis: How Could So Many Good and Smart People Get It So Totally Wrong for So Terribly Long?

This is not the first time that such a thing has happened. There was a time when millions of people believed that the earth was flat. There was a time when millions of people believed that the earth revolved around the sun. There was a time when millions of people believed that man would never walk on the moon.

These things happen.

The good news is that the reckless promotion of Buy-and-Hold Investing has been an anchor on economic growth for so long now that it is hard to overestimate how good we could have it if we made the shift to a more realistic approach. Rational Investing (the investing model proposed as an alternative to Passive Investing in a number of articles and podcasts at this site) is such an advance that making the shift from Passive to Rational may well provide the lift to middle-class spirits (and pocketbooks!) needed to escape today’s economic and political crisis.

It frustrates me that The Great Safe Withdrawal Rate Debate has often been perceived as a negative story. The abusive posting we have seen is indeed a dark business. But many community members have given generously of their time to help us craft together an exciting new model for understanding how stock investing works. I believe that the ugly stuff will in time be blown away in the wind. The good stuff is going to be enhancing middle-class lives for many, many years to come. This is an up story. Please don’t let anyone tell you different!

Question #23 Re The True Cause of the Current Financial Crisis: What’s Next?

I believe that we need to launch a national debate about the flaws of Passive Investing and that the advocates of Rational Investing principles need to work with the advocates of Passive Investing principles to build a better model for the benefit of all investors. I am not able to imagine how such a debate could work to the detriment of anyone alive on Planet Earth today. I see this as a win/win/win/win/win. Understanding how investing works in the real world will permit us all to obtain far higher returns while taking on far less risk.

Question #24 Re The True Cause of the Current Financial Crisis: Are You Not Telling Us That You Have Found the Proverbial Free Lunch?

I am. I view the idea that there is no such thing as a free lunch as one of the most unfortunate ideas popularized by widespread promotion of the Passive Investing concept. All learning experiences permit us to partake in free lunches. John Bogle’s launching of the Indexing Revolution brought a free lunch to millions. Life itself is a free lunch — did any of us pay for an admission ticket to this wild adventure? Being able to obtain higher returns at reduced risk is our reward for learning how stock investing really works. We should not be reluctant to grab this free lunch and gobble it down hungrily.

Economic Worries

Question #25 Re The True Cause of the Current Financial Crisis: You Acknowledged Above That the U.S. Economy Generates Only Enough Productivity to Finance an Average Long-Term Return of 6.5 Percent Real. How is the Rational Investing Free Lunch Going to Be Paid For?

Promotion of the Buy-and-Hold concept leads to huge market imbalances. At the top of the bubble, stocks were priced at three times fair value. That means that, for every $1,000 that we invested in stocks, we obtained about $350 worth of stocks and about $650 worth of cotton-candy nothingness that was fated to go “Poof!” in days to come. We all possessed huge amounts of pretend wealth. Those with portfolio statements saying that they possessed an accumulated wealth of $100,000 in reality possessed an accumulated wealth of $35,000. Those with portfolio statements saying that they possessed an accumulated wealth of $500,000 in reality possessed an accumulated wealth of $175,000.

The result is that millions of us were spending large amounts of money on houses and cars and vacations that we could not afford to spend. We started businesses that we thought were properly capitalized but that in reality were much undercapitalized. We handed in resignations from jobs in the belief that we were ready to retire when in reality we were not close to being ready to retire. We miscalculated risk in thousands of different ways.

That comes to an end when we begin reporting accurately the numbers we use to plan our financial affairs. In a Rational Investing world, you would never see a report of the S&P value or the Dow Jones value without seeing next to it an indication of the reduction in the nominal number needed to adjust for the effect of overvaluation. For the first time in history, we would be using accurate numbers to plan our financial futures. The implications are almost unthinkable (unthinkably good, not unthinkably bad).

Disappearance of the Middle-Class

We live in scary but exciting times. If we play our cards right, we could turn this economic crisis into a very good thing for all of us. The hard part is working up the courage it takes to say the three hardest words to pronounce in the entire English language — “I” and “Was” and “Wrong.” After that, it’s all downhill sledding.

The economic crisis is over — if we want it to be.


The Last Bear Market,The Last Bull Market

The first sign that we may see a lessening of the intensity of the cycle from bull market to bear market is the increased middle-class participation in the stock market that we have seen in recent decades.

The Last Bear MarketThere was a day when it was only rich people who bought stocks. That obviously is not the case today. If the increased middle-class participation in the stock market proves to be a long-lasting reality, it will likely cause a moderation of both future bull markets and future bear markets.

A big factor in the fueling of the recent bull market was the decision of millions of middle-class investors to buy stocks for the first time. The middle-class worker became wealthier over the course of the 20th Century. By the early 1980s, he had become wealthy enough to invest the way rich people do–in stocks. That change brought a flood of new money into stocks, sending prices soaring.

If all of that money leaves stocks in the bear market that follows, the bear market will be a tough one indeed. But my guess is that most middle-class workers will not abandon stocks when prices go down. I believe that many will lower their stock allocations. But I also believe that the middle-class now possesses sufficient wealth that stock investing has become a permanent part of middle-class life.

That development may temper both bull markets and bear markets of the future.

If the middle-class remains invested in stocks, the next bear market will not be as deep as it would have been if the middle-class abandoned stocks.

If the middle-class remains invested in stocks, the next bull market will not be able to take advantage of as big a flood of money as the last one did from middle-class investors discovering the appeal of stocks for the first time.

The second sign that we may see a lessening of the intensity of the cycle from bull market to bear market is the growing sophistication of middle-class investors.

Articles in personal finance magazines are often critical of middle-class workers for their lack of understanding of money matters. We don’t save enough. We don’t understand investing well enough. We don’t shop carefully. We don’t keep budgets. Yada, yada, yada.

There’s a good bit of truth in all these criticisms, of course. There’s a lot of stuff that we don’t do exactly right. I don’t buy into the idea that that’s because we are dumb, however. I think it is more that incomes have risen quickly over a short amount of time, and we have had to learn a lot of new tricks to know what to do with our new wealth, and that the lessons that need to be learned take some time to sink in. I don’t see much evidence that we are as clueless as we are made out to be. It’s just that we are new at this, and we have a lot going on in our lives, and learning how to manage money is not our #1 priority.

The truth is, despite all the complaining about how dumb we are, we are learning new tricks all the time. There was a time not all that long ago when Money did not exist. Today, there are half-a-dozen copycats. Lots of middle-class investors today find fault with Money for not being sophisticated enough. These are the sorts of people who post about money topics on discussion boards and who read academic studies on investing questions and other stuff like that.

We are getting smarter about money matters every year.

That means that we are less likely to get caught up in either the wild greed of a bull market or the out-of-control fear of a bear market. Most of us are not yet true buy-and-hold investors, in my view. But we are getting there. We are learning what works day by day, year by year.

What Causes Bear Markets?

As we get smarter, we are likely to see a moderation of swings in market prices. Prices may go not quite so high in the next bull market. Prices may go not quite so low in the next bear market.

The third sign that we may see a lessening of the intensity of the cycle from bull market to bear market is that we now have statistical tools that help us rein in our fear and greed.

Investing experts have been advising investors for a long time to rein in the greed that causes bull markets and the fear that causes bear markets. For a long time, people have been ignoring that advice.

It would be easy to conclude from this that bear markets and bull markets will always be with us. To some extent, that’s no doubt so. The headline of this article is a bit of an exaggeration. I don’t really believe that we will never again see a bull market or a bear market. But I do believe that it is possible that the next bull market will be less intense and that the next bear market will be less intense.

There is nothing new under the sun. So the emotions that caused the last bull market and the last bear market are going to cause future ones too. The other side of the story is that the only true constant in life is change. Yes, we will see future bull and bears. But maybe we will see new kinds of bulls and bears.

Investing research has made great advances in recent years. We now have the statistical tools needed to show how damaging it is to get caught up in the emotions of fear and greed. These tools make the case in a more powerful way than do the warnings we have been hearing from investing advisors for many years now. I believe that these tools may persuade large numbers of middle-class investors not just to think about reining in their fear and greed, but to actually take concrete steps to make sure to get the job done.

The fourth sign that we may see a lessening of the intensity of the cycle from bull market to bear market is that we are close to coming to a better-informed understanding of how stocks really work.

We live in exciting times for investors. The Stocks-for-the-Long-Run Investing Paradigm taught us something important about stocks. It taught us that stocks are less risky when held for 20 years or longer. We take that for granted today. We need to take a step back from time to time and appreciate what a breakthrough insight that is. That insight revolutionized our understanding of what it means to invest in stocks.

We are about to revolutionize our understanding of how to invest in stocks yet again. It’s true that stock prices become far more predictable when stocks are held for 20 years or longer. But another key insight was missed by advocates of the Stocks-for-the-Long-Run Paradigm. The newer insight is — Stocks are far more risky when purchased at times of high valuation than they are when purchased at times of moderate valuation.

Combine the new insight (developed by the Financial Freedom Community during The Great Safe Withdrawal Rate Debate) with the old one, and you have a powerful paradox to consider–stocks are both less risky and more risky than we once thought they were. Stocks are less risky because their prices are highly predictable when they are held for the long-term. Stocks are more risky when they are purchased at times of high valuations because their long-term return in those circumstances is predictably not as good as it is at times of moderate valuation.

Bear Markets vs. Bull Markets
Two lessons are being taught. One is that just about everyone should own stocks; given the predictability of the prices of stocks held for the long term, there are few who should be rejecting stocks altogether as an asset class that is just too risky. Another is that just about no one should be going with high stock allocations at times of high valuations; in such circumstances, stocks are so predictably risky that there are few who benefit from going with a high stock allocation.

If it comes to be that just about everyone makes it a practice to always own some stocks, bear market lows will not be as low as they have been before. If it comes to be that just about no one goes with high stock allocations at times of high valuations, bull market highs will not be as high as before.

The fifth sign that we may see a lessening of the intensity of the cycle from bull market to bear market is that the middle-class changes just about everything it touches.

When airplane travel was just for rich folks, it was different. When restaurant dining was just for rich folks, it was different. When television was just for rich folks, it was different.

Now that stock investing is becoming more and more a middle-class phenomenon, the nature of the stock investing experience is likely to change.

What do middle-class investors need from stocks? Less volatility.

Extreme volatility is bad for middle-class investors. Why? Middle-class investors are not in a position to endure large losses. They just don’t have enough in the way of backup funds to see their stock values drop dramatically and not feel intense pain over experiencing the hit.

We need some volatility. If stocks had the low volatility of Treasury Inflation-Protected Securities (TIPS), stocks would provide the long-term returns provided by TIPS. That doesn’t work for us. We need stocks to be risky enough to provide us with appealing long-term returns.

But it may be that stocks are too risky today. I believe that the middle-class is over-invested in stocks today. I believe that the strongest and longest bull market in U.S. history has caused us to let down our guard. I believe that a good number of us are going to take a big hit in days to come, when we see for the first time what a bear market looks like not in books but in real life.

I don’t think we are going to abandon stock entirely as a result, though. I believe that we will learn some lessons. I believe that we will lower our allocations. I believe that we will become more cautious about going with high stock allocations in days to come. But I believe that we will stick with this asset class. I believe that our love affair with stocks is not a summer romance, but the real thing.

If we stick with stocks but become reluctant to return to the excessively high stock allocations that have become commonplace today, the nature of the stock investing experience is going to change. If that happens, stock prices are going to become less volatile. I think that will be a positive change for most middle-class investors.


When Will the Bear Market End?

The long-term annualized real return for stocks is about 6.8 percent. That’s a mighty attractive return. If stock prices become less volatile, the risk premium for owning stocks will diminish. Perhaps the long-term return will drop to 6 percent or something in that neighborhood.

Is that a bad thing? I don’t think so. Many middle-class investors of today will not see that on-paper 6.8 percent return brought to fruition in real life. Many will be so traumatized by the wild price swings we are likely to see in coming days that they will sell at the worst time for doing do, and be made to settle for a less exciting return for their stock investment.

If most middle-class investors stick with stocks, though, and if most middle-class investors become reluctant ever again to go along with advice that they over-invest in stocks, both price volatility and the long-term annualized real return will drop. As middle-class ownership in stocks increases, stocks will become an investment class more suitable for the middle-class worker.

The sixth sign that we may see a lessening of the intensity of the cycle from bull market to bear market is the growing artificiality of the terms “bull” and “bear”.

I often point out the dangers of going with high stock allocations at times of high valuations. For this reason, I am often characterized as a “bear.” Is that characterization an accurate one?

I say “no.”

The historical stock-return data indicates that the most likely 10-year annualized real return for the S&P 500 for a purchase made today (this article was written in May 2006) is 1.1 percent. It is possible that we might see a return as good as 7.1 percent (there’s about a 5 percent chance of this) or as bad as a negative 4.9 percent (again, a 5 percent chance). Is it “bearish” of me to report that this is what the historical data tells those of us who believe that stocks may perform in the future somewhat in the way they always have in the past to expect? If so, how so?

If I were to predict that returns would be on the low side of the spectrum–somewhere near a negative 4.9 percent–that would be bearish. If I were to predict that returns would be on the high side of the spectrum–somewhere near 7.1 percent–that would be bullish. But to report the results of a statistical study of historical returns without taking a position as to whether we are likely to see a lucky returns sequence or an unlucky one is not to be either bearish or bullish. It is merely to be informed and realistic.

How Do We Stop Bull Markets?

As we learn more about what the historical data tells us regarding what sorts of long-term returns to expect from various valuation levels, the idea that all encouraging stock reports are “bullish” and all discouraging reports are “bearish” becomes an increasingly silly idea. You don’t need to be a bear to want to obtain value for your stock investing dollar.

Stock investing in the past 20 years has become a more rational endeavor as new statistical tools have become available to us for analyzing the historical stock-return data. There is still a lot of emotion that goes into stock-purchase decisions, to be sure. But there are a good number of reasons to believe that the trend is toward greater use of data and logic and common sense and away from reliance on feelings and impressions and hunches. Our understanding of how stock markets work is maturing.

As our understanding of how to invest successfully for the long run continues to mature, my guess is that the ups of bull markets may be a little less up and the downs of bear markets may be a little less down. Stock prices will become a good bit more predictable and a bit less volatile. Stocks will become in days to come an asset class of increasing appeal to the middle-class investor.

A Bear Market Analysis of Where Things Are Headed for Stocks from 2012 Forward

Bear Market Analysis Point #1: Bulls Cannot Understand Bear Markets

The first thing you need to understand to appreciate the power of a bear market analysis of where things are headed for stocks from 2012 forward is that no bull market analysis matters at this point. The is a subtle but highly important point. Please take a few moments to let it sink in.

Bear Market Analysis What does it mean to say that stocks are overvalued? It means that stocks are priced irrationally. Mispricing is always irrational.

Why would large numbers of investors become irrational? No one wants to lose money. How could this happen?

It can happen only when bulls become so convinced that they are right that they will no longer listen to other points of view. Bears were not proven wrong in the late 1990s. They were silenced.

If the bears were right in the late 1990s, then the bull were wrong. And they were not wrong because they are dumb. They were wrong because they stopped listening to the other point of view.

Bulls have not been listening to the other point of view for many, many years now. The smartest bull in the world is uninformed about what causes bear markets because by definition no bull truly listens to the bear case. So, if you believe we are today in a bear market (this article was posted in June 2011), you should not have confidence in anything said by any bull.

Bear Market Analysis Point #2: Bears Predicted the Economic Crisis

In contrast, the most intelligent bears have an amazing track record of predicting events in the stock market in recent years. Robert Shiller predicted the economic crisis. So did Rob Arnott. So did Andrew Smithers. So did Jeremy Grantham. So did John Walter Russell. So did Cliff Asness. So did Ed Easterling. So did John Mauldin. So did Rob Bennett.

Bear Market How did we all get to be so smart?

Smart bulls say that it is not even possible to predict future stock market events. Yet all the bears just happened to predict the most important event years before it happened? Huh? This is a mighty, mighty strange reality.

Bears predicted the economic crisis because bears were looking at things that bulls never look at. To develop an informed bear market analysis of your own, you need to come to understand what that something is.

Bear Market Analysis Point #3: The Rational Investor Does Not Ignore Evidence of Irrationality

It’s not something that is hard to understand. The thing that the bears got right and that the bulls got wrong is very easy to understand.

Stock investing is not a rational endeavor.

The entire Buy-and-Hold Model for understanding how stock investing works is rooted in a premise that all investors act in their own self interest. This is why we are told that timing never works. If investors were rational, stock prices would always reflect the economic realities and it would be very hard if not impossible for any individual investor to gain access to the special information needed to predict future stock prices effectively.

But if investors are irrational and if stock valuations reveal to us the extent of that irrationality, there is nothing amazing to be found in the ability of the bears to predict future stock market events or in the power of any investor to time the market effectively.

The P/E10 level (that’s the price of a broad stock index over the average of the past 10 years of earnings) reveals where stock prices are headed over the long term. Stock prices must reflect the economic realities in the long run. So, when prices are insanely high, we know that they will be coming down hard over the long run. And, when stock prices are insanely low, they will be rising like a shot in the long run.

In the late 1990s, stock prices were insanely high. Stocks were priced at three times fair value in January 2000. The dollar value of the overvaluation that needed to be eliminated over the next 10 years or so was $12 trillion. Bears do not tune out information about valuations. So we knew that prices were going to fall very hard over the next decade, hard enough to cause the second biggest economic crisis in U.S. history.

Bear Market Analysis Point #4: There Will Be Another Price Crash

The stock crash is not complete. Again, we know this because we are able to examine the historical stock-return data without the blinders that were required of those who remained bulls in the late 1990s.

bears vs. bulls

This is the fourth time in U.S. history that stock prices reached insanely high levels. Prices never fall all at once; bear markets play out in stages as investors gradually let in the extent of their foolishness over the bull years. On the three earlier occasions on which we permitted stock prices to reach two times fair value, prices continued to fall in the subsequent bear until they had reached a P/E10 level of 7 or 8, one half of the fair-value P/E10 level of 14 or 15.

That’s a 65 percent price drop from where we stand today (a P/E10 level of 24). The bear market has a long way to go.

Bear Market Analysis Point #5: Prices Crashes Feed on Themselves Because the Loss of Wealth Scares People

It’s easy to understand why stock prices must drop to fair value. If prices don’t eventually reflect fair value, the entire market would collapse.

But why must we drop to price levels of one-half fair value? Those are prices as insane on the low side as the prices of the late 1990s were insane on the high side.

The reason is that the drop from three times value to fair value scares people to death. Millions of middle-class people made plans based on a belief that the phony numbers on their late 1990s portfolio statements reflected something real. People bought cars they couldn’t afford. People went on vacations they couldn’t afford. People bought houses they couldn’t afford.

Now those people (all of us) are scared.

That’s why prices will drop so low. Yes, it will be irrational for the P/E10 level to drop to 7 or 8. Irrationality begets irrationality. Insanely high prices lead to insanely low prices a few years later. It always happens that way. There is not one exception in the historical record.

Bear Market Analysis Point #6: We Can Overcome People’s Fears By Informing Them of the Realities

Does it have to happen that way? A 65 percent price drop may put us in the Second Great Depression. Can anything be done to head off this disaster?

Yes, something can be done.

What Is a Bear Market?

We need to see a drop to P/E10 level of 14 or 15, fair value. The economic realities require that. But price drops below that are irrational and can be headed off by doing something about investor fears.

We need to start telling middle-class investors about the realities of stock investing. We have been filling people’s heads with dreamy Buy-and-Hold marketing slogans for 30 years now. We need to tell people what the academic research actually says — that valuations always affect long-term returns, that staying at the same stock allocation at all price levels is buying a ticket to the poor house.

Won’t that upset people?

It will indeed upset people.

But it will also help people come to terms with what they have done to themselves. Bull markets always cause huge economic and political destruction. We should never have let the bull of the 1990s (caused by the promotion of Buy-and-Hold strategies) get so out of hand. That’s over now. We need to act like grown-ups. We need to begin a rebuilding process.

When people learn the realities, they will regain their confidence in the future. No one can say when the 65 percent price drop is coming. But we don’t necessarily have a lot of time to waste. We need to get to work.

Bear Market Analysis Point #7: We Can Bring the Economic Crisis to an End By Acknowledging Our Mistake in Believing in Buy-and-Hold Investing

There’s a lot of good stuff waiting for us on the other side of the Big Black Mountain.

Secular Bear Market The Buy-and-Holders messed up. Big time. But you know what? They were also right about a lot of important stuff. Short-term timing really doesn’t work. Stocks really are a great asset class. Investors really do need to be focused on the long-term and to tune out the short-term noise. Index funds are the best choice for a majority of investors.

We need to take all the good stuff about Buy-and-Hold and put it in a package that does not include the Get Rich Quick component (the idea that it is okay to stay at the same stock allocation even when stock prices reach insanely dangerous levels) that has caused such human misery. I call this package of ideas “Valuation-Informed Investing.” I hope you will read other articles and listen to podcasts here at the www.PassionSaving.com site explaining what Valuation-Informed Indexing is all about and to share with your friends what you have learned and to encourage them to pay us visits as well.

It was no small group of people who got us into this mess. We messed up as a society. Now we need to dig ourselves out of the hole in the same way. It doesn’t have to be depressing. The most painful stage of the process is the stage we are going through today, the stage in which we all know on some level of consciousness that Buy-and-Hold has failed but in which most of us are still trying to pretend that somehow or other this is all going to go away without us working up the courage to say the Three Magic Words (“I” and “Was” and “Wrong”). Once we say those Three Magic Words, our fears lose their power over us and we become enabled to turn our focus from the past to the present.

I Was Wrong! I Was Wrong! I Was Wrong! I Was Wrong!

— Now it’s your turn!