A Cheat Sheet for Ed Easterling’s Unexpected Returns –Insight #1: The Intermediate Term is the Great Unknown for Most Investors
There was a time when many investors focused on short-term stock investing results. That’s where all this silly bull vs. bear business came from. Bulls were those who expected stocks to do well in the next year or two or three. Bears were those who expected stocks to do poorly in the next year or two or three.
We still often hear the bull vs. bear terminology. It doesn’t make a great deal of sense anymore, however. In recent decades, most investors have learned that the short-term is unpredictable. They have also learned that, while stock prices are unpredictable in the short-term, stocks generally do well in “the long run.” Most investors of today think of themselves as long-term investors. This is progress. We have advanced in our knowledge of how markets work and of how to use that knowledge to accumulate wealth over time.
However, we’ve been learning in recent years that we have not advanced nearly as far as we once thought we had. A huge flaw in the conventional investing wisdom of today has been discovered: The phrase “long-term” is poorly defined. Is the long-term 5 years? Is it 10 years? Is it 15 years? Is it 20 years? Is it 25 years? Is it 30 years? Is it 40 years?
Most of today’s investors do not expect to need to wait much longer than 10 years to see stocks provide reasonably solid returns. Most of today’s investors are due for a rude awakening in days to come. In the event that stocks perform in the future anything at all as they always have in the past, it could take a long time indeed for stocks to provide a return that justified taking on the wild short-term volatility of this asset class. Starting from today’s valuations, it is not hard to imagine it taking 25 years for stocks to provide a satisfying return.
Ed Easterling notes early on in Unexpected Returns that “while traditional investment philosophy mutes the details of highly relevant five- to twenty-year periods of market action by focusing on long-term average returns,” the focus of his book “is on intermediate-term time frames.”
One of the breakthrough ideas in John Walter Russell’s research has been his focus on the intermediate-term time-period. That’s where the action is today. Ed Easterling is planting his insights in the same fertile soil. Unexpected Returns is not yet another investing book parroting the same stale insights you have read or heard discussed dozens of times before. Easterling’s research tells us something new. Easterling’s research matters. Easterling’s insights are breakthrough insights.
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #2: The Old Buy-and-Hold Is Doomed
Regular readers of this site know that I am a big advocate of buy-and-hold investing. I am not at all an advocate of the conventional approach to buy-and-hold, however. The old buy-and-hold is dangerous stuff. It’s ready for the ax and I pray that we get the word out to as many middle-class investors as possible as soon as possible.
Easterling is not a fan of the flawed approach to buy-and-hold. He says: “The conventional wisdom of buy-and-hold worked quite well — not because it is a timeless strategy but because it was the right strategy for the market environment over those two decades [the 1980s and 1990s]. By contrast, the conventional wisdom of buy-and-hold was devastating to investors during the 1960s and 1970s; it simply does not work in all environments.”
The old buy-and-hold is dead. Long live the new buy-and-hold!
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #3: Today’s Popular Understanding of Investing Risk Is Tragically Flawed.
Many of today’s investors have been led to believe that all they need to do to obtain higher returns is to take on greater amounts of risk. Um — it does not work quite like that. At times like today, riskier assets often promise lower returns than safe assets. It makes no rational sense, but then who said that us human investors must always be big on rationality when making our investment choices? If investing decisions were entirely rational, stock prices could never get to where they are today, could they?
Ed Easterling gets it. Here is what he says on Page 12 of Unexpected Returns: “Risk is not a knob that one turns to automatically receive higher returns…. They [investors] naively approach investments with a mistaken confidence in future returns by assuming that higher risk means only near-term volatility rather than permanent losses to their account…. History and the operation of rational markets have shown that stocks should return more than bonds over the very long term, but the degree of risk in stocks varies greatly depending on market valuations.”
Bravo, Ed Easterling! That’s a point that very much needs to be made, to be made clearly, and to be made often.
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #4: The Efficient Market Story is a Tall Tale.
Easterling doesn’t tell the readers of Unexpected Returns bedtime stories aimed at helping them sleep at night despite the excessive risk they are taking on in their oversized stock portfolios. He tells it like it is. He warns us that: “Markets are an efficiency process, not an efficient condition…. Over longer periods of time, prices tend to reflect the value of securities. In the short run, prices can vary significantly from the underlying value based upon the daily battle between buyers and sellers.”
That’s right. There are pockets of efficiency in the stock market. Investing decisions are not entirely emotional. Decide on a portfolio allocation at today’s prices with the thought that markets are entirely efficient, however, and you are cruisin’ for a bruisin’. The markets are just efficient enough to trick most of the popular investing experts into believing that it’s not necessary for investors to adjust their stock allocations in response to huge price rises.
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #5: The Accumulation Stage Is Shorter Than Most Experts Seem to Realize.
Why is it that the focus of the conventional investing wisdom has been how stocks perform over time-periods of longer than 30 years (it is only for time-periods of over 30 years that it is reasonable to argue that stocks are always best “for the long run”)? In the real world, most investors are focused on significantly shorter time-periods.
In fact, “Most individuals are forced by the realities of life to work with a shorter time frame of about 20 years. They do not accumulate substantial assets until they are in their 40s, and need to begin drawing on those assets in their 60s.”
My view is that the typical investor’s most significant time-frame is often even shorter than that. Investors don’t save only for retirement. They save to have something to fall back on when hit by economic recesssions or corporate restructurings. They save to be able to afford college for their children. They save to move into bigger houses. They save to be able to start their own businesses. Portfolio losses of 50 percent or more, which should not come as a surprise to those investing heavily in stocks at today’s prices (this article was posted in March 2007), are going to put the strategies of many investors purporting to be following a buy-and-hold approach to a serious test.
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #6: Investors Need to Keep Secular Market Cycles in Mind When Planning Portfolio Allocations.
There are no allocation rules that work equally well for all investors. Some of us begin to accumulate investable assets when stock prices are low and long-term returns are highly attractive. Others of us begin to accumulate investable assets when stock prices are high and safer asset classes offer more appealing long-term returns. Should both types of investors be going with the same stock allocation early in their investing careers? Hardly. If the latter group wants to earn solid long-term returns from stocks, it needs to protect its assets until prices return to reasonable levels.
As Ed Easterling puts it in Unexpected Returns, “The cycles that occur during an individual’s period of investment will dramatically influence the returns that investor realizes.” For investors to ignore the strategic implications of this investing reality is folly.
A Cheat Sheet for Ed Easterling’s Unexpected Returns –Insight #7: Valuations Matter Big-Time.
Valuations matter. Where have we heard that tune before?
Easterling observes: “The highest-return 20-year periods peaked during the late 1990s bubble and contributed to the currently popular, and misguided, notion that stocks are always a good investment, regardless of price…. Periods that start with lower valuations tend to have higher returns, while periods that start with higher valuations tend to have lower returns.”
Our common sense tells us this has to be so. It’s hard to keep in mind when so many “experts” are only too pleased to tell us what we desperately want to hear rather than what we desperately need to hear. I think it would be fair to say that Ed Easterling takes his responsibilities to the readers of his investing advice a bit more seriously than do a lot of the more popular of today’s “experts.”
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #8: It’s Not Just High Returns That Cause Us to Underestimate the Risks of Holding Stocks.
Most investors raise their stock allocations far too high when prices go to the moon and then lower them far too much when prices go to the bottom of the ocean. The nice warm feeling of obtaining outsized returns for a long stretch of time during a secular bull market causes us to come to a flawed understanding of how stocks really work. Easterling explains that it’s not just the high returns of secular bulls that fool us. Volatility is relatively muted during long-running bulls too.
As he puts it, “The low volatility that characterizes bull markets contributes to the comfort and confidence many investors feel during those periods. As you might expect, the higher volatility that occurs during bear markets adds greatly to the discomfort and anxiety felt by investors who experience declining markets.”
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #9: It’s Not the Economy That Matters Most.
“Despite the general contention that the economy and the stock market are closely connected, the facts get in the way of confirming conventional wisdom.” So says Ed Easterling in his book Unexpected Returns.
A Cheat Sheet for Ed Easterling’s Unexpected Returns — Insight #10: Stocks Are a High-Risk Proposition at Today’s Prices.
Stocks are sometimes a good investment for the long run. Not today, though. The potential return is too limited. The potential downside is an ocean of pain.
Here’s how Ed Easterling puts it in his book Unexpected Returns: “There is a natural limit to the level of sustainable P/E ratios. Icarus could not fly to the sun, and P/Es cannot be sustained on a broad basis much above the low to mid-20s because of limits on the real growth rate of the economy and the market’s requirement that equities be priced to return more than bonds. It took a bubble in the late 1990s to break through this natural barrier temporarily. It is not a coincidence, though, that many of the secular-cycle tops over the last hundred years peaked with P/Es in the 20s.”