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.
There 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.
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.
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.
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.
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.