Anders Geertsen Ph.D
Contributing Writer
instructor@mywealth.com
I wrote recently about the bubble in housing (How to Know that you are NOT Overpaying for a Home). In some parts of the country, it is now time to start looking for a house if you’ve been on the sidelines. But in a lot of places it’s still too early. You have to look at the long term trend as well as affordability. Until housing is back at the historical trend, you shouldn’t buy.
Keep on renting instead and save money for the down payment. With the speed of the housing crash, I think there’s a good chance that you can buy at reasonable prices starting in 2010 in most of the country. But in 2009, it’s too early in most areas.
Now the other big “boogey man”, the stock market, which has crashed in its own right. The S&P 500 is some 50% below its high set in 2007. And the stock market has been extremely volatile in the past few months. See Bob O’Brien’s article on the recent 8% surge in the S&P:
The current bear market has lasted around 17 months, which is close to the “average” length of bear markets over the past century. The decline, however, has been much larger than most bear markets.
That’s because this bear market is accompanied by a financial crisis. A financial crisis doesn’t always happen alongside a bear market, but when it does, it really hurts. The tech bear market of 2000-2002 had no significant impact on the nation’s banks. But this time it is different. No industry or sector has escaped the claws of the bear, because when a banking crisis hits, it impacts everyone. That’s because when banks stop lending, the whole economy freezes over.
History shows it takes several years to work through a banking crisis, and we’re not there yet. A lot of banks (hundreds) will fail this year and the next. Unemployment will keep going up at least through 2009 and perhaps into 2010. Profits will suffer and earnings will stay depressed at least through this year.
The longest recessions in the past 50 years were the 1973-74 recession and the twin 1980-1982 recession. Both lasted 16 months. We’re already there; officially, this recession began in December 2007, so we’re now at 16 months and counting. There’s no way this recession will end next month. It will last at least another 6 months. So we’re looking at a full two year recession. That hasn’t happened since the Great Depression.
Here’s what to do with stocks!
So what should you do with your stocks? Well, if your investment horizon is at least 10 years and you’re already in the market, you may want to stay in. The stock market is not overpriced anymore; in fact, it’s now below trend.
The 10-year rolling operating earnings of the S&P 500 companies is around 60. With the market now trading around 750, which gives it a P/E of 12. That’s below the long term trend of 16, and historically returns over the next decade have been in the 7-10% range per year when the stock market started out at these levels.
If you’re young (in your 20s or 30s or perhaps even 40s) with a stable source of income, then you will likely do well if you dollar cost average in the current market. That means, don’t try to time the absolute bottom (no one can). Instead keep buying at regular intervals (say every month) and stick to it, even if the market drops further.
The great investing mistake that a lot of people make is they only dollar cost average in the good times, but give up on this strategy when the markets drop. But you should stick to it; the best time to buy small pieces of the market is when it’s down. And you will be rewarded in the long run.
Here’s some historical data. Let’s just jump right at it and use the Great Depression for comparison. Say you invested at the peak of the market in 1929. Let’s look at two investors, A an B. Investor A jumps in with all he’s got (the buy and hold strategy). Investor B, however, knows that it’s better to dollar cost average. So he buys small pieces of the market, at regular intervals, also starting at the peak in 1929. (For simplicity we’ll ignore reinvesting of dividends, since most investors don’t manage to do that on a consistent basis.)
Investor A, who bought at the market peak in 1929, would break even after 25 years. That’s when the stock market reached its previous 1929 highs (in 1954). 25 years is a long time. Investor B, by contrast, who dollar cost averaged, would break even after only 5 years (again without counting dividends).
There are really three basic rules to successful stock market investing. The rules would have kept you out of trouble in the 1929 crash, the Japanese stock market crash in 1990, the tech bubble and the debt bubble of recent years. Best of all, the rules are very easy. They require very little work to follow. In future articles I will explain each rule in greater detail.
Here are the rules:
Rule #1. Don’t buy unless the market is at or below its long term pricing trend line.
Rule #2. When you buy, try to dollar cost average. Don’t put it all in right away; instead keep adding to your positions as long as the market is at or below its trend line (Rule #1).
Rule #3. Diversify and use low cost ETFs. To buy the US market, simply use the SPY, which will cost you 0.08% in yearly expenses (+ trading costs). To buy Europe and Asia, use EFA. To buy emerging markets, use VWO. Stay away from the very speculative sectors unless you have special knowledge. Keep it simple.
Our course on investing is designed to help you understand these rules and other techniques for managing your finances: http://www.mywealth.com/investing.html
Contributing Writer,
Anders Geertsen Ph.D.
