Stupidity versus the Universe – Round 1

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Our favorite German Nobel laureate Albert Einstein once remarked, “Two things are infinite: the universe and human stupidity; and I’m not sure about the universe.”  While bond markets have been pricing Armageddon, stock markets have been on a tear, celebrating new all-time highs.  What are we to make of this and what, if anything, should we do about it?


First of all, none of the latest market action has anything to do with common sense such as the economy improving or companies being more profitable.  In fact Q2 earnings for the S&P 500 are expected to be down 5% year over year, and this is the sixth consecutive quarter of declining earnings.  Rather new market highs have everything to do with stock markets pricing in the hope of more free money from central banks around the world.  Free money has driven interest rates to record lows; $13 trillion of $58 trillion of outstanding government debt worldwide now has negative interest rates.  That’s why on a comparative basis a 1.5% yield on the US Treasury bond looks attractive, even though it’s less than actual inflation.


Ultimately, the party can’t and won’t last.  Everyone knows this.  Consequently we have been seeing ever increasing numbers of well-respected investors liquidating stock, bond and real estate positions and moving into cash.  The problem, however, is that it is extremely difficult if not impossible to predict accurately how much longer the music will be playing.  The band could go on strike shortly or decide to entertain us for a few more months, or perhaps even a few more years.  It’s psychologically painful to watch other people making money when one is not.  Ultimately in the cycle of greed and fear, it is this greed based on other people’s gains that causes us to act most irrationally and decide to stay in or jump in to the market even when we know that there is no economic basis for our actions.  This is how all bubbles form and eventually burst.  Therefore, if anyone feels highly captivated by the stock market action and somehow wants to participate, we would urge extreme caution.


In order to prove our point, we did some research.  We looked at S&P 500 price data since the beginning of 1950 to see what returns were achievable on average for a long term investor who invested his/her capital in the market on a given day and held a position for twenty years.  Then we varied the entry according to some simple conditions so that we had four groups:  The first group shows the average return of a twenty year hold during the time from 1950 until now in the S&P 500, with start dates beginning in 1950 through 1996 (in order to reach a 20 year holding period today).  The second group shows the average return if the portfolio was purchased on a day the market had reached a new high and was subsequently held for 20 years.  The third group shows the average return if the portfolio was purchased on a day the market had fallen 10% or more from its latest high and subsequently held for 20 years.  The fourth group shows the average return if the portfolio was purchased on a day the market had fallen 20% or more from its latest high and subsequently held for 20 years.  Note this data excludes dividends as we only have price data going back to 1950.


PST_market returns based on entry


The results are as logically expected.  If you buy at a new high and hold for the long term, you do much worse than the market.  And if you buy on dips you will on average do much better than the market and far better than buying at new all time highs.


But what should you do if you are already in the market?  Is this a good time to sell or should you let it ride?  While we’re quite confident that the market at some point in the future will be lower than it is today, we cannot say by when or how much.  Therefore a probabilistic bet on the market timing, while it can be profitable and provide uncorrelated returns, is not appropriate for the core holdings of an investment portfolio.


Rather than making an all or nothing bet on whether or not the market is going to go up or down, it might make sense to think about a different type of portfolio, one that is less volatile and has some embedded downside protection.  In this way one can participate in further market gains, should they come, bank some dividends in the meantime, and have some level of protection in the case of a market meltdown.


It is exactly these characteristics that define Carden Capital’s Smart Wealth Indices.  Carden Capital’s Smart Wealth Indices focus on less volatile and dividend paying equities.  In addition they contain a volatility hedge that helps protect on the downside.  Exactly for these reasons our Indices were virtually unchanged while the market lost significantly during the recent Brexit vote.


You can find more information on our Smart Wealth Indices here.  If you are interested in discussing a Smart Wealth portfolio that tracks one of our indices, please feel free to contact us.


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