How to Survive a Market Downturn

Copyright 2002 Tom Madell, Ph.D.
Publisher, Mutual Fund Trends/Research Newsletter
http://funds-newsletter.com

An amazing feature of stock markets is the tendency to move in a given direction long past what seems reasonable. An upward or downward trend, once established, can continue for years.

One might expect that after several months or even a year of continually rising prices many investors with large paper profits would start to exit the market, while those who missed out would think twice about jumping in. Sellers would therefore outnumber buyers and prices would fall. Exactly the opposite would be expected to happen if prices went into a six to 12 month downswing. In this case one might presume that selling energy would have been spent and pent up demand would favor rising prices.

Reality, however, shows just the opposite. As a favorable market progresses investors become convinced that these assets are intrinsically valuable, and even a succession of negative events doesn't alter expectations. It is only through a series of negative economic changes that the long-term trend finally reverses and a long bout of pessimism sets in.

The bull market of the 1990s was stereotypical of a long-lasting trend. Investors first assumed that the dip beginning in March 2000 would pass quickly, and continued to put the majority of their funds into aggressive growth stocks. Unfortunately, most did not see fit to put more than a relatively small amount of their assets into bonds or other types of investments that would provide diversification.

Even as the bear trend became more apparent toward the latter part of 2000, many investors' prior successes prevented them from recognizing and acting upon the change. However, the negative trend was now firmly established, and it too is lasting considerably longer than expected.

What Governs Market Movements?

The movements of the investment markets are not governed by complex valuation formulas, but rather represent the collective judgments of their participants. On the whole, people are very much conditioned by prior long-lasting successes (or losses, in the case of a bear market) and do not change their assumptions until forced to do so by a great deal of opposing information. Initially they base their decisions more on psychological factors than on actual current market conditions.

Long spells of over and underperformance hold true not just for stocks, but all investments, including bonds, specific sectors such as gold and energy, and sub-categories such as "value-oriented" stocks. A positive trend in one category often occurs simultaneously with a negative trend in other categories. Since no one can fully anticipate these trends, it would be a fundamental error to base your investment program on an all-or-none strategy, fully invested in one single asset category at any given time. A more sensible approach is to maintain a "core" holding of different investment categories throughout the years, regardless of the ups and downs of each category.

But assuming you could recognize the rising and falling trends of different asset classes as they were happening, wouldn't it be wise to direct new investment into well-performing categories, and to shift holdings from poorly performing categories to positively performing ones? The answer is a little more complex than you might think.

Identifying Long-Term Trends

You can identify important trends within different fund categories by examining long-term returns. Many sources show the returns for major fund categories over the last one, three and five-year periods. Typically you will find huge performance differences between asset categories. Many investors assume that the positively performing classes will continue to outperform while the negative categories will continue to trail. This makes sense to a certain degree. Ultimately, however, evidence shows that once overperformance or underperformance becomes extreme, showing itself over a number of years, the trend will likely not continue. For example, in March 2000 value funds had substantially underperformed growth funds for about 10 years in a row. As a result, it no longer appeared wise to assume a continuing advantage for growth over value. Yet that is exactly what most investors did, to their ultimate regret.

A protracted period of over or underperformance (say, five years or more) should tip you off to the possibility that a reversion to more average returns may be forthcoming. Diabolically though, it is also true that underperforming categories may go on underperforming much longer than expected as a result of the longevity of trends. How can you avoid jumping in or out too soon?

Long-term trends are built on economic fundamentals. As long as prevailing fundamentals remain in place, an existing market trend is likely to continue. But when economic fundamentals begin to change, the time may be near for a change in the direction of performance. Look for changes in basic economic fundamentals such as GDP, corporate profits, consumer confidence and the unemployment rate to alert you to a possible upcoming change in investment trends.

Here's an example. Looking at the average five-year performance of US and European stock funds, you will see that these asset categories are currently performing well below the expected long-term returns for stocks. Are they therefore undervalued? Not necessarily. Both categories are clearly in a severe negative downtrend, as shown by the negative one and three-year performance results. Of course, history suggests these categories must reverse their poor performance sooner or later. Until returns become positive, however, preferably for a full year or more, any investment in such funds may wind up falling victim to the ongoing long-term negative trend. As well, as of this writing (early October 2002), there has been little clear evidence that economic fundamentals have changed for the better in either the US or Europe, suggesting that the long-term bear market in stocks in these regions may persist despite their underperformance over the past five years.

In the event of a lack of change in economic fundamentals, the best advice is to seek out asset classes that are underperforming over five years as compared to their long-term asset category returns, yet show positive performance trends over the last year or so. Although currently it is difficult to spot such opportunities in light of the overall downturn, some of the categories of funds that meet both these criteria might be those that invest in Pacific/Asia excluding Japan, natural resources, real estate, and international bonds.