Where Is the Market Headed?

January 29th, 2010

The exact date and location of America’s first cocktail party is lost in the mists of time, but we know what the main topic of conversation was. “Where is the market headed?” ranks with weather and sports as one of the three conversational mainstays. Notwithstanding all the effort and attention paid to it, the level of forecasting expertise is no higher for the stock market than for the other two.

You Can’t Beat the Market

The world’s leading portfolio managers are unable to consistently forecast the prices of individual stocks well enough to “beat the market” – that is, compile a rate of return higher than that of market averages such as the Dow Jones or S&P 500, or sector benchmarks such as the Russell 2000. For years, The Wall Street Journal invited experts to select portfolios in competition with a portfolio created by throwing darts at its stock listings. The darts generally won.

Even if we recognize the difficulty of successfully picking individual stocks, does it follow that overall market performance should be just as unpredictable? There is at least one powerful reason to suppose otherwise. The underlying source of gains in real income over time is productivity, which should increase gradually and predictably over time – say, 2-3% per year in real terms. Why doesn’t this produce stable and predictable market performance?

The roadblocks to overall-market forecasting are the same as those militating against individual stock-picking. Publicly available information about stocks is absorbed by market professionals and incorporated into stock prices very quickly. How quickly? Estimates vary, but it may be within seconds of release. This leaves little window of opportunity for capitalizing on “hot tips” and other market intelligence in order to buy stocks whose price is about to rise (or sell those whose price is due to fall). By the time the average person learns relevant information about a stock, the significance of the information is already “baked in the cake” – that is, incorporated in the stock’s price.

Why Do Stock Prices Fluctuate So Much?

The stock-price fluctuations we observe daily, weekly and monthly are largely due to random variation. Something happens that will affect the company over the course of the next few days, months or years. A sudden shift in consumer demand, the illness or death of a key manager, a technological innovation that came out of nowhere, a regulatory ruling or political initiative – these things happen all the time but aren’t predictable specifically or in the aggregate.

The common sense of this is that the things we can predict are “already” reflected in stock prices – incorporated too quickly for us to do anything about it – while the other things that affect stock prices don’t help us predict them because they can’t be foreseen in advance. Faced with a prognosticator who purported to call the future turns in the market, an economist would counter with the famous old saying, “If you’re so smart, why ain’t you rich?” Anybody who could reliably forecast turns in the stock market could earn enormous profits simply by buying (or selling short) the relevant market index, such as the S&P 500.

The Business Cycle

Overall stock prices are also affected by the course of the business cycle. Since we have compiled a staggering volume of information on the 36 recessions suffered since 1776, you might expect to find this phenomenon susceptible to prediction. Yet it has proved stubbornly difficult to foresee turning points in the general level of economic activity. The most recent example is the current recession, which began in December, 2007, but wasn’t even acknowledged officially until almost a year later. The accompanying financial crisis, by common consent the most cataclysmic since the 1930s, was likewise foreseen by few. If we can’t successfully forecast events this momentous, it’s not surprising that everyday stock-price movements elude us.

Government intervention to stabilize the economy and counter the business cycle has not made market movements more predictable. In the first place, the intervention doesn’t work. (This fact is widely acknowledged within the economics profession.) In the second place, the effects of the intervention are hard to predict because politicians and their appointees are seldom systematic and consistent in the way they respond to economic change. The responses are tailored to the political exigencies of the moment. They are not analogous to the actions of a doctor treating a diagnosed illness with demonstrated therapies. Rather, they more closely resemble the actions of a patient afflicted with hysteria.

Don’t Trade – Invest

The upshot of all this is that serious conversation about the future course of the stock market is a waste of time for most people. The operative word here is “serious.” We can and do talk about the weather, complain about it and make provision for it. But nobody short of a meteorologist would dream of betting their future well-being on it. One could argue about whether gambling on sports is a scientific endeavor or not, but the woods are full of people who have lost their shirts testing the proposition.

Yet there are apparently millions of people who believe that it is necessary to trade stocks in order to profit from them. Promoters of stock-trading programs and systems encourage this belief. People who angrily denounce the stock market as a casino tend

to equate “playing the stock market” to playing a lottery, when in fact investing could not be more different from gambling.

The watchwords of respectable students of economics and finance might be: “Don’t trade stocks – invest in them.” Pick a diversified portfolio of stocks – or, even better, pay somebody to pick them for you – than hang onto it, adding to it as circumstances allow and rebalancing the portfolio as necessary to preserve the desired allocation of assets. Don’t expect to beat the market. In fact, the optimal strategy may well be to buy the lowest-cost index fund. This will minimize the annual bite taken out of your capital by management expenses.

Dilute your holdings with lower-risk investments such as bonds, money-market funds and CDs to dial risk down to your level of tolerance. Indulge your craving for security with annuities. Hold real assets like a house and hedges against inflation and market meltdown such as gold. Where finance and investments are concerned, strive for “boring” rather than “exciting.”

Get a Good Night’s Sleep

By all means, pontificate about “where the market is headed” at cocktail parties if it amuses you. But don’t toss and turn at night worrying about it. You not only can’t affect it, you can’t foresee it, either. Instead, try to build wealth the old-fashioned way – by earning it, then investing it at a positive return. Look elsewhere for the flamboyant, exciting rewards in life. You may or may not die rich by adopting this philosophy, but the chances are you’ll die happier.

Category: Annuities, Economic Analysis, Economic News, Retirement Planning | Tags: , , ,

Comments are closed.