The Stock Market Is Cyclical But Not in the Way That You Think

The Stock Market Is Cyclical But Not in the Way That You Think
FirmBee / Pixabay

Valuation-Informed Indexing #340

by Rob Bennett

I was recently at a dinner party at which the subject of the high valuations in the stock market came up. A fellow explained why he is not too worried. “Stocks go up and stock go down,” he said. “They always have.”

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I am always listening for those sorts of statements, statements that reveal why the average person is not nearly as alarmed about today’s stock prices as I am. It was a very simple statement and of course a true statement. Stock prices really do go up and down. And it really is so that they always have. It hit me that this simple and obvious reality offered this fellow and millions of others who see the situation as he does a good bit of reassurance.

He gets it that prices are high. But he doesn’t believe that he can identify the date when they will come down (I agree with him re this one) and so he has adopted a philosophical take. There have been times of high prices before and prices really have come down from those high levels. But what of it? There’s nothing that the individual investor can do about it. It would be crazy to avoid stocks altogether (I agree with my dinner party friend re this one too). So why devote mental energy to worrying about high prices? Buy and Hold. Stick to your pro-stock strategy and it will pay off in the long run. Yes, prices will go down from where they are. But eventually they will go up again. There’s no sense worrying about the ups and downs if we cannot identify them in advance.

I do not agree with this perspective. But I do see the logic in it. I can see why it has persuaded so many good and smart people to follow and advocate the Buy-and-Hold strategy.

The statement that “stocks go up and stocks go down” is a declaration that the market is cyclical in a short-term sense. The fellow at the dinner party was making an observation that five years ago stock market prices were somewhat higher or somewhat lower than they are today and that five years before that they were somewhat higher or somewhat lower than they were five years ago and that these differences have not really amounted to much. Five years from now prices will again be somewhat higher or somewhat lower and again there will be a general feeling of “who cares?” These short-term price changes cannot be predicted. And all investors must invest in stocks. So the best attitude to take toward the cyclical nature of price changes is a philosophical one.

Stock prices are cyclical in a second way. They are also cyclical in a long-term sense. There are two critically important differences between the two forms of cyclical price changes. Unlike the short-term cyclical changes, which are not predictable, the long-term cyclical changes are highly predictable. So it does not make sense to fail to ake them into consideration when setting your stock allocation. And, unlike the short-term cyclical changes, which can safely be ignored with employment of a philosophical attitude, ignoring the long-term cyclical changes is investor suicide.

The reason why most of us are aware of the short-term cyclical changes and not the long-term cyclical changes is that we experience the short-term cyclical changes over and over again during the course of an investor lifetime. We experience the long-term cyclical changes only once or twice. The typical bull/bear cycle plays out over about a 35-year time period. An investor who begins investing at age 25 might not experience the completion of a single bull/bear cycle until age 60. Research can reveal to us how the same long-term patterns repeat over and over again. But we are unlikely to notice them on our own. And of course it has only been in recent decades that extensive research into these questions has been performed.

If you look at a chart of P/E10 values over five years or ten years, you will see the numbers bouncing all over the place. There will be up years followed by down years and there will be down years followed by up years and there will be strings of up years followed by strings of down years and so on. Essentially you will be looking at a random walk of stock prices. Unpredictable. Re these sorts of stock price changes, my dinner party friend nailed it with the observation that: “Stocks go up and stocks go down. They always have.”

But this is not at all the case when it comes to the long-term cyclical price changes. Those have played out in a repeating hill-and-valley pattern for the entire length of U.S. stock market history. The hills stretch on for many years and are always followed by valleys. The valleys stretch on for years and are always followed by hills. Very predictable stuff. And not stuff that can safely be ignored. Get hit unprepared by the onset of one of the long-lasting valleys and you can see decades of gains experienced during the preceding hill wiped out in a few months of time. Few investors can recover from that sort of hit, especially given that the valley that arrives is likely to remain in place for many years.

The hill-and-valley pattern is a counter-intuitive phenomenon. This is why it can take a long time for an understanding of how it works to click into place for most of us. We think of today’s stock market price as reflecting today’s stock market reality. But if Shiller is right that valuations affect long-term returns, then today’s stock market price reflects only today’s emotional reality, not today’s economic reality. Today’s valuation level tells us how much of a disparity there is between today’s economic reality and today’s emotional reality. Given that this disparity is always erased over time, we can know by looking at today’s valuation level where stock prices are headed in the long term.

Stock prices do not play out in the pattern of a random walk in the long term. They do that only in the short term. In the long term, they play out in a hill-and-valley pattern. From a long-term perspective, it is not true that stocks go up and stocks go down. From a long-term perspective, high-priced stocks always go down hard and low-priced stocks always rocket upward. It makes perfect sense to ignore the unpredictable short-term price changes. But ignoring the highly predictable -long-term price changes is a dangerous and costly business

Rob’s bio is here

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Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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