High Market Levels: The market is near its all-time
highs and there have hardly been any down periods since 1990.
Sooner or later it is going to fall. Isn't it dangerous to stay
invested? Does it make sense to reduce exposure to the stock market?
I agree that sooner or later we will have a down market. The
business and stock market cycles have not been repealed as has
been claimed in a few articles. The problem is that no one knows
when and from what levels the next market fall will start. It
is possible the market will continue to go up long enough so that
the bottom of the next drop will be higher than we are now. Other
than "it will fluctuate," I make no claim that I know
what the market will do in the near term, which includes the next
few years. I doubt that anyone else (including Chairman Greenspan)
really knows either, so your guess is as good as mine or those
of the "experts." When people tell me they are scared,
I usually ask how long they have been scared and what the market
was at when they became so. The typical answers are "for
a year (or two)" and at market levels well below where we
are now. Fortunately, most I talk to did not pull out of the market
when their fears first set in. Being scared is much better than
being overconfident and thinking you know everything that is going
on. The key is not to let your emotions get in the way of making
sound decisions.
Rather than trying to decide when the market is "too high,"
it is more important to evaluate your overall investment in stocks
and mutual funds in the context of your financial posture and
investment horizon. Where are you now financially? Where do you
want to be and why (e.g. to fund retirement or college)?
How long in the future is that? Assuming your investment horizon
is at least five years, you probably should not worry too much
about what the market is going to do in the next year or two.
Since we can't forecast short-term movements consistently and
accurately, why try? Certainly, the market may go down in 1997
and/or 1998, but it should also go back up. Historically, the
stock market has provided better returns over long periods than
just about any other investment. On the other hand, if you think
you will need the money invested in stocks and mutual funds within
three to five years, if those funds are already (nearly) enough
to satisfy your needs, and if significant losses will result in
not having enough money when you need it, then it makes sense
to take some or all of your investment out of the market and put
it something else, say short-term bonds, where it will be sheltered
from losses and can grow a bit if that is all that is required.
Money needed within three years should not be stocks.
Select Switching in Poor Markets: OK, I should stay
in the market. How will your system do in a down market
? This is a harder question to answer since there really haven't
been any lengthy down markets since 1987, which is the beginning
of my analysis period. It was not until mid-1986 that Fidelity
created enough Select funds for my methods to be practical, so
going much further back is not possible. There was the crash in
1987, but the Dow was up over 2% that year. The system tests well
for 1987 because it would have been in the money market fund during
the crash had one started in the first half of the year. In 1990,
due primarily to Iraq's invasion of Kuwait, the DJIA was off more
than 4%. However, the test sequence did well that year, gaining
over 30%. 1994 was a choppy, sideways year in which the Dow went
up by a bit more than 1%. Since I started my personal accounts
in late 1993, we do have some realtime experience. The system
was a bit different then, probably not as good, and I added money
five times during the year as it became available. Averaging my
returns in the same way I compute the weighted returns for the
client accounts and subtracting 2% for the management fee, my
1994 return was about 10%. The money invested at the beginning
of the year did much better, but I think 10% is a reasonable estimate
for how diversified client accounts would have done had they been
in existence for the entire year. The only bad year for the system
in the backtesting was 1988, which was a pretty good year for
the market.
The last sustained and deep bear market was in 1973-74. Nelson
Freeburg in Formula Research analyzed my methods by creating
17 synthetic sector funds going back to 1971. There are some important
differences between the synthetic funds, which always have the
same composition, and real mutual funds that are actively managed.
Nonetheless, his may be the only possible approach for analyzing
periods when the market was not as good as it has been for the
past decade or so. He found mixed results. There were some large
drawdowns, but at other times the system identified a fund that
rose when the market did not.
I anticipate that in weak markets the select switching methods would be in the money market fund more often than they have been recently. The last time that fund was top ranked was in December 1994. Also, even in down markets there are sectors that do well. With a wide range of sector funds, 33 plus the money market (excluding the two gold oriented Select funds), there is a reasonable chance some of them will move counter to a market decline. My hope is that we will be able to get in and out of these funds in a timely way and frequently enough to generate profits even in poor markets. We won't be right all the time, nobody is, but sticking to the system should work well over the course of several years.