The InvestMentor

February 19, 2003

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There's a pretty popular view being espoused by many talking heads in my profession these days. Namely, that it makes sense to be "on the sidelines" instead of being invested in stocks until "the market recovers." Unfortunately, while it makes for good copy, it's bad advice and has cost investors in every past Bear-to-Bull-Market transition point. So, paint me the pariah if need be, because this head is going to talk about why the endeavor to "time" the market is a losing one; and my message goes out equally to those on the sidelines, as well as others tempted to pull out of stock at this late stage.

Simply put, to ride a new Bull Market it's better to be way too early than a little too late. Market's have a dicey way of racking up returns—quick bursts followed by prolonged moves sideways. Most of the returns of any recovering market are disproportionately skewed to the beginning of the recovery.

To prove my point—one I've been making off hand for years—I downloaded the daily returns of the S&P 500 Index back to 1950. Using that data, the table below shows the market's ensuing return over six, twelve and 18 months, measured from the bottom of every Bear Market of the last 53 years. (A Bull Market begins, by definition, when a Bear Market ends, or "bottoms.")

From the data above, you see that on average a new Bull Market has produced gains of 25% in the first six months, 34% by the end of the first year, and 40% fully 18 months along. Note that the first six months provide most of the return of the entire first year (25% of the 34%, or nearly three-fourths of it) and most of the return of an 18 month recovery (25% of the 40%, or nearly two-thirds).

Thus, it's key to capture that first six months. However, if you're on the sidelines waiting for proof of new Bull Market, you're likely to wait until at least six months of recovery are evident, and probably sit out the first year in order to get the faith necessary to jump back in.

Market "Timers" may claim to be able to act quicker than that, but in this now-three-year-old Bear, we've had several six-month rallies that didn't draw in the sideline cash, and they petered out before developing into Bull markets.

In fact, speaking from years of watching the market every day, I'd argue that it will take 18 months of a market recovery before you'll read about the "New Bull Market," and before the majority of the cash comes in off the sidelines. Timers write it off as prudence. I call it opportunity cost.

But what if I'm invested too early, before the market bottoms?

If you get in the market before its bottomed, or for that matter decide to stay in and ride it out, the penalty is not nearly as harsh as the cost of missing the early recovery—and there's no guessing involved! To illustrate the point, I used the same S&P 500 data to calculate the loss associated with being invested for the last six, twelve, and 18 months of the Bear, up to where it bottomed (or ended).

As you can see, the average loss in the six, twelve, or 18 months leading up to the end of a Bear Market is usually between 18% and 20%. But the only way to guarantee that you get the full effect of the recovery is to be invested at the end of the Bear, and lying in wait for the Bull. And since no one knows when the recovery starts, until way afterwards, you need to stay invested throughout the end of the Bear.

Let me put it another way. Let's say you're out of the market for the last year of the Bear Market, and then get invested after the market has clearly recovered—a year from the bottom. You missed the early run up, but you didn't suffer the last of the Bear either, and you banked a money market return—currently about 1% per year—while you waited.

Feel pretty good? It shouldn't. A fully invested person riding out the last twelve months cost them 20%, but they got a 34% rise on the other side—and came out ahead of a 1% money market yield or even the yield on bonds, for those that opted for bonds over cash (and overlooking the likely hit to bonds that typically accompanies a stock market recovery).

Let's make it more extreme, giving Timers benefit of the doubt as to their acuity. Say you sidestepped the entire final 18 months of a Bear Market in cash, and with great prescience, jumped back in after just six months of evidence of a market recovery (and, with great prescience, you didn't get suckered into any of the other six-month-rallies that occurred before then). You would come out behind the individual that stayed invested throughout, because their six-month, 25% gain was more than their 18% loss endured over the last year-and-a-half of the Bear.

The fully-invested-throughout-strategy does best of all—it would cost you an 18% hit over the last year-and-a-half of Bear market, but give you all of the 40% recovery.

An old adage says that the challenge with investing is overcoming fear and greed—buying when everyone is selling and vice versa. Those competing emotions are never more intense than at turning points in the market, like now. Money that needs to be in the stock market for the long run best be there today—not in cash or bonds, or over-allocated to any of the fads du jour like gold and real estate.

Apropos of fads, next month, I'll continue on my myth-busting mission and discuss whether you should be now piling into real estate, or whether it's just real-late.