Know When to Hold, Know When to Fold
Lee Rosenberg, CFP | October 18th, 2008
Capitulation sounds like one of those SAT words you can immediately forget after the test, but with the recent economic crisis, it’s a good time to review the meaning. In financial terms, capitulation is when frightened investors lose faith in the market after a period of losses and decide to jump ship en masse. In other words, unable to stomach any further losses, they collectively sell in a panic and look for safer havens.
This group sell-off is certainly what has been happening in the past few weeks, though the government would prefer to call it a “correction” rather than capitulation. But call it what you will, staggering losses coupled with “expert” analysis that the sky-is-falling (thank you James Cramer) have sent small investors scurrying for the exit doors in droves.
But whether you are among those who ran for cover, or those who have nerves-of-steel and are still holding on, it is important to understand historically what took place after large numbers of investors pulled out. Eventually the market turned around and those who held on were rewarded with returns that made up for their losses. It just takes time and patience, and admittedly a strong stomach.
Here are some interesting facts that put this in perspective (Ned Davis Research, 2008):
* Since 1948, a typical recession lasts 10 months and takes another 5 months from the time it ends to see a market turnaround. The average 1-year return from the recession low is 39%.
* Oil up 60%, personal savings under 1%, the stock market is tumbling and fear of a major recession or even a depression is on everyone’s minds. Sound familiar? This was the economic story thirty years ago, right from the pages of Business Week. But investors who remained in the market were rewarded. A typical $10,000 investment in large company U.S. stocks would have grown to $305,000 by December, 2007, roughly a 12.73% return.
* On Black Monday (Oct. 19, 1987), the market tanked, losing 22% of its value in a single day.
Again, those investors who didn’t pull out of the market were rewarded. A modest $10,000 investment would be worth $80,818 by December, 2007, an annual return of 10.89%.
Point being, the market may be suffering measurably from low self-esteem, but it is not the end of equities by any means, and you can already see signs of savvy investors shopping for fantastic bargains. Warren Buffet is leading the way, investing billions in stocks. Naturally he can afford to, but keep in mind that he made his money by being shrewd, intelligent and a visionary when it comes to opportunity. He has never viewed his investments in the market as risky- he just knew he had to persevere. So too should we all.
What I Know That You Might Not
Q. With so many investors jumping ship, are there any life boats out there?
A. Yes, there are sectors in the market that can help preserve capital, but they are not the ones that people seem to be gravitating to. Typically, spooked investors will look to bank CDs and money market funds, assuming they are the safest places to wait out the storm. The trouble is, with the government working to restimulate the housing and mortgage market and business borrowing, they are going to be lowering rates. That means that the return for a CD could be 2%, which hardly makes up for the current 20% loss in the market. With that approach, it could take 10 years for an investor to recover.
I recommend instead that investors look to the sectors that have been unfairly punished by the market sell off, such as health care stocks. Given that both Obama and McCain are proposing to increase spending for health care plans, this is going to bode well for future returns. The same is true of other “basic necessity” investments, such as utilities. Right now that sector has been beat up in spite of oil prices dropping by half. Also keep in mind, that they had no involvement in the Wall Street debacle and so in issuing new bonds (essentially they’re borrowing money at far lower rates than they
did two years ago), they can do so at lower rates, also reducing their overhead and business costs. This offers greater potential for total return, which is dividend and growth than a CD.
Q. If the recovery is going to take a long time, why can’t I pull out of the market now and return when it’s more stable?
A. We learned from every market decline that once investors leave the market they are unsure about choosing a re-entry point. Furthermore, there is no such thing as a straight line in terms of growth, there is always some degree of volatility. This makes it even more confusing to decide when and how to reinvest. The other issue is that the old adage is buy low sell high, a nice concept if you can get it. But when is high and when is low? No one can time the market.
Just look at these past few days. One day the market was up 920 points and people were kicking themselves for pulling out. The next day it went down and we were giving back 700 points. The “point” is, you don’t want to be caught up in the yo-yo effect. You need a long term investment strategy so that you are always ready (and ahead of) the next big wave.
Q. What is the biggest misconception about the recovery of the market?
A. All of these emergency government measures to bail out the banks will have a dramatic effect on the market to insure stability. However, as this complex economic environment continues to unfold, we’re seeing a daily reaction from investors and the media that are both emotional and realistic. As a result, you’ve got a lot of investors sitting on the sideline, hoping and waiting for one of these new measures to change the situation overnight, but this is not reasonable because we are still in the midst of the crisis. The storm is not over. This is why Ben Bernanke made a speech this week to remind people that this is going to be a long term recovery and they need to manage their expections.
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Tags: avoiding panic, economic crisis, financial distress, financial planning, jim cramer, lee rosenberg, retirement, stock market
About the Author: Lee Rosenberg is the Co-founder of ARS Financial Services, Inc. As a Certified Financial Planner with more than 34 years of solid financial expertise. Lee is a registered representative of Cadaret, Grant & Co., Inc. He was also named one of the top 25 Independent Financial Advisers in the US by Rep magazine.
October 22nd, 2008 at 8:19 am
[...] On Black Monday (Oct. 19, 1987 ), the market tanked, losing 22% of its value in a single day. Again, those investors who didn’t pull out of the market were rewarded. A modest $10000 investment would be worth $80818 by December, 2007, …[Continue Reading] [...]