Smart Advice for the HuffPost Investor

At last, a definitive answer to the question troubling so many investors: Is a market meltdown on the horizon?

Since nothing could be more important to my readers, I devote my entire column to this issue. After all, if a financial Armageddon is just around the corner, as so many of you believe, what else could possibly matter?

Your questions are thought provoking and stimulating. Please continue to add them as comments to this blog.

Question From opines:

Over the past 60 years individual stocks have been a sound investment. Prior to WWII, market crashes occurred about every 15 years and small time investors were cyclically wiped out.

It has become an axiom of current day pundits to preface their buying advice with a disclaimer to the effect of "barring a market crash".

It would be welcome if Mr. Solin would address the possibility of a near term market crash. The enormous overhang of housing debt and falling home prices warrant more than the dismissive "barring a market crash" disclaimer.

If, say, he believed a market crash was a 15% possibility, perhaps the best option for the small investor would be to take a 'wait and see' attitude for the moment. For that reason, it would be helpful to Mr. Solin's Huffpo audience if he would devote at least part of a column to whether he foresees a major downturn in the immediate future.

It is a scary thought that anyone would rely on my opinion of whether there is a market crash on the horizon and make an investment decision based on my views.

My concern is not shared by most "investment professionals" licensed to sell you stocks and bonds. Predicting where the market is headed is the daily grist for their mill.

And it is not just individuals who rely on these predictions. Thousands of investment advisors provide predictive advice to trillions of dollars of pension plans and mutual funds. And they make a darn good living doing so.

Unfortunately, most of their predictions are dead wrong.

They are wrong so often that, when one of them happens to be right, it is big news. Remember Elaine Garzarelli? She was credited with predicting the 1987 market crash and won great acclaim as a market guru for doing so.

This superb call apparently used up most of her predictive powers. In the ensuing seven year period, the mutual fund she ran consistently underperformed the S & P 500 index.

Nevertheless, I promised you a definitive answer, so here it is:

I don't know.

No one does. But financial advisors make a lot of money pretending they do. When they are right, it is due to the laws of chance and not to any measurable skill.

Not only do they not know, but no one understands why markets crash, much less how to predict them.

For those of you who want to delve deeper into the complexities of this issue, I recommend a study entitled: A Theory of Large Fluctuations in Stock Market Activity, by Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou and H. Eugene Stanley. It is available for a free download here.

Even a cursory review of this impressive study will demonstrate the complexity of this subject and the folly of trying to predict the next market meltdown.

Events that you think would trigger a market crash do not have that effect. After the attacks on the World Trade Towers, the Dow fell by only 7%.

Instead of engaging in the fruitless search for a financial psychic, here's the question that investors should be asking:

If there is a market crash, how long will it take the markets to recover?

This issue is critical to the determination by investors of their asset allocation--the division of their portfolio between stocks and bonds.

One study ran what is known as a "bootstrapping" analysis that took source data from July, 1926 through December 2002. Using this procedure, which is imperfect but probably more reliable that any other available statistical measurement, the author was able to simulate 250,000 years (that is not a typo!) of stock returns.

The study found that, if the markets lost 30% of their value (which certainly would qualify as a market meltdown), most asset classes would have about a 45% chance of a full recovery within 3 years. Over a ten year period, the probability of a full recovery increased to more than 80%.

Investors who cannot withstand short term market volatility--cataclysmic or otherwise-- should not be exposed to significant market risk. This should not be a market timing issue that changes with the latest doomsday prediction. Your asset allocation should remain static, unless your investment objectives or tolerance for risk change.

Finally, what about the strategy of assuming a market meltdown in the near term and taking a "wait and see" attitude?

The data on this approach is not encouraging.

One study looked at the performance of a broad index of domestic stocks from 1963 through 1993. During this extensive period, the average annual gain of this index was 11.83%. However, if investors missed only 1.2% of the total trading days that were the best trading days during this period, their annual returns plummeted to a pathetic 3.28%.

Sitting on the sidelines is a form of market timing. The odds are stacked against investors who engage in this practice.

Investors would be well advised to stick to the basics:

* Don't rely on the predictions of investment professionals who claim to have a crystal ball;
* Determine an asset allocation appropriate for your investment objectives and tolerance for risk;
* Use low cost index funds to implement your asset allocation.

I know it is hard to believe that an entire industry is made up of emperors with no clothes. But you owe it to yourself and to your families to view the data objectively and to be guided in your investment decisions accordingly.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.

Comments

[The Collinbrandt]

For a serious investor the question has nothing to do about a market crash. A company that is well run by honest managers will weather any storm. Ahh, the question is, will the federal government fulfill its fiduciary responsibilities and prosecute for fraud those managers that mislead investors. Under current circumstances with the Bushies, they have not and therefor, will not go after their base (crooks). Kickbacks, treason and bribes are the mainstay or our overlords and the managers of our money be it in securities, banks or, real property (real estate). Do due diligence and research and, hope no one like the Bush people, ever control your money.

[Halsey]

Dan,

You're a smart guy..your advice is...I'll leave it at decent..but, again, I take offense at:

"My concern is not shared by most "investment professionals" licensed to sell you stocks and bonds. Predicting where the market is headed is the daily grist for their mill."

As an dirty rotten investment professional..I fight daily..tooth and nail..to GET clients to take profits..and go to cash equivalents...

I got lucky (no crystal ball..just...educated myself) with Google..Apple, and boring old Deere....and on a day the market fell over 100 pts..boring Deere was up 5 pts..and is splitting..raising their dividend..
I have to talk people OUT of buying (bottom fishing) Citigroup (sym. C)..yes.nice dividend..but will it hold...me thinks not..
I am very willing to make less money in order to save client's "nesteggs"...

so...continue to educate...but please...give some of us credit...I do invest my clients in low fee ETF's..for global exposure.. We buy Germany, Sweden, South Africa...and I don't make much on these trades...but sleep at night.

[mmckinl]

Who got us into this mess ?

A brief history of the Federal Reserve ... and some questions.

Few people are actually aware that the Fed is privately owned and operated, though it gets a Congressional nod on certain posts. Few people are aware that the Fed, through its charter, creates the fractional banking system enabling member banks to loan money ten times their reserves, which can only be called steep leveraging.

The Fed has been in business for over seventy years and botched the economy many times now. In 1919 and 1929 it caused severe problems by contracting the money supply. Of course 1929 was especially severe. Many people put the blame on trade restrictions, but that simply wasn't the cause, it was the Fed. After WWII there were several instances of the Fed blundering us into minor recessions. Then in the '70s the Fed, through a loose money policy, gave us a decade of run-away inflation.

Follow the Greenspan years. Bubble after bubble, scandal after scandal, crisis after crisis. Market Crash '87, S&L '88, Bond Bubble '91, LTCM '98, the Asian Meltdown '99, the Market Crash '01, and countless scandals. Now, the Sub-Prime Crisis that is spreading through both the financial and consumer sectors due to an irresponsible policy of cheap money from '03 to '07.

The privately owned, owners unknown, Federal Reserve Bank needs to be held to account. With seventy years of dubious achievement one must ask: Why can't we create a public institution to control our money supply? Why can't we print our own money? Can we do worse than this Greenspan cycle of crises?

Questions from a liberal.

[CharlesMac]

Let's take out the fact that the current Administration of the past 6 years, it's lockstep co-conspirators Congress and Wall street, and its financial/monetary manipulating FED... have devalued America by any historic standard.

We will add it back in at the end.

After you have the 6 mos - 1 year worth of disaster money set aside...

And (for 90% of people) you have the vast core of your money invested in the Index funds Mr Solin has recommended. Do it with consideration of proper asset allocations. The nearer to retirement, the less you want to be exposed to the stock market. (you might also want to consider uncorrelated investments like real estate equities and precious metals for some of it)...

That may leave you with money YOU WILL NOT NEED for at least 5 years, and better off more than that. And you want to get involved in stronger growth.

The first thing you should do with it is...

NOT buy stocks.

You will never find the next hot stock. They do, but act like they don't exist.

Learn how to buy companies.

Brokers, financial pundits on TV, and your brother-in-law who got into energy funds early.. have little to no idea what one would like if it bit them on the behind.

It takes a lot of interest and a lot of work. But there are sites where people work together to churn out the numbers. They all have to be there, plus a great and committed management to run them. American Express, Coca-Cola, Procter and Gamble are all great companies which now provide modest, but consistent, gains and a dividend.

The solid fundamentals and financials are the same as they were early on. They have survived and thrived during and after recessions or "crashes". The people who bought into them early, really made the money.
(cont)

[CharlesMac]

(cont)

Now let's add back in an imminent devastation of the stock market. (BTW, I read this the other day and its not too far off... the "market" has predicted 17 of the last 4 recessions.)

Historically, because they are so sound, good companies weather a storm better and come out of it faster. But that is incidental. They grow steadily and strongly until they are Johnson and Johnson, Wal-Mart (no jeering), Conoco-Phillips.

When the stock market collapses, they are still a good company. You just buy more of it, because it is undervalued. You have to accept setbacks and make sure the companies don't choose a stupid direction. As problems present themselves, good managements are proactive and tougher than a Waffle House pork chop.

That is why the money has to be invested for at least 5 yrs. Up and down... and you don't want to need the money during a down. By 5 yrs a good company will have made you money year on year, so even if things are "down"... if you really need the money, a cash out isn't so bad.

If you own good companies, even George Bush can't ruin you for too long.

[alibe]

How difficult is it to see that these Bush criminals are in the process of looting the store as fast as they can. They are printing as much money for them to steal as fast as they can. They are hiding it as fast as they can. It is disappearing as fast as they can hide it. The courts are being packed to prevent the crooks from facing their due. It does not take a genius to see the writing on the wall. We are f*cked. I don't see how we can avoid a meltdown. And if we can comeback is debateable. And just what will happen to precipitate a recovery? Have another war?
I can't see anything that will save our butts.

[mmckinl]

Human knowledge is finite . Just a few years ago geologists thought the earth to be a slowly evolving system with no major interuptions. Then we learn that one major extinction was due to a meteor and happened virtually overnight. We now know , though highly improbable , that a major meteor hitting the earth could come close to wiping out the human race. We have trained telescopes to the sky to scan for these meteors and comets to be forewarned.

Well , there is something on the horizon that is an event that hasn't happened in human history , so that there is no precedent or predictive model available. Man's use of ever increasing amounts of energy to sustain civiliisation has never been interupted over a significant period of time throughout the world.

The event is Peak Oil : The end of cheap energy ... Sure oil will be around for a century or two , but the availability of massive amounts of inexpensive oil , coal or natural gas is over. Never in human history has the world , as a whole , at one time , faced such a change in its circumstances , for the worse.

Put that in your models.

[Brucemoose]

I am an investor who is 20+ years from retirement and have to ask what effect the retirement of the boomers will have on the stock market?

An other way to ask this is how much of the current market's run up has been caused by people and institutions investing in pensions and retirement saving? What will happen when these people are required to start to pull money from the market to pay the bills?

Certainly in the short term this is not going to be as large effect as the current credit crunch is but long term could this cause another 1970's style bear market?

As one who is being told to invest for my retirement because the social security net is going to become insolvent this question seems to be ignored by all who believe that the stock market will save us.

[Mormondude]

"One study looked at the performance of a broad index of domestic stocks from 1963 through 1993. During this extensive period, the average annual gain of this index was 11.83%. However, if investors missed only 1.2% of the total trading days that were the best trading days during this period, their annual returns plummeted to a pathetic 3.28%."

I've read this before as an argument against 'market timing'.

HOWEVER, that only provides one half of the information necessary. What happens to the returns if an investor missed out on "only 1.2% of the total trading days" that were the WORST trading days? I assume that their annual returns would skyrocket far above the average return.

Thus, the negative impact of market timing is utterly unproven by such an argument, and it really shouldn't be used at all.

[travy]

it seems to me that much of the market's historical success has relied on the contiuned health of american businesses which were propped up by cheap oil and a strong dollar. take those away and we are nothing.

what do we actually produce anymore? what american companies will continue to be 'profitable' in this new environment? to me, it's not looking good...

[knowhelpnow]

Do I not have enough to fear with Islam taking over the world, and some terrorist putting some medically enhanced virus in the drinking water or New York being destroyed by a dirty bomb, now I have to think that my US Bonds are going to be worthless. Heaven help us all. I have to cook dinner before everything I buy has either e coli or lead in it. bye

[jbatch]

One other observation -- One of the reasons for the Crash of 1929 was the extreme concentration of wealth in the hands of a very few.

Thorstein Veblin notwithstanding, when much of the wealth is in the hands of a few, they can't spend fast enough to sustain production. Put another way, if the wealth is evenly distributed, then more gets spent -- the middle and lower class aren't buying increasingly optional luxuries, they're hoving closer to necessities and therefor spending whatever income they get.

A few Ultra rich, however, cant sustain the kind of demand that is critical to a vibrant economy. How many Yachts can one buy, after all?

And investing their excess wealth in productive stock doesn't help. If you don't have the consumer base to buy what you produce, you can't sell. So you end up with a poverty of plenty, just like 1929 and an inevitable crash.

Well, guess what? Thanks to bush's policies, we are now at record levels of income inequality -- matched only by what we saw in the 1920's. And when the debt balloon pops, the consumptive demand will whither and we will likely see another serious crash.

That's the thing about policies based on greed -- they are not only ethically wrong, they are ultimately self-defeating. And absent government intervention, this kind of inequality is all but inevitable because the rich assuem power and shape the economic landscape to their liking and benefit, in the process assuring their own demise.

[procrustes]

MY crystal ball back-lit with hard earned cynicism says the following:

(In the spirit of full disclosure I must confess that it's actually Pyrex)

I too, don't know but I think I can barely discern...
--A rally when the fund managers windowdress their funds by taking god-awful results and running them through the Yr/Yr or CAGR calculations so they can lie about how well they did
--China will continue to be a good-guy banker for USA debt until after the Olympics
--Post Olympics, China , along with the rest of the world, will dump the dollar.
--China will exert tyranny over Taiwan, if not outright invade.
--The USA will be on her financial knees unable to do much.
--But Bush will still be in office with nothing to lose
--He and Lord Cheney will want to bomb everyone in sight
--Europe may save us
--Or not
--Or the Supply-Side Fairy may pee on our tongue (that's a Dutch thing meaning good luck), but I wouldn't advise walking around with your tongue hanging out waiting for those livelihood saving drops.

Thanks to Ron Paul I'm setup with gold and commodities and foreign currency investments. During the liar's rally (you'll know it's arrived when CNBC does its Snoopy spring dance to Ode to Joy and quotes Professor Pangloss) I'll be heading for the mattresses with more commodities, gold, bonds (gov types that are non-USA) and European currencies.

WAIT, this may all be just an imperfection, an effing swirl deep inside my ball! Damn Chinese Walmart crap. I take it all back. There used to be an Optician's shop that sold real crystal balls before Walmart put them out of business.

Sigh.

Maybe we can pray. I know Christians of the Falwell/Robertson ilk that give all their money to them and then pray for Jesus to pay-off their credit cards. They say it works.

[jbatch]

The obvious problem of taking historical trends and statistics and extrapolating them into the future is that the future might be fundamentally different than the past.

I would argue that it is.

Securitization of debt and other unreal acts of commoditization -- as well as massive investments by institutions with nowhere else to put their money -- means failures can be both masked and catastrophic.
Masked because the institutional money will keep returning when the market goes down a certain amount. This puts an artificial "floor" on the market, which allows it to retain "value" that is, in fact, not there.
Catastrophic because once this floor is pierced, the bottom could fall out. Catastrophic because so much "value" is represented by securitized debt. And debt -- even good debt -- is not an asset, particularly when the entire enconomy is fueled by debt. We have record consuemer debt, a record imbalance in the current accounts deficit, a record federal debt, etc. etc. etc.

If this isn't a house of cards, i don't know what is. So, why can't we see it?

For that, read Nassim Teleb's excellent writing, includng The Black Swan and Fooled by Randomness.


Bottom line: we draw the boundary conditions for what we analyze based on what we know, but it is always what we don't know that is significant in terms of both surprise and change.

[ernstge]

All the above are true. However with specfic reference to the stock market, I believe ever upward prices are a direct result of positive trades (buying volume), not performance. The real problem occurs starting now. As baby boomers stop putting into 401Ks and take out instead, all that massive buying becomes selling. The markets have to collapse by definition. You don't need a crystal ball, only common sense. The collapse of the housing markets was obvious 3 years ago with low interest rates and people maxing out on 4% interest-only or adjustable rate loans. It had to end, and housing demand had to end with it. The banks are now officially in the real estate business. They will suffer the worst of the looming disaster. Just think about it!