What The Market Ralley Means
by Richard Schroeder
The U.S. stock market has rallied almost 24 percent since it reached new recession lows on March 9. What does this mean and what lessons can we draw from this swift and unexpected rally?
The biggest lesson is that the markets cannot be predicted. Things looked very bad on March 9; I don't know of anyone, amateur or professional, who expected a 300-point Dow Jones Industrial Average rally the next day, or a climb of over 1,400 points over the next four weeks.
In fact, I had lunch with five veteran investment advisors here in Western New York on March 10 as the rally was beginning. All have been managing money longer than me (and I am in my 15th year) and all have my respect. Yet every one of them was negative on the market's short-term prospects that day.
Another lesson is that this rally doesn't even tell us whether the bear market is over yet or not. It is typical in big bear markets to get several bear market rallies that take stocks up as much as 20% in a short period of time, only to fall back to the lows again. Note that we had a 20% rally in 2008 from the end of November through December. Since then we fell to new bear market lows early in March.
This rally may mark the end of the bear or it may be a head fake. No one will know for sure for a year or more. At that time we will look back and say, "Oh sure, it was so obvious," but that "obvious" outcome currently is pretty hard to see.
Next we have to admit that the market is not predictable because the news that moves the market is not predictable. Even thought some upcoming news seems obvious - such as the possible bankruptcy of GM and Chrysler - who would have predicted today that we would get news that included:
- An unexpected gain in Chinese production
- A change in the mark to market rules for banks
- An unexpected jump in U.S. factory orders
- A smaller than expected reduction in Eurozone interest rates
- Unanimous agreement on aid to the International Monetary Fund and stricter financial institutional regulation at the G-20 summit in London
If you predicted all of that and the market's reaction please come to work for us!
Marlena I. Lee of Dimensional Fund Advisors, meanwhile, just published a short study on stock market performance during recessions. Contrary to popular thinking, the stock market does not exhibit negative returns during a recession. The declines come at the beginning of the recession, that's true, but the upswing that comes before the recession is over make up for that. Someone who holds a diversified investment portfolio through an entire recession should come out ahead. Here is her conclusion:
"The relative strength of market rebounds in the early stages of an economic or market recovery highlights why attempts to time the market are unwise. It is easy for researchers to identify peaks and troughs in past data, but recognizing one in real time is much more difficult. Once investors realize a recession or bear market has begun, it is likely that significant losses have already been incurred. Exiting the market after a recession has begun will protect a portfolio from additional market fluctuations, but the opportunity cost from missed returns is a risk that remains. There is no historical evidence that stocks tend to realize negative returns during recessions.Additionally, investors waiting for signs of recovery are likely to miss the high returns that tend to occur at the onset of the recovery.
"Fleeing the market can be tempting. In uncertain economic times when stock return volatility can top 20% per month, switching investments to safe assets can spare investors from the pain of fluctuating portfolio values. However, the lure of fleeing must be tempered by the risk of being left behind when markets rebound. Of course, nobody can predicts where the bottom is, but this is part of the risk one must accept in order to reap the ultimate rewards."