Odds Are Stacked for Positive Gains

We may be seeing green shoots or maybe they are yellow weeds as Roubini suggests. To me that's all noise and I wonder why so much of the blogosphere and media is full of speculation on such matters. As even the best economists have a poor predictive track record, why should an average punter like me even bother thinking about it? There are easier and more profitable things to think about, but each their own.

Perhaps some people will ask why bother looking at historical market data. My simple answer is big picture reassurance. The main reason is that I do not want to get bogged down in the here and now of unemployment reports and the like, such stats are psychologically damaging and cloud the mind. They induce fear and you don't want to go there.

The conspiracist in me believes they are promulgated to confuse poor investors and make them freeze instead of act. I say, stand on giants shoulders to get a better view of the future so that you may act now.

According to most people worth listening to (it's my article, so I get to choose who's worth listening to ) the stock market is in the fairly valued ball park. Jeremy Grantham recently said there was about 30% chance of the market making a new low. Through options trading I've learnt there is a big difference between something happening during a time period and the same thing occurring at the end of the period.

While the market may be significantly down sometime within the next year the chances of it being down in a years time are significantly less than 30%. Does it really matter if the market makes a new low within the next six months if it ends up higher in a years time? How long is your investing horizon?

I find a lot of market statistics frustrating as they often refer to financial or calendar years. As I don't invest based on either financial or calendar years I decided to look at some market stats from the perspective of how I invest, as if I invested today or tomorrow or any day.

I spent some time over the weekend looking at S&P 500 historical daily data back to 1950. I started by looking at where do we stand today. The market has been down every day year on year (YoY) since Jan 4 2008. It has been down for two years YoY since Jan 5 2009. We've now had two down years for the last 130 trading days. If the S&P is below 927 on 4 Jan 2010 that will make it three down years in a row.

So what are the chances of having a third down year? What does history tell us? Since 1950 the probability of three down years starting from any day in that period is 1 in 93 or 1.1%. That's 159 days out of 14,726. If those odds aren't good enough to get you back in the market then consider this, 150 of those days with three down years in a row occurred between Nov 2002 and June 2003.

If, like me, you think that was a rather special period with a very special starting point then you may choose to exclude those days. That sends the odds skyrocketing to the chances of the market being lower in a year to 1 in 1635 or 0.06%. Do you like those odds?

Some more stats. Out of the almost fifteen thousand trading days since 1950, 29% were down YoY, 71% were up. The stat I like the most is that there has never been four down years in a row. So if the economic malaise outweighs historical stats and the market is below 927 next Jan then back up the 16 wheeler, it's time to load up.

There have been 4,665 days or 31.7% of trading days which had three years in a row of up days, YoY.

We all know there's lies, damn lies and statistics so perhaps I should add some balance. Today is not just any old market day. We're in one of those infrequent periods of two down years. So maybe, just maybe we should take a gander at how things transpired in similar periods.

The good news is the market went on to average a 12.5% gain in the following year. If you're fully invested and prefer to live in denial then I look away now.

Since 1950 the S&P 500 has ended up down one in five years following a two year decline, or 19% of the time to be more exact. Those down years are skewed towards badly down. I'm talking crushed spirits. Down 20-32%. Could you stomach that?

For the optimists, let me say that the odds are still clearly stacked in our favor. The market has been up four out of five years following two down years, 81% of the time the market has been up. While the up returns are more evenly distributed than the down years they are also larger on average.

After looking at history I may have to recant my statement of significantly less than 30% probability of a down year ahead. History tells tell 20% looks about right.

Since October 2008 I've been suggesting people should start averaging back into the market. In February and March I was recommending aggressive investing. My friends keep asking me "How's that working out for you?" I'm not sure they believe me when I say really well.

Therefore, this week at Fusion Investing I'll show the returns experienced by an investor who has averaged into the market since October 2008. I'll also share my long term market outlook and why I'll continue to invest new money into the market. Then maybe, just maybe I'll go back further in time to look at some stats since the late 19th century.

NOTE: Definition of down years may not be what you intuitively think. One year occurs when a day is down YoY. Two down years occurs when a day is down YoY and the year ago day was also down YoY. I'm sure you can figure out what three down years represents. Perhaps I should have used first, second and third, instead of one two and three.

Disclosure: No stocks mentioned, currently net long US stock markets.

Comments

[Tom Colangelo:]

The market will continue to move sideways based on the numbers and guidance given this week BECAUSE:

1) FIRMS will say nothing or say that the outlook looks better than the recent past. It would be a SELF-FULFILLING PROPHESY if companies with weak Q2 results give negative guidance for Q3. A literal death wish for any firm saying that they won’t improve their numbers even though the economy is beginning to level out and the stimulus is still gaining momentum.

2) The banks will report good numbers because they talk to Geithner EVERY DAY about how they are doing. He is protecting the $1 trillion we have given to banks and financial institutions and for his own sake, must know how the banks are faring. If they were in trouble, we would know about it already because nobody likes surprises.


3) Q2 earnings will be presented as improving month-to-month versus the less favorable Y-O-Y. You will be sold on how things are improving and to forget about t he Y-O-Y because it is not valid in this recession.


The market will meander until Q3 reports. In the mean time, get dividends while you wait for the market to move. Take advantage of this by getting into a strong position in some of the things that we CANNOT DO WITHOUT like:

OIL – BP (Yield = 7.43%), RDSB (Yield = 7.11%), etc.

UTILITIES - ATT (Yield = 7 %), VZ (Yield = 6.4%), VOD (Yield = 6.2%), NGG (Yield = 5.9%), CHL, etc.

FOOD - ADM (Yield = 2.1%), MOO (Total Return = 23.7%)

BANKS - NYB (Yield = 9.3%)

I hold positions in all of the mentioned stocks.

Good Luck.

Jul 13 06:24 AM

[Davewmart:]

I would read up on the gambler's fallacy.
Because a coin flip has come up heads doesn't alter the odds on the next coin flip.
Trends continue and you can make pretty graphs based on the probability that they will continue in the future.
Most of the time you are right.
Until you are not.

If you like graphs and like to base your guesses on them, you could also take a longer trend, say for the last 300 years, decide that we had a short period of excess above-trend growth since the Second World war or so, due to cheap fossil fuel and in particular oil, and that we would now revert to trend and grow at 1% a year or whatever.

Graphs don't substitute for a fundamental analysis of what is happening.

Jul 13 06:26 AM

[richjoy403:]

Good article, it presents the data for all to interpret as they see fit.
Some think we are not in a recession, but another Great Depression. I say BS!

I am betting we are closer to the end of this recession than the beginning -- I know others will see another 3 or 4 years of recession/depression, and that's OK, as it tends to present myself and others with bargains.

Agreed: it is NOT presently obvious that we will exit the recession in 2010. However, since the markets have a tendency to look forward, I am also betting they will improve before it is obvious the recession is ending.

In short, having reduced my stock allocation from 60% to >40% in 2008, I am now using this summer's doldrums to return to my 60% stock 'market neutral' allocation (and I expect to increase that to 70% stocks in 2010 in the midst of an expected 'W' recovery).

Jul 13 08:19 AM

[enigmaman:]

"A mind all logic is like a knife all blade it makes the hand bleed that uses it"
If you approach the market as you suggest " Logically" how will one do, that would depend on what you think "logical" means, since the market is driven by fear and greed, logical would have a different meaning to each, wouldnt it. So what I might consider logical you may consider illogical.

While you look back over all the stats, over all the years to prove that in the long run your better off in the market then out, stats wont fix the hurting people have lived through the past ten years, that is real to them, its in their memory as happened just like those that went through the great depression, its not something that you can resolve with stats. In 2000 if you were invested and worth $1.00 and then lost 50% in the bubble, you were then worth .50, then over the next sevenyears you slowly re invested and were up 50%, your portfolio would be worth .75 not great but not bad either when you consider your your home has gone up probably 100%+ from $2 to $4 during those same years, all in all things were good, if your were retiring in the next tens years you had to be feeling pretty darn good, until the third quarter of 2008 when the wheels started to fall off the wagon. In the next six months most would see their .75 portfolio fall to .35, a vlaue less then it was ten years before, your homes value fall by 50% from $4 to $2 bank failures, no gain in seven years, 25% of homeowners upside down on their mortgages, home foreclosures at never seen before rates, GM and Chrysler bankruptcies, unprecedented government intervention of private companies, unemployment at 20 highs, talk of the End of Days, the last ten years have put American through a meat grinder, not once but twice to think that after being through everything that they hvae that they will approach the market Logicaly is naive and illogical, no matter what the stats may show. mark Twain said " If a cat sits on a hot stove it wont sit on a hot stove again, but it wont sit on a cold one either because it has over learned from its bad experience" The bad experiences people have lived through the last ten years will take years to overcome if at all, that would be a logical reaction.

Jul 13 08:56 AM

[chap08:]

I think that you should look at your stats from the 19th century forwards as you suggest. It wont change your results but it might make you think again.

People might think that 1950 is plenty far back in time, but actually the period since 1950 is unique in history. This period has been defined by: US hegemony, unprecedented peace in the developed world, cheap energy, demographic advantages, productivity gains, globalisation, deficit spending and ever expanding credit. We can't rely on all of these factors to help us in the future. Hopefully something else will come along - but the next 60 years may be rather different from the last.

If you look at the period prior to 1950 you see something rather different: a different world and a different stock market. Yes, the stock market went up over time (remember that inflation will always give you this in the long term, even if it does nothing for you in real terms) but there were long periods of poor performance and times when the results were devastating to your wealth. In this period, buying and holding the stock market was not your best investment policy.

I've looked at my own investment strategies in the pre-1950 period and its amazing how many differences there are. Strategies that work for the entire post 1950 period, simply didn't work before.

So yes, the stock market will continue to go up in the long run, but don't bet on it always behaving as though we are in an economic sweet spot.

Jul 13 09:07 AM

[YoYoMama:]

I like the long term as well. That doesn't mean I am not putting in stop losses and taking profits right now.

I don't like the head-and-shoulders formation the market is in now. There's also not many stocks that are consistently channel up, and those that are are breaking through support. Not pretty.

I'm increasing my cash position where I can, because the short term technicals just look butt-ugly.

Jul 13 09:31 AM

[Tomcat101:]

What were the odds that the market would fall 50% last fall in such a short period of time? What were the odds that the Dow would fall 1000 points in one day? What were the odds that people with horrible credit would be allowed to get a mtg. with little or no down payment? What were the odds that a black senator with very little experience would convince rednecks all across the south to vote him for president?

Looking at the same charts back to 1950, the market looks to me like the SP belongs somewhere between 400 and 1200. The double top from 2000 -2007 also looks bullish and bearish at the same time. I think it's very plausible that we fall to 400 before going to 1200.

Jul 13 09:43 AM

[grey road:]

Your historical outlook to the year 1950 is not long enough. This was basically the beginning of a long term bull market. Your odds dont matter. We are now in a long term bear market. Why not take a view of at least a few hundred years or at least a hundred years. This market is for traders only or very bright people who understand where this is likely going. Rosy thinking bulls will be crushed like bugs. Good luck with that.

Jul 13 09:44 AM

[TeresaE:]

You should have gone back to 1929/1930 to '33.

Then make your assumptions.

We have not seen the devastation at this level since then.

The 70s/80s recession was just a practice run for this one.

Jul 13 10:22 AM

[enigmaman:]

I agree with teresaE, the author should have included several years leading up the 1929 crash, the years during as well as several years after WWII ended, the similarities between then (leading up to, inlcuding Gov intervention and philisophy) and now (living it) is undeniable, so to exlude the Great Depression from the analysis distorts its findings. Just as if you did a stock market analysis from 1990 to 1998, or 2000 to 2007 or March 2009 to date, things would look very good, but if you look at 1998 through today it would look very different indeed. It all comes down to what one wants another to believe, "go long, go short or go no where" it all depends on ones point of view and doesnt have to have anything to do with facts

Jul 13 10:59 AM

[enigmaman:]

Took at look at the DJ since 1930, always based on ten years results ending February.
1930-1940 -46%
1940-1950 +40% (20 yrs dead money)
1950-1960 +192%
1960-1970 +29%
1970-1980 +1%
1980-1990 +234%
1990-2000 +285%
2000- present -20%

What can you tell from these stats, depends on what you want to see, in the long run the author is right the market will be up, but will it be up during the time you need it to be up, that is the question, if you look at the time frame 1930 to 1950 (before, during and after the depression) the DJ was flat, dead money for long term investors who were fully invested, since there are many similarities between then and now whose can say if it will be any different going forward the next 20 years, I guess it all depends on what you believe the word "logical" means.

Jul 13 11:23 AM

[richjoy403:]

It is still true...the stock market reacts to fear and greed (and in any 10-year period, greed has won).

Agreed: We have been through a meatgrinder; however, I prefer to see opportunity, and thus I lean toward greed.

Some here see it otherwise.

Enigmaman's argument that many people are hurting is true, but their pain doesn't FOREVER determine the direction of the market (if all those who had lost large amounts in the market didn't return to their greedy ambitions, we wouldn't have a market in 2009).

Jul 13 11:57 AM

[Davewmart:]

richjoy403,
I have seen a couple of your comments indicating that we may soon see an upside.
Not being funny, but can you tell us where it will come from?
Everything I have seen is downside.

Jul 13 12:56 PM

[richjoy403:]

OK Davemart, I'll take a nibble at your bait, but only to this extent:

First: No rings a bell at the bottom and yells "ya'all get back in now!" I remind you the best time to invest is when others are fearful (we all know this, but we are wired to ignore it, and thus we stick to the safety of the heard--which we also know the most successful investors do not do). As none of us knows the EXACT bottom -- we can only buy within some personal comfort level, say 10%-20% of what we think may be a bottom (same goes for selling at top). I'm comfortable that I am buying near enough to the bottom for the stocks I am buying; and I'm comfortable that I will make a very large profit on most of them within the next 2 years. (Day-traders feel just the opposite.)

Second: There are in fact a number of datapoints that are off their lows -- both in the USA (which most here seem to think the only place in the world to invest), and worldwide. Emerging markets are doing fine. Industrial production in Germany (world's largest export market) is up. China is handling the worldwide recession best, and is the #1 place to be invested for the foreseeable future. (Question: what markets will grow most in the next 10, 20, 30 years?...In my opinion if you are not investing in China/India and other emerging markets you are limiting your gains to a much slower-growing economy--now is an excellent time to get in, or add to your positions).

Third: Regarding the USA market--We have seen the bottom here at 667 (yes, opinion). The S&P500 started today at 879. I have been buying for several months, and presently have 14 limit-buys to add to my positions in financials, oils, techs, small caps at prices these stocks last crossed in March/April -- these stocks may go lower (though I think not by much), but these prices will look cheap in a year or so (but perhaps not to those who wait to buy when the talking heads are saying "guess what, it was a good time to buy 9 months ago".

I should also add that though I manage several portfolios, the one I trade most is an IRA, and I don't need to access it (but will have mandatory withdrawals in another 4 years). I have been investing for over 35 years, and this is not my first, second, fourth, or sixth recession experience (where were you when the world as we knew it was to end with the first Arab Oil Embargo, and you could not get gasoline...at any price?

Jul 13 02:38 PM

[Davewmart:]

richjoy403,
it was not a question designed to set you up.
I was genuinely curious.
It seems that you are looking at technical points, rather than anything like 'Commercial Real Estate won't wipe out the bank's earnings'.
I hope you are right.

Jul 13 03:28 PM

[richjoy403:]

Thanks Davewmart
Yours was a very reasonable question. My response was framed by my knowledge that most of the responders here are extremely negative on the market (it may be fair to say they think the market is going to hell for the remainder of their lifetime...or that may not be fair...but they certainly tend to pounce on all that is written in a positive tone.) We'll see what others post.

I am not looking for technical points, nor am I a chartist. I am a fundamentalist who (from prior experience) recalls that markets always start their recovery while the bad news is still coming...the S&P has always improved from a recession during the recession, and for NO OBVIOUS REASON other than (perhaps) that value reaches some kind of tipping point, and stocks go up in spite of an expected poor earnings quarter or even two (look it up). In my experience, the 4 most mistaken words in investing are "it's different this time". (One example you may recall was in the late1990s, when it was widely said Internet stocks could continue to go up in price because they didn't need to borrow money--they could just issue more shares to raise capital.)

Yes, the market is well aware that commercial real estate is forecast to suffer declining values (and we can cite a list of other real or potential problems). I think those fears are ALREADY priced in my bank stocks (USB, BAC, and speculative positions in HBAN and RF). It seems to me that if ever there was a time to take a 'flyer' on a few speculative stocks for huge gains, this is it!

The market just closed up about 22 S&P points, or 2.5%. None of my limit buy orders were executed today. For the moment, I'll accept that I have very nice gains in 28 positions (small loses in FXI and AMLN) and hope my buys never execute.

Good luck to you.

Jul 13 04:47 PM

[grey road:]

It not only needs to go up in the right period , it needs to go up more than inflation, to be taking risk like that and you could have it in the bank making the same.. so actually it needs to go up more than inflation. And heres the other problem.. you only go back to the 30s so you just see it has always gone up since then, and assume it will keep going up into the future. This isn't neccesarily the case. It could go down for the next 100 years. This is unlikely but it needs to go up more than inflation. All in all this article is ridiculous and unlikely to go as the author says.. again.. good luck with your theory.


On Jul 13 11:23 AM enigmaman wrote:

> Took at look at the DJ since 1930, always based on ten years results
> ending February.
> 1930-1940 -46%
> 1940-1950 +40% (20 yrs dead money)
> 1950-1960 +192%
> 1960-1970 +29%
> 1970-1980 +1%
> 1980-1990 +234%
> 1990-2000 +285%
> 2000- present -20%
>
> What can you tell from these stats, depends on what you want to see,
> in the long run the author is right the market will be up, but will
> it be up during the time you need it to be up, that is the question,
> if you look at the time frame 1930 to 1950 (before, during and after
> the depression) the DJ was flat, dead money for long term investors
> who were fully invested, since there are many similarities between
> then and now whose can say if it will be any different going forward
> the next 20 years, I guess it all depends on what you believe the
> word "logical" means.

Jul 13 04:53 PM

[enigmaman:]

from 1930 to 1950 dead money , 1950- 2000 simple average 14.5% gain per year if you stayed invested the entire time. So far since 2000 -20% if we are up 20% from here by year end we would be at 0% gain for the last decade (lost decade), what does the next ten years bring us is anybodies guess, It just doesnt look like we will come close to the last 20 years returns with all the government regulations impeding profits, especially on banks and financials, so discount these as well and also the 30s and 40s your yearly average return for the next ten years would be 7.4% so around a 50% return average, just a simple look at a complicated matter that nobody really knows anything about.


On Jul 13 04:53 PM grey road wrote:

> It not only needs to go up in the right period , it needs to go up
> more than inflation, to be taking risk like that and you could have
> it in the bank making the same.. so actually it needs to go up more
> than inflation. And heres the other problem.. you only go back to
> the 30s so you just see it has always gone up since then, and assume
> it will keep going up into the future. This isn't neccesarily the
> case. It could go down for the next 100 years. This is unlikely but
> it needs to go up more than inflation. All in all this article is
> ridiculous and unlikely to go as the author says.. again.. good luck
> with your theory.

Jul 13 05:40 PM

[Davewmart:]

Yo richjoy 403,
I am not one who thinks that the market is going down for the rest of my life!
OTOH the next 20 years or so could be a bit rough! ;-)
I basically see this as 1930, with a heck of a lot of debt unwinding to come, but I reserve the right to be wrong, and certainly hope I am!
I was just curious what other folks thought, as you seem a pretty level-headed sort of guy.

Jul 13 06:20 PM

[richjoy403:]

Davewmart -- 20years!...I hope you will reconsider.

I am not suggesting we are going to return to the 1990s soon, but to suggest the investing landscape will limp along for a generation is fringe at best. (And it ain't that bad today..as of quarter ending June 30th, I am ahead by 13.79% YTD, and the S&P was up 1.8%. There certainly are opportunities.)

I'll leave you with this: If you study investing, among the points repeated again and again is that the retail investor (that's us responders here) is GENERALLY a poor investor. We are guilty of driving via their rear-view mirror; we typically buy what was hot in the last cycle or buy into a trend near the top; we consider our stock selections as reflections on ourselves and refuse to acknowledge we bought a loser and thus will hold it all the way down while swearing we will sell it when we again break even (thus missing a better opportunity); our vision is myopic as we think the present investment landscape (good or bad) will last indefinitely; and finally, women make better investors than men, as women (remember they are the ones willing to ask for directions when lost) are more flexible in their thinking, willing to listen to other voices, take a longer-term view, and don't see their performance as a reflection of their manhood (I am a man).

Most retail investors shouldn't be managing their portfolios. They don't have the time to devote to becoming a good investor, and just as important, they don't have the temperament for it and can't separate their emotional side from their analytical side (for example those who concentrate on the pain of unemployment, a well-known lagging indicator). They are ill-suited to compete with professionals, and would net greater returns if they paid the +/-2% fee for good professional management.

I apologize to those who find this off-topic...Dave, it's unfortunate there is no good way for us to have a sidebar conversation.

Jul 14 07:42 AM

[Davewmart:]

richjoy 403,
Apologies likewise to any who find this off-topic - but this thread is pretty old, so I will indulge myself once more.
As for small investors, I like Warren Buffet's comment:
If you have money but no experience, and invest it with the experts who have experience but no money, pretty soon you have experience but no money.
In my view the market is just Vegas on steroids, and the only way to beat it is to have insider knowledge, a sweet deal by being an insider and taking fees, or to follow value investing like Buffet.
Considering managed funds on average do no better than trackers and charge you a handsome commission for making random investments and stock churning to generate fees, then a low-fee tracker would seem to me to be the little guy's best option.
You can follow Buffet, but you don't get his sweet insider deals.
The cream is gone by the time the punter gets to play.

Jul 14 09:03 AM

[richjoy403:]

'nough said.

Jul 14 09:22 AM