Last week, I showed two charts on returns on the Dow Jones Industrial Average that had two seemingly contradictory messages. In the first chart, measuring 10-year returns, one could clearly see that long-term returns have been declining since 1998, signaling that we are in the midst of a secular bear market. And, from the looks of the chart, those declines in returns are far from over. The chart would have looked much the same had I used 15-year or 20-year returns. This is bearish for equities.
However, the second chart I showed you, for 5-year returns, was quite different. It demonstrated that we have just seen one of the three sharpest corrections in medium-term returns in the last 75 years, with 5-year returns falling by an enormous 53% in merely 9 months. As markets tend to revert to mean, this could be seen as a moderately bullish sign.
I happen to believe that we are in a secular bear market and that the likely path of stocks in the US and Western Europe is lower. I have held this secular view for quite a while now to the point where I risk falling prey to my own biases. So, in seeing the second chart, I was reminded of another of our psychological biases which make investing so difficult: the confirmation bias.
In psychology and cognitive science, confirmation bias is a tendency to search for or interpret new information in a way that confirms one's preconceptions and avoids information and interpretations which contradict prior beliefs. It is a type of cognitive bias and represents an error of inductive inference, or as a form of selection bias toward confirmation of the hypothesis under study or disconfirmation of an alternative hypothesis.
Confirmation bias is of interest in the teaching of critical thinking, as the skill is misused if rigorous critical scrutiny is applied only to evidence challenging a preconceived idea but not to evidence supporting it.
Basically, human beings become anchored to a particular 'world view' and look at everything through that lens, minimizing any information that challenges this view and holding dear any confirmatory evidence. This is true in judgments about others character, in religion, in politics, and in the markets. As markets can turn on a dime, confirmation bias can be an especially deadly weakness for investors and analysts alike. By the way this is the chief bias of which the Bush Administration has been accused in going to war in Iraq.
So, where am I given this new data? I still do believe we are in a secular bear market that began in 1998 or 2000. The evidence supporting this is too overwhelming. However, over the near term, things do not look so bad for many sectors of the stock market outside of financials. While I do believe we will go lower, perhaps even testing 2002 lows, I would not be surprised if we ended the year higher. All of which is to say that we are in a period in which it pays to be defensive, take low risks, and keep a decent amount of cash on hand.
My expectations for the next few years is a mid single-digit return with a far greater chance of a large drop than a large rise -- that's not the 20%+ returns of the late 1990s, but it's not bad. Investors will be rewarded for picking the right sectors and avoiding the wrong sectors as the financials have shown.
So, did I overcome my biases?
Disclosure: I have no position in any of the Dow-30 stocks to which this story refers or any financial services shares.