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When the Going Gets Tough

The Tough Hang In There...

As the current bear market approaches 2 ½ years, it is critical for investors to keep the proper perspective. It is important to remember that the stock market is an auction process where prices are set at the margin by the greediest or the most frightened individual. We witnessed the crowd phenomenon take over on the greed side with "irrational exuberance" and the internet stock bubble in the late 1990's. Irrational exuberance has been replaced by an equally irrational degree of skepticism of the new century.

Research in behavioral finance is gaining formal academic recognition for its value in explaining investor behavior and the fact that the short-term price of stocks is shaped by the "crowd's" irrational tendency. As quoted in Adam Smith's book "The Money Game" "Crowds are emotional, impulsive, careless and like an unruly child, incapable of anything but the simpler forms of reasoning."

We have lived through a quiet, creeping bear market since the spring of 2000 and, as is typical, the bear has become quite ferocious in its final stages. Herd mentality and crowd behavior cause three very human tendencies, regardless of whether the stock market is operating in the greed or fear mode:

1) Emotions frequently overcome reason
2) Shortcuts that violate logic are regularly taken: and
3) Facts that have been gained by experience are rejected.

As Warren Buffet has often said, "A group of lemmings looks like a pack of individuals compared to Wall Street …" Crowd behavior and excess euphoria can lift the price of a stock to unrealistic heights. Likewise, pessimism at its extreme can cause similar excesses to the downside. Investors must exercise patience and rely on logic and common sense to avoid the folly of the crowd.

It is our job to remind you that at times like these you need to ignore the news media and crowd behavior. Just as we reminded you in our July 1999 newsletter article "Are You a Rational Investor" about the mania that was occurring within the technology area, we now remind you that all bear markets do end and better times are ahead. As we all know investing in equities is cyclical. We have constantly pointed out over the past several years in our communications the fact that the disciplined long-term equity investor has historically been the only one to build true wealth over time. To illustrate how tough in practice it can be, the following example is taken from the last truly great bear market of 1973 - 1975.

What if you had kept $100,000 invested in the S&P 500 January 1, 1973?

3 months later................................$95,120
6 months later................................$89,631
9 months later................................$93,951
12 months later..............................$85,345
1 Year, 9 months later.....................$57,378

At what point do you think most investors would have given up and thrown in the towel?

	$57,378 removed from the market and reinvested in an interest bearing GIC at 5%	$57,378 invested in the S&P 500 instead of going to cash?
6 months later	$58,813	$77,157
12 months later	$60,247	$79,262
2 years later	$63,259	$103,404
5 years later	$73,230	$124,768
10 years later	$93,462	$244,437

Remember, bear markets always reduce risk rather than increase it, because they remove valuation risk, and this bear market is no different. Equities move to prices that are closer to replacement value, and that translates to bottom-line good deals. The investment returns one experiences from a bear market are historically very good. The question you need to ask yourself is: are you going to follow the crowd or act like an investor?

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