By Scott Reed
I hear you talking; I know what you are saying. And it makes sense. Anyone who says it doesn’t make sense isn’t being realistic.
The market has had a heck of a run.
With only two trading days left in 2010 as I write this column, the Dow Jones Industrial Average is up 11.1 percent year to date and it is up a whopping 80 percent since the bottom of the latest bear market in March 2009. The economy is still having problems that it seems will take years to fix. Unemployment is still high and houses are still not selling.
We all know that the investment world is a reversion to the mean business. With all the bad news that’s still out there, isn’t it reasonable, almost a foregone conclusion, that the market will certainly tank again and give back all the profit we have seen over the past year and nine months? It seems like everyone thinks so.
But wait – there is your first problem. If everyone thinks so, it may not be true because the majority is wrong so often that there are contrary indicators used with great regularity by professional investors to determine what the majority thinks and how to bet against it.
The equity markets have been blown way off course in the past few years but let me give you a few reasons I think the equity markets may have a tailwind instead of a headwind over the next few years.
• First, it is important to remember the difference between the economy getting “less worse” and “more better.” For a long while, the economy was getting worse at a slower pace. The bleeding was less, but we were still bleeding. Now the economy is actually showing signs of improvement. Granted, the pace is not as fast as we would like to see, but improvement is very different from getting worse.
• Second, it is hard to believe that this country is going to stay on a straight line of steady growth. After everything we have been through and all the money that the government has spent to regenerate this economy, it seems only reasonable that we will either move toward a deflationary environment or an inflationary environment.
With Bernanke at the helm of the Federal Reserve, it seems more likely that we will move toward inflation. Inflation means that fixed income securities like Treasury Bonds will decrease in price as the yield on bonds goes up. Inflationary environments are not a good place to be if you own a lot of bonds. Investors fare much better by owning stocks, real estate, commodities, and the relatively new Treasury Inflation Protected Securities issued by the government.
As investors move out of bonds and into stocks, stock prices should rise. That’s kind of what the free market system is based upon – greater demand makes prices rise.
Still, we’ve got to deal with this reversion-to-the-mean business. I certainly can’t claim to be an opponent of that theory. I have written in defense of the theory so many times I couldn’t possibly count them all. So how could I believe in reversion to the mean and still be bullish on the stock market?
Well, that goes back to time horizon. I have never been very short-term oriented. And I know that the markets don’t move in a straight line. I certainly plan to see the market go up and down quite a bit in the short-term, and I would expect to see the equity markets take some of their short-term profits from this extraordinary run we have seen.
But if you look back you will notice that as far as we have come, we are still 2,695 points or 19 percent below our previous high in October 2007. Even more significant to me is that we have made virtually no progress in the stock market over the past 11 years. Eleven years! That’s saying something.
The Dow ended the century at a price of 11,497. On Wednesday, it closed at 11,585 – virtually dead even. For an index that has averaged more than 9 percent per year since 1900, that is an awfully long period with no return. If you believe in a reversion to the mean, you must believe that the equity markets have some real upside over the next few years.
The tricky part is to know when that return is going to come. I’m not smart enough or confident enough to know when that will happen. In my 25 years in the business I have met many who claim to know, but no one who has proved it with any regularity.
My advice, as always, is to make your decisions based on reason, facts and a long-term horizon. Leave the gambling to those that don’t need their money down the road.
Happy new year and good investing.
Scott Reed is CEO of Hardy Reed Capital Advisors in Tupelo.