A friend recently pointed out that he had decided to move out of stocks when the Dow hit 15,000 -- which it did. So now his challenge will be to determine when to get back into the market assuming that he won't want to stay in money market funds forever. The conundrum of market timers is that they have to make two effective decisions. One is to determine when to get out and the second is the decision as to when to jump back in.
The stock market's continuation of gains right through the summer doldrums says a lot about the underlying strength of corporate profits. But the question now becomes one of deciding when it might end. Stocks can't continue to be gaining at rates of 20 percent per year. To underscore this point, in about six more months we will be seeing a five-year average annual return for stocks that will be "off the charts." This is because the bottom of the market in March 2009 marked the starting point for a five-year time period that will show average annual market gains of more than 20 percent.
What I remember about the late 1990s was the 16-month period during which the overall stock market gained almost 40 percent. I was reminded of this when I read about a recent paper by James Xiong. His work involves the study of market bubbles and crashes.
Basically, what we need to look for if we think we might be in another bubble is an accelerating growth rate. There is the term "exponential growth rate," which measures the extent to which growth occurs at a fixed percentage increase of the year's previous number. Compound interest at a fixed annual rate is an example of exponential growth. A dollar earning 10 percent will be $1.10 at the end of the year. Another 10 percent gain will bring the total by the second year to $1.21 -- and so on. In 7.2 years, the original dollar will have doubled -- the result of an upward-curving line on a graph.
A sneak preview of a bubble that might burst is offered by annual returns that are beyond normal exponential results caused when the annual returns themselves are growing by a greater percentage amount each year. In other words, when the market grows at an increasing rate that is more than just the constant compounding at, say, 10 percent per year, we should assume that a bubble is in the making and that it will burst sooner or later.
In theory, markets are supposed to be rational in the long run and the wisdom of crowds determines the true value based upon fundamentals and a fair price for a stream of future profits from corporate America. However, some rational people make the decision to ride the bubble and to make money as long as they can. As long as they understand that this is what they are doing, there is an argument that they are just as rational as the crowd. They're just prepared, psychologically, to walk the plank when the bubble pops.
Here are some numbers to consider: Vanguard's total stock market index fund (VTSSX) has gained 18 percent per year over the past three years. More recently, its one-year return has been 27 percent. Moreover, its year-to-date return for the first eight months has been 20 percent. That's an annualized rate of 30 percent. These numbers represent the condition that Xiong would classify as a bubble waiting to pop, according to his research.
For those of us who might be getting a little nervous, it might be time to consider rebalancing. Taking a few chips off the table and adding them to a combination of bond funds could make sense for someone within 10 years of retirement. The "sweet spot," remember, is to have approximately one-third of a portfolio in bonds if you want to maximize downside risk protection at a minimum cost of upside gain. Another sleep-inducing antidote would be to segue toward large-cap dividend producing stocks represented by funds such as Vanguard's Dividend Growth fund (VDIGX). After all, a repeat of a bubble that produces what could be a 40 percent return in 16 months would be nice to be a part of with at least some portion of our assets. Systematic rebalancing could capture much of the gain.
Stephen J. Butler is CEO of Pension Dynamics. Contact him at 925-956-0505, ext. 228 or firstname.lastname@example.org.