Sunday, March 17, 2013

Individual Investing ... Our Tendencies and the Market's Tendencies ... Reversion to the Mean

Individual investors' buy and sell decisions more often than not provide solid indicators about where the stock market is heading. That's because as individuals we have an unblemished and sorry record of buying high and selling low.

But those in the know do just the opposite. They understand and practice 'reversion to the mean' investing. That's why we hear about trading ranges and such from market professionals. What goes up will come down (temporarily) and what has come down will go back up (over time).

But short term trading is not what most of us should do. We should be long term investors instead.

But we should also take the time to understand and internalize the principle of reversion to the mean and the historical patterns of market pricing and its teachings. We also must come to realize that for every buyer there is a seller and vice versa. Being on the longer term side of the street allows to take advantage of the habits of short term oriented traders. In other words, be prepared to jump in when others are bailing out and get out after others have all jumped in.

Of course, the habits of individual investors are just the opposite of what successful investors do. And that's exactly what Warren Buffett is talking about when he recommends that we should be feraful when others are greedy and greedy when others are fearful.

Our personal proclivities are to follow the crowd, and the pros know that. Accordingly, stock market investing is simple but not easy. We need to understand ourselves and others as well. Then we can win.

So how do things look today? Pretty well, thank you. The trend is our friend, both for the short and longer term.

Do the Math: Dow 18,000 Next Year provides the good news story for today's stock investors from a historical perspective:

"Barron's called its own forecast "conservative" when in February 2012 it put the odds at seven chances in 10 that the Dow Jones Industrial Average would reach 15000 by year-end 2013. The story also spoke of Dow 17000 occurring in the same two-year time frame—with a 50-50 shot. Both targets, with the assigned probabilities, remain relevant for 2013, since they are based on patterns of market history that still apply.

Even with the Dow reaching a record . . . , the performance of the market over the past five years is still below par. That bodes well for the bulls. Lower-than-average returns over five years are generally followed by higher-than-average returns over the following two years. Accordingly, the Dow has four chances in five that it will be flat or higher by year-end 2014, and a 50-50 chance of approaching 18000 over the same time frame.

These market odds are derived from long-term market patterns whose source is Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School. Prof. Siegel has amassed numbers on stock-market performance dating back to 1871 . . . . The numbers . . . provide the basis for projecting the likely path of the Dow.

The 142 years of market performance reveal a fairly straightforward cyclical pattern of worse-than-average returns followed by periods of better-than-average returns. Last year, the five-year returns were in the lowest quartile of all returns for five-year cycles.

This year, the five-year returns through March 5 were in the lowest third of all returns for five-year cycles. . . . found 45 five-year periods in the lowest third. The median annual return on these 45 two-year periods was 14.59%. To apply that 14.59% to the Dow, we first subtract 2.48 percentage points for dividends, leaving a median price return of 12.11% a year.

Grow the Dow at 12.11% from the March 5 close of 14254—the final number in our last five-year interval—and you get 17,915 within two years. . . . of these 45 two-year periods, in 38 cases the market was either flat or higher, making that more than four cases out of five.

Prof. Siegel believes the outlook for year-end 2013 remains intact: "15000 by year-end looks pretty easy now," he observes, "with 16000-17000 within range by the end of the year.""

Summing Up

The market's technical indicators still look good at the present time, and reversion to the mean teaches that the market's likely direction is still up and will be for another year at least. {NOTE: The fundamentals with respect to sales and earnings growth are looking better as well, but we'll save this story of the fundamentals for another time.}

And of course, longer term the market's direction is always up. That's one of the underlying common sense based truisms concerning the basic principles of risk and reward. If the potential for reward weren't greater for stock investors than for making alternative 'safe' investments, there simply would be no point in owning stocks.

And reversion to the mean combined with positive economic indicators going forward lead me to conclude that reaching 30,000 on the Dow within the next 10 to 15 years is more likely than not. Together with solid dividend income now and earnings growth and increased dividends over the next several years, that means stocks are the place to be, at least for me.

But not for those who are going to panic and sell when the inevitable 5% to 10% 'market correction' hits, which it certainly will. That's just the influence of the professional market traders at work.

Accordingly, individual investors who take the time and trouble to understand reversion to the mean probabilities and that there is a profound difference between a short term trading and long term investing mentality, are the ones who are going to win in the long run.

The deck is stacked in our favor, but only if we have the knowledge and the temperament to stay the course and think and act, or not act, as the case may be, in our long term best interests.

That's my take.

Thanks. Bob.

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