A few lessons from 2002

Here's a picture of what it looks like when things get ugly in the stock market.

This is a chart of the Dow Jones Industrial Average during the last bear market, which stretched from January of 2000 through October 2002.

Note the three different bottoms, marked by red arrows on this chart (these three successive bottoms are also visible in the chart we posted in this previous blog entry).

One lesson from this chart is that it is very difficult to predict the real bottom in any significant correction. The third arrow marks the actual low for the bear market of 2000 - 2002, which occurred in October, 2002 for both the Dow and the S&P 500. Investors who were waiting for another bottom after that one may well have missed the strong rally that began in March, 2003. Overall in 2003, the Dow was up 25.3%.

Also, this type of diving three or even more times as the market tests for the final bottom is not unique to the chart above -- you can see it in other significant corrections, for example between the dates of January 1, 1981 and December 31, 1982.

Another lesson from the above chart is that, if you have cash available and your financial assets include an equity strategy as part of your long-term growth component (based on a time horizon of more than five years), you should add to your equity strategy during market corrections. Remembering the three arrows in the chart above, you should be willing to add and then add again later during corrections (if your cash-flow situation makes that possible).

Many investors (even wealthy investors and supposedly "sophisticated" investors) did not do that during the period covered in the chart above, and therefore missed the opportunity to add to equity positions during periods of lower prices.

The chart below shows that investors were pulling money out of equities and pouring money into bonds at greater and greater rates right up until the market bottom in the fall of 2002. The chart depicts net fund flows into equity mutual funds minus net fund flows into bond mutual funds. When the red line is above zero, flows into equity funds outweighed flows into bond funds. When the red line is below zero, flows into bond funds outweighed flows into stock funds.

Clearly, bond fund inflows were peaking at the very bottom of the equity market (second yellow circle). In fact, you can see the three bottoms from the first chart (the ones marked with red arrows) reflected in this chart as well.

Most investors will make similar mistakes in the current correction, and in future corrections, because adding money to equity positions during market drops takes intestinal fortitude and far-sightedness, and because the conventional wisdom is shouting that it is time to head for bonds and take cover. In fact, a Wall Street Journal article from this past Friday states that "Traders said it appears investors are shuffling money directly from stocks into bonds."

However, investors with historical perspective should be adding now, if possible, and remain prepared to add more in future months, knowing that drops like the one we are experiencing are opportunities.

For later posts dealing with this same topic, see also:


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