Don't jump off the ship in the middle of a hurricane

Here are two revealing diagrams, one which we posted back in January showing the three successive market lows during the bear market of 2000-2002, and one which is beginning to look very similar to it from today.

In the first diagram, we marked with red arrows the three successive sharp bottoms, each lower than the one before, which look like someone took an axe and whacked the market three times, each one harder than the last.

As we pointed out back in January, long before the market downturn had become an official bear market, "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."

After the final bottom in October 2002, the stock market rallied strongly in the first quarter of 2003, although many investors were so shell-shocked from the effects of that bear market that they missed that significant move. We know that many investors missed it because the historical data (which we also presented in that January post) show successively larger investor inflows into bonds and out of stocks during those successive "axe blows":

The similarities to today's situation are striking. Yesterday, for example, the amount of money flowing into three-month Treasury bills was so large that some investors were bidding for the bills at almost 0%. Much of the frantic buying was a result of fear that money market funds and other cash instruments would not be safe, leading to a rush to buy a bill that would pay no interest but was sure to be paid back.

From a portfolio manager's perspective, the important thing to remember in the current storm is to remain centered and not panic. We have already recommended that investors not hold large amounts in bank CDs or savings account, which we discussed in our post entitled "The bond market rules the world." Money market accounts may temporarily see some turmoil, but they are still diversified and a better alternative for cash, and they pay dividends.

Additionally, as the comparison of the current market chart above to the market chart from 2001-2002 shows, we appear to be heading into a situation which looks similar to the market bottom of October 2002. It is a fact of history that when the upward movements finally take place, they are so rapid that it is very hard to catch them unless you are prepared in advance. It is fairly widely known that a 1994 study found that 95% of the stock market gains between 1963 and 1993 occurred on just 1.2% of the trading days.

As we have pointed out in a series of in-depth examinations of the ramifications of years of Dalbar studies, ample evidence supports the conclusion that "investors make most mistakes after downturns." It is easy to conceptualize the idea of not jumping off the ship in the middle of the hurricane, and yet that is what a large percentage of investors do time and again.

Baron Rothschild is credited with the expression "The time to buy is when there's blood in the streets." It is easy enough to say that when things are going well, but you have to be in the kind of environment we are currently experiencing to absorb the full impact of that idea. The late John Templeton was known for his philosophy of investing at "the point of maximum pessimism." And the famous money manager Peter Lynch has written that "In many ways, the key organ for investing is the stomach, not the brain."

These are important truths to remember during weeks such as this one. Our view is that the financial system is undergoing a serious challenge, but that the overall economy is nowhere near as bad as it is being portrayed, and that investors should not confuse the two. Finally, we have stated many times our philosophy that it is dangerous to try to time economic and market cycles, and that it is much wiser to follow a disciplined investment process which is based on ownership of well-run businesses in front of fertile fields of growth.

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For later posts on this same subject, see also:


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