Investors need some kind of disciplined selling strategy.
I say this because of a point I made recently – that the ratio of the world’s money stock to share prices suggests that the latter are over priced.
This gives us a nasty dilemma. On the one hand, there are reasons to doubt this claim. It’s possible that the high prices of big US tech companies are sustainable because they have the monopoly power to generate ongoing earnings growth; this is a big difference between now and the tech bubble of the late 1990s. And even if equities are over priced, it does not follow at all that they will fall soon. Asset price bubbles develop momentum, such that big returns are sometimes to be made just before prices peak.
On the other hand, though, when bubbles do burst the losses can be calamitous. After Japanese shares peaked in 1989 the market halved in the following three years. The Nasdaq composite index lost 70 per cent between 2000 and 2002. And UK shares halved between 1928 and 1948 after inflation.
Being in top-quality companies is no protection against such losses. During the 2000-02 crash Apple fell more than 70 per cent and Amazon more than 90 per cent. When bubbles burst, they drag down even the best stocks.
Nor are these losses quickly recovered. The Nikkei 225 is lower today than it was in 1989. The Nasdaq only returned to its 2000 peak in 2015. And UK equities only returned to their 1928 level in real terms in 1993. The idea that you can ride out losses if you stay in the market long enough can be dangerously wrong.
Hence our problem. There is a danger that global equities are in a bubble that’s likely to deflate sometime and if it does the losses will be horrible. We can’t quantify this risk or say when it will materialise. But risk is probability multiplied by impact – and the potential impact is big.
There might well come a time when we need to get out of equities, therefore, even if that time is not now.
Herein, though, lies a danger. There are always powerful motives to stay in over-priced equities. Bubbles don’t suddenly burst. They deflate slowly precisely because investors are slow to sell.
One of these motives is simple wishful thinking. Guy Mayraz at the University of Melbourne has shown that simply owning an asset makes us more optimistic about its returns, even when that ownership was acquired randomly. This is an example of the endowment effect, whereby we value things highly merely because we own them. Falls in over priced stocks are often initially regarded as mere dips, perhaps even as opportunities to top up.
This tendency is exacerbated by the fact that we are often slow to change our minds when the facts change. In itself, this is not silly: evidence about companies’ future growth is usually ambiguous. It is, however, easy to cling more strongly than we should to our prior beliefs especially if we grow attached to the stories we tell ourselves. Stocks such as Apple (US:AAPL), and (especially perhaps) Tesla (US:TSLA) have been powered upwards not just by dry corporate analysis but by good narratives. And it’s easy to continue to believe stories after mere facts have changed.
If these motives stop us selling during the early phases of a deflating bubble another kicks in later. We hate admitting, even if only to ourselves, that we are wrong: selling at a loss is an admission of failure, something we are loath to do.
Such motives mean it’s easy to stay in a deflating market all the way down.
All this means investors cannot rely upon either futurology or judgment to tell us when to sell. Futurology doesn’t tell us for sure when a bubble will deflate. And unaided judgment tempts us to stay in a falling market.
Instead what we need is some rule that tells us when to sell in response to changing market conditions. One such rule is of course to sell when prices fall below their ten-month moving average, as first advocated by Meb Faber at Cambria Investment Management.
This rule isn’t perfect. It never gets us out of the market right at the top or into it at the very bottom. And it loses us money in those circumstances where a strategy of buying on dips works.
For all its drawbacks, however, it has one huge merit. It protects us from the long and deep bear markets which happen when bubbles deflate and which can really destroy our wealth. It is for this reason that the rule would have delivered better long-run risk-adjusted returns than a buy-and-hold strategy in markets as various as Japan, the US, UK, emerging markets and mining stocks. If you want to avoid the worst that can happen to investors, you need something like this kind of rule.
Which isn’t to say you need this exact rule. There are alternatives such as various types of adjusting stop-losses. There’s no point looking for an optimum rule: what worked best in one market or period won’t necessarily work best in another. What we do need is a rule that’s good enough to protect us from the sort of terrible losses that can happen when bubbles deflate – because we know for sure that neither futurology nor unaided judgment are sufficient protection.
