High Unemployment… Debt Crisis… Inflation… Tsunami… why does the market keep going up?

5 05 2011

By Jon Castle, CFP®, ChFC®

Many times, while working with clients, we get the question,  “WHY are you generally bullish on the market?  All the news I hear is BAD.  How can you possibly think the market is going to keep going up?”

I will get around to answering this question – but bear with me a moment as I wax philosophical.  It has been my experience in working with individual investors saving and working toward retirement – that the most successful investors develop an investment philosophy – a set of guiding principles and beliefs that shape an investor’s decision making process.  This set of principles essentially guides the investor during the darkest times so they can remain disciplined during times of economic and market volatility.

“I think the market is going to go up – so I want to be invested NOW – but not if it goes down,” is NOT an investment philosophy!  An investment philosophy guides an investor’s decisions consistently, based upon their fundamental beliefs about the way markets work.  For example, MY own investment philosophy (not necessarily the right one – just what I happen to believe) can be summed up as follows:

1)  Capitalism – perhaps best described as “Pay Upon Results,” ultimately drives the financial markets.  It creates the impetus for new developments and for entrepreneurs to take risks, to create new businesses or opportunities, to hire people to do work, to think up new goods and services that people will buy.  Without capitalism, there is no opportunity for reward, so no one will take undue risk – and the economy will languish as it did in the old Soviet Union.  Sometimes capitalism gets a little out of control… and can be cruel… thus the need for prudent regulation.  However, it is the best economic system invented so far and is amazingly efficient.

2)  Capital Markets work.  With all of the competition to outdo the other guy – millions upon millions of investors seeking the highest reward for the lowest possible risk creates an environment of extreme efficiency in our Capital Markets.  Just about all known information – and the probabilities of all imagined outcomes- about any particular stock or bond – is very quickly factored into that security’s price.  Any “surprise” information that can significantly give one investor an advantage over another is factored into the price very quickly – usually within seconds of that information becoming public knowledge.  Therefore – most of the time – doing tons of research about any particular stock or bond is a waste of time because the market prices the information faster than you (or a mutual fund manager, hedge fund manager, or other money managers) can do the research.

3)  I do believe that there are those few who have the “gift” and have been able to outperform the general market by some margin.  However, this “gift” is usually fleeting  – numerous studies show if someone has outperformed the market in the past – the odds of them continuing to outperform in the future are miniscule.  More often than not, managers who outperformed merely increased the risk within the portfolio, and pay for that risk later in under-performance.  Picking a money manager (or a mutual fund) who will outperform the market – in advance – is extremely unlikely.

4)  Successful investors focus on what they CAN control instead of what they cannot.  We cannot control fund manager performance.  We cannot control the Fed’s actions, nor can we control the markets.  However, we CAN control costs, the structure of our portfolio, and our own behavior.  So, in general, better and more predictable performance can be achieved by capturing the movement of the entire market and its various sectors – through the use of lower-cost ETF’s, index funds, and institutional “total market” funds – than through individual stock picking, trying to hop in and out of the market based upon tips or media input –  or by using more expensive mutual funds where managers try to beat the market while enduring higher risks, tax inefficiencies, and trading costs.

5)  Above all – manage risk.  If the market gets bumpy and shakes you loose from your philosophy – you have failed.  Likely, you took too much risk and will probably never recoup that risk by reaping the rewards the market has historically given those who structure their portfolios so they can ride out the market’s bumps.  Risk tolerance is best described as the amount of money in your account you can watch disappear (through market fluctuation) without changing your philosophy.  If the market drops 20% – but you freak out if your account drops 10% – then you need to structure your account so it will most likely only drop 9% when the market drops 20%, instead of gambling on when the market will go up and when it won’t.  More often than not your gamble will be wrong.

OK, so that was my investment philosophy in a nutshell.  Now – back to the original question.

With all the bad news – why does the market keep going up?  Aren’t we just setting ourselves up for another disaster?   Personally, I think not.  I could be wrong, but I believe my logic is sound.

First – much of the “bad” news is sensationalized.  Right now, as I write this, the media is just about going bonkers trying to get the Obama administration to release photos of the dead Osama Bin Laden.  Now let’s think about this for a minute.  What real purpose would that serve?  Suppose the photos ARE released:

1)  He isn’t any less dead with the pictures than without.

2)  Pictures can be faked.  People (and countries) who don’t believe he is dead, will believe the pictures are faked.

3)  People who believe he is dead will still believe he is dead.

4)  If the photos are released, the media would get more people either watching their shows, reading their magazines, or logging into their websites to see the pictures.  This would sell more magazines (with the photos), and allow them to charge more money for advertising in those magazines, sell more web banners, and charge higher rates for their commercials!

AHA!  The net worldwide effect of the administration releasing the photos would likely be – the MEDIA MAKES MORE MONEY!!!!  Hmm…

So… let’s apply this logic to the stock market and the economy.  What if the media were absolutely unbiased and did not sensationalize anything?

Responsible Media:  “The preponderance of the data shows that the economy is slowly recovering.  Unemployment is slowly going down.  Generally, economic activity is increasing while housing still continues to lag.  Corporate earnings are healthy and corporations are sitting on mountains of cash which they will likely continue to invest over the next 5 years in new production, jobs, advertising, commerce, or in the stock market.  The Federal Reserve will likely, very slowly, reduce the amount of stimulus in the economy to try to control inflation – but must do it carefully in order not to derail the economic recovery.  (They know this, by the way, since they all have PhD’s in economics and finance).  The dollar is weakening a bit – but a weakening dollar can be good for America because it creates jobs at home (versus being sent overseas) and it allows us to sell American goods overseas more competitively.”  (REPEAT EVERY DAY OVER AND OVER with tiny adjustments… )

BOOOOORRRRRIIINNNNGGGG!  After about the third day, no one would watch that show anymore!  And of course, that show and its network would make no money in advertising.

Now – compare that with OUR MEDIA:

1) “Tsumani causes Nuclear Disaster!!!!  Will this cause a global stock market crash?!?”

2)  “Osama Bin Laden Killed.  EXPECT TERRORIST ATTACKS which may cause a global stock market crash!!!!”

3)  “Initial unemployment claims increased by 0.005% last month!!! Is the economic recovery DOOMED?”

4)  Fed to reduce Quantitative Easing.  Is the economic recovery DOOMED?!?!

5)  Fed did Quantitative Easing which boosted the economy.  Oh, No, we’ve got DEBT!  Is the economic recovery DOOMED?!?!

You get the picture.

 The simple reason the market keeps going up is this:  Investors seek investments which give the highest reward for every unit of risk.  Currently, cash is paying virtually nothing.  Bonds are trading at the highest prices (and lowest yields) in most of our lifetimes – so very little new money is moving into bonds.  There is a TON of cash sitting on the sidelines – and it has to go somewhere.  Slowly, it is making its way to the stock market.  The stock “Market” is driven by supply and demand.  As demand increases, the prices go up to reflect that demand.  Expect occasional bumps as unforeseen events unfold – but in general, our economy is expanding and is likely to continue to recover over the next several years.  The stock market is a “leading” indicator of the economy (investors invest for the future, not for the now), so it will generally rise BEFORE recoveries and will generally fall BEFORE recessions.  This is not new – it is basic economics.

It can be helpful to remember that the stock market NEEDS some uncertainty to do well.  Only when there is cash sitting on the sidelines (as a result of worry or uncertainty) can the markets continue to go up.  It is this very “worry cash” that gets the fed into the markets over time, which, in turn, drives the markets up.  OF COURSE investing is risky – why in the world would there be any significant reward without any risk??  The problem is – once everyone FEELS great about the market – once the last investor FEELS great about the economy and goes “ALL IN,” – then there is no additional cash left on the sidelines.  Thus – there is no further demand to continue to drive the market up.  THAT is when we need to really worry… that event occurred in March of 2000 – at the very height of the tech bubble… when all was well, the economy was booming… monkeys with dart boards could outperform professional money managers… and we all know what happened next.

Disclaimer:  This blog article is not personal tax advice.  Please consult your tax professional for personal, specific tax information.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP(R), CERTIFIED FINANCIAL PLANNER(tm) and federally registered CFP (with flame logo) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Investment advisory services provided by Paragon Wealth Strategies, LLC., a registered investment advisor.

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