During the last year we have seen some spectacular (and rare) events. From the credit crisis last Fall which generated enough serious concern to compel the US government to “bail out” a number of large companies, to the nearly-unprecedented rally in the stock market from March, these are strange days, indeed. The biggest problem with these unusual times (aside from losing money, of course) is that they tend to skew our perception of what is normal or usual. In less volatile times, most of us have a clear idea of where the borders of normalcy lie. Occasionally, something happens that makes us think, “Hmm, now that’s unusual,” but most days, time marches on in a steady and familiar beat.
In more volatile times, we tend to assume that anything can happen, no matter how low the chances really are. “If Lehman Brothers can fail,” we muse, “why not ALL the investment banks?” “If AIG can be driven to the brink, why not ALL insurance companies?” “If stocks can fall 40%, why not 100%?” Whereas before one “black swan” would have evoked appreciative “oohs” and “ahhs” of wonderment at its rarity, we now expect flocks of them descending into our turbulent ponds. Much of the commentary I see continues to suggest that the events of the last 12 months are the “new normal.” Some experts still call for stocks to revisit the March lows. Others think that the economy will sink back into recession. Still others predict that the US dollar will continue to fall due to the US government’s massive budget deficit or a permanent lack of confidence that the US economy can ever again maintain sustainable growth. To all this, I say “poppycock.”
I still believe that the four most dangerous words in the investment parlance are “this time is different.” Investing is an exercise in probabilities, and those who are always counting on a highly unlikely outcome generally perform a lot worse than those who operate within the bounds of normal distributions. Let’s take a look at the US dollar for an example of this. The chart below shows the S&P 500 compared to the US dollar over the last few years.
In normal times, we expect the dollar and the stock market to move together – what’s good for stocks is generally good for the currency. This is the normal relationship. As seen in this chart, when the crisis hit last year the dollar became a “safe haven” currency and appreciated vis-à-vis other currencies, and at the same time stock prices fell. In March, the spread between the dollar and the S&P 500 peaked. At this point, anyone who thought that the “normal” relationship between the US dollar and the stock market should return would have shorted the US dollar and bought stocks. The chart shows that since March, indeed the US dollar has weakened and the stock market has risen. The purported reasons for these moves are legion in number, but most commentators will talk about the big, macro factors. Smaller factors like simple reversion to the mean, in other words, returning to normal, seem to be too insignificant to be real. I wonder.
So what do I think “normal” is right now? First, the economy is recovering in a fairly normal fashion from its recessionary trough. The pace may be below past recoveries, but many of usual elements of the recovery are there. The stock market is also responding in a normal fashion to the key drivers of performance – earnings, interest rates and sentiment. The media is also acting as one would suspect – searching out the most sensational stories or highlighting those experts with the most extreme opinions. After all, “normal” is not newsworthy. Finally, I think that many retail investors are acting in line with expectations. Some of them sold near the bottom and continue to hold cash ($4 trillion is still sitting in money market funds), waiting for the “all clear” signal from someone they can trust.
In a “normal” bull market, we should expect stock prices to rise over time with the occasional correction of 10% or so. The next time stocks begin to look a bit weak, we should try to avoid the natural tendency to think that they are somehow destined to go back down to the March lows, and simply accept the correction as a normal part of this new bull market.