This market isn't pounding just your portfolio. It's also smashing some of the biggest myths that investors have relied on for a generation.
1. You can't time the market. So much for that. Two metrics have done a very good job of telling you over the decades when to be in stocks and when to be out of them. And both appear to be on the money once again: They were flashing red for months leading up to the summer swoon.
The first, called "Tobin's q," compares share prices to the cost of rebuilding those companies' assets from scratch. The logic is obvious: Why would you pay $1 billion to buy a company if you could start an identical one, with identical assets, for, say, $700 million?
The second metric is the "cyclically-adjusted" price-to-earnings ratio, also known as the "Shiller PE" after Yale professor Robert "Irrational Exuberance" Shiller, who has popularized it. The measure compares stock prices to average earnings over the past 10 years, in contrast with a typical P/E which is a one-year snapshot.
Both measures continue to signal caution, though less than they did six months ago. The Shiller measure can be found on the professor's website. Tobin's q is trickier: It requires sifting through the Federal Reserve's quarterly Flow of Funds report.
2. The cash on the sidelines will drive this market higher. How often have we heard this? Not long ago I met a bunch of professional investors, and this line came up again.
But it's a total myth. Take a deep breath, please. For every buyer of a stock, someone else must be a seller. Sorry, but there it is. If someone "on the sidelines" takes $1,000 in cash and uses it to buy, say, Exxon Mobil (XOM, news) stock, then someone else must sell $1,000 of Exxon Mobil stock . . . and take the cash.
3. Markets are efficient. You know the line: Stock and bond prices reflect all available information. Attempts to outperform are fruitless.
Not long ago, this myth dominated Wall Street and financial theory. The Supreme Court even relied on it in rulings.
But this is nonsense. Three months ago Greek government bonds were already trading as if a default were nearly inevitable. The yield on the one-year Greek bond was 35%. At the same time, the Russell 2000 Index ($RUT.X) index of small company stocks was at 850, nearly an all-time high -- and a record compared with the price of large-company stocks.
So back then, the "efficient" market was simultaneously betting that Greece would default, small companies would keep booming and investors would continue to want more risk in their portfolios. On which planet?
4. Share buybacks will drive the market higher. We've been told over and over again that companies have "record amounts of cash on the balance sheet," and that this should be great for stockholders. After all, they are going to return that cash to investors by buying back shares. And that should raise the stock price by reducing the amount of shares in issue.
So much for that. Standard & Poor's 500 Index ($INX) companies spent a massive $103 billion buying back their stock in the second quarter, on top of $85 billion in the first quarter. And the results so far haven't been that impressive. InsiderScore reports that the second-quarter figure was the highest amount spent on share buybacks "since the first quarter of 2008." Hmm. How'd that work out?
Turns out this logic was flawed in at least three different ways. First, the "record cash on the balance sheets" is matched by record debts. Second, if a company spends $100 million buying back stock, it should, rationally, make no real difference to the share price: The market value should fall by $100 million. Third, "buybacks" are largely a fiction: While the company spends stockholders' money buying in stock, the compensation committee quietly hands out new stock to executives.
Net result: You're actually going backward. Standard & Poor's reports that from 2000 through 2010, S&P 500 members spent a massive $2.7 trillion buying in stock. Yet at the end of the decade they actually had more shares and options outstanding than they did at the beginning.
5. To get higher returns you have to take on more risk. This one is still alive. But is it really so straightforward? Back in 2000 I had lunch in London with a very wise old portfolio manager. He told me to sell all my stocks and buy inflation-protected U.S. bonds. As it happens I didn't own many stocks, but I was a young whippersnapper who had grown up during a two-decade bull market, and I didn't see much appeal in Treasury inflation-protected securities -- the "safest," supposedly dullest, investment around. After all, wasn't a young investor supposed to be taking on "risk"?
Since then, the Vanguard Inflation-Protected Securities (VIPSX) fund has more than doubled investors' money. That's been a spectacular result -- from the "safest" investment around. Meanwhile the risky S&P 500 Index has actually lost money. (Over the same lunch, the same manager also told me to buy gold. We keep in touch).
In early 2007, according to an analysis by fund firm GMO, the relationship between "risk" and return was actually upside down. At that point, they said, "risky" investments were so overpriced that they were virtually guaranteed to produce worse returns than "safe" investments. In other words, investors were not being "paid to take on risk" -- they were instead paying for the privilege.
Continue to the next page for more. Stock mentioned in this article: Bank of America (BAC, news)
Move along folks, nothing of value worth seeing here. Learn to think for yourselves and act on your own.
