Do Stocks Always Go Up?

Two rules govern successful investing: "know yourself" and "stick to your knitting". With these as your foundation, you can easily achieve reasonable and excellent returns.

Know yourself. This has everything to do with setting your objectives and ensuring, by studying financial market history, that your expectations are realistic. Parenthetically, market history is not the past five or ten years. These years are all part of the same Deflation era and offer little insight into the likely returns over the coming five or ten years. If instant gratification is part of your expectation set, just give your money to your favorite charity. A crucial part of your self knowledge is how much money can you afford to lose and how will you react when your portfolio declines by 15 or 20%.

Stick to your knitting. If you hope to outperform the experts, you must have a comparative advantage. Surprisingly, this is easy. Most investors have bad plans and execute them poorly. The most deadly errors are trading excessively, refusing to recognize and eliminate mistakes, and risking too much capital on a particular bet. Decide how you want to make you money, develop a plan and stick to that plan knowing that there will be times when the market will not reward your effort.

If investment success was easy, everyone would be wealthy.

A quick financial market history lesson. Stocks do not always go up. Some companies go bankrupt. A surprising number of sovereign governments have defaulted on their debt. Financial markets are volatile and, most of the time, not easily forecasted.

A second history lesson. This century there have been six distinct eras in financial markets, and the return patterns of various types of financial assets have been very different in each successive era. Average returns calculated over the broad sweep of history hide more that they reveal.

To realize returns above average over the coming decade, it will be crucial to understand the driving characteristics of the era.

• First, there are almost infinite quantities of unskilled labour in a globally mobile world, which means that there is no realistic threat of wage inflation. It also means that the gap between the "knows" and the "know-nots" will continue to widen, increasing social tensions and forcing politicians in democracies to back away from the neo-conservative agenda so popular over the last fifteen years.

• Second, the cost of information technology will continue to fall, reducing the cost of capital to businesses. This in turn will allow increased business mobility to seek the lowest cost labour supply.
• Third, population growth is very high, putting ever greater pressures on commodities such as food, energy and water.
• Fourth, globalization of transport mechanisms, communication, and financial markets is bringing a great homogenization to our lives.
• Fifth, but certainly not exhaustively, the US will continue to dominate world events. This is due to America's flexibility, productivity, mobility, technology and relative political stability.

Forces such as these, in concert with certain economic developments, tend to create a teleological "pull from the front", a very vague kind of destination. Among the economic forces which will dominate are: the very high levels of outstanding debt, the current fixation on cutting government spending, financial speculation shown in mutual fund purchases, and excess supply in the financial services industry.

The path toward this "destination" is unknowable, but it probably will appear, in retrospect, as one of: a Bump-Along (unnotable) economic path; Deflation, which might result from an unwinding of the excessive debt levels; or Strong Growth, as world economies respond to the vast stimulations provided since 1992 by Central Bankers.

No one knows which of these developments will actually occur, but it is possible, nevertheless, to take sensible action by understanding that generalized wage and profit margin inflation is unlikely. Given that the stock values are on the high side of fair, and stock market expectations already include the likelihood of strong growth, the risk to stock prices is severe if anything resembling deflation is to evolve. This is the action that portfolio management demands today.

It may be time to reduce your exposure to equities in order to protect your assets against any change in outlook by market participants.

Article by Bob Swan - September 17, 1996

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