There is a big difference between investment returns and investor returns.  The key findings in Dalbar’s Quantitative Analysis of Investor Behavior (QAIB), first published in 1994, suggest that investor behavior is the main determinant of investor returns.  For the most part, investor returns have lagged investment returns during the past 20 years by a wide margin—over 700 basis points per year, according to Dalbar.

I was reminded of this a few weeks ago, when major stock indexes finally fell more than 20% from their October 2007 peak. This was accompanied by SEC Commissioner Christopher Cox announcing that his agency was going to actually enforce “already on the books” naked short selling rules, and the FDIC takeover of IndyMac Bank in Pasadena, CA.

Imagine picking up your copy of the Los Angeles Times on Monday, July 14 and Tuesday July 15.  On Monday, the front page headlines blared “IndyMac Bank Fails” followed by Tuesday’s over-sized picture of about 150 customers lined up for hours outside bank doors, waiting to extract their deposits.

No doubt, investors nationwide were calling their investment advisors, wondering about the return of their money, not the return on their money.  And just as this was happening, as it has happened many times prior, the market bottomed—at its maximum stress point.

This time wasn’t different, because it’s never different.  Investors repeatedly make the same mistakes, over and over again.  What accounts for the mistakes?  Simply put, it is relying on one’s emotions instead of the data. Chasing strong investment performance seems to be a permanent feature of investor decision making, whether it was technology stocks in the late 1990’s or the most recent burst bubble, real estate. Current candidates include international equities and oil/energy stocks/commodities.

On the flip side, excessive emphasis on near-term returns, especially when they are negative, almost surely leads to bad choices.  The reason investors do so poorly on their own is because they make emotional decisions at the wrong time—because they have no plan.  Despite the fact that market downturns are a fact of life, bear markets test the patience and forbearance of investors.  People will tell you they don’t mind volatility—as long as its up, but the bottom line is, people just don’t like losing money

A Bottom, But Not Likely THE Bottom

Since the July 15 low in the S&P 500 at 1214.91, that index has rallied over 7% in just four weeks.  Advisory sentiment indicators from both Ned Davis Research and the weekly AAII survey are in position to support at least a trading rally, as are a number of technical studies, including breadth. 

The NYSE High/Low indicator, a 10-day moving average of daily highs divided by highs+lows recently moved below 10% and reversed upward for only the 16^th time since 1980 (according to Dorsey Wright Money Management).  The accompanying table shows the average gain in the S&P 500 3 months after each reversal has been 4.4%, with gains over 8% six months out and nearly 17% on average 1 year later, though the last signal in August 2007 will almost certainly show losses across all three time periods.

Ned Davis has often pointed out that sometimes, market breadth is “so bad, it’s good.”  That seems to be the case recently, when daily new lows on the NYSE reached 1304, eclipsing the 1114 from the January low.  That resets the clock though, as most market bottoms occur with a lessening of downside momentum, with fewer and fewer stocks making new lows when the major indexes make their final lows.  You can see this example of a positive divergence during the 2000-2002 bear market (see chart), with daily new lows contracting at the final lows in October 2002 and March 2003.

For this reason, the odds do not favor the July 15 low as being the final low of this bear market.  That will likely come several months down the road, or possibly even into early 2009, with the S&P 500 potentially reaching into the 1125-1175 zone.

Still, Good Odds Ahead

Knowing that many investors have to be wondering (because they have no plan) what to do now that most stock indexes have entered Wall Street’s definition of bear market territory, I asked the Ned Davis Research Group to do a study of all declines of at least 20% in the S&P 500 from 1929 to the present.  The results are shown in the accompanying table.

First, we assumed that an investor hypothetically invested in one of three asset mixes, one day after each decline reached at least 20% from a peak.  The three mixes were the S&P 500, a 60% stock/40% bond mix using the S&P 500 Total Return and the Lehman Long Term Government Bond Total Return, and finally, 1 year Treasury Bills.  We then computed the returns 1 year later, 3 years later and 5 years later.

In all three time segments, the stock/bond mix, most representative of a prudent investor’s portfolio, substantially outperformed Treasury Bills.  More reliably, with a minimum three-year time horizon, the stock/bond mix had only three losing periods, two of which began in 1929 and 1930.  The third, in 1939, lost just 0.9%. 

Going out five years, the only two losing periods for the stock/bond mix also began in 1929 and 1930.  The mean return over 23 different occurrences was 8.8% per annum compared to 2.3% for Treasury Bills.

The message is quite clear to me.  Unless you think we are in a Depression similar to the early 1930’s, the data suggest that a diversified portfolio of equities and fixed income over the next three to five years will likely beat cash, and possibly by a substantial margin.  Some disciplined risk management would enhance these odds even further.  And quite frankly, if you think we’re in a Depression, you probably shouldn’t be investing anyway.  The U. S. stock market has been through bad times before, and recovered impressively, but buying and hoping is not the answer.  Invest with the data, not your emotions.

Bob Kargenian, CMT is President of TABR Capital Management, LLC, a fee-only registered investment advisory firm based in Orange, CA.