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Keeping it simple and a lost decade for investors

This U.S. advisory tells us why investors don’t want too many choices and whether or not stocks are still in the midst of a long bear market.

During the Cold War, the occasional report would surface indicating that Soviet defectors wanted to return to the U.S.S.R. for one reason: too much choice. After having just one type of bread on the shelves, they were overwhelmed by the assortment of a dozen or more brands.

Well, it’s been almost twenty years since the Berlin Wall fell (hard to believe it’s two decades already), so we assume folks in eastern Europe have gotten used to comparison shopping.

But those confused Soviet shoppers aren’t much different from most investors, according to one expert on the matter. Too much choice makes them nervous, we read in Bob Carlson’s Retirement Watch.

Mr. Carlson also offers some perspective on whether or not what he calls the “lost decade” for investors will continue.

But we begin with what makes people happy… and things that are supposed to make them happy but don’t.

Choice brings unhappiness

“Not surprisingly, money does not make people happy,” says Mr. Carlson, referring to several studies he has read on the subject.

“Financial security can ease the mind and give one the time to pursue things that contribute to happiness, but wealth itself does not lead to satisfaction.”

And having too many choices, like the ex-Soviet grocery shoppers, tends to breed unhappiness in investors. That, at any rate, is what sponsors of 401(k) plans — U.S. retirement savings plans— have discovered. Offering greater choice leads to lower participation.

“Most people do not study investments and do not want to,” says Mr. Carlson flatly. “They want few choices, and many want to be told how to invest.

“I learned this lesson years ago. When given many options or even many steps to take, people procrastinate.” That, he says, is why he keeps his recommended portfolios simple.

As you would expect with an advisory that has “retirement” in the title, the editor believes that successful portfolios are built first and foremost on managing risk. Offering a limited number of clear choices based on this simple approach, he reckons, makes it more likely that people will actually follow his advice.

Mr. Carlson’s portfolios consist largely of U.S. mutual funds, which are not on the radar of most Canadian investors, but the reasons he chooses the funds he invests in is instructive, and we’ll consider them later on.

Now here’s another simple statement: stocks haven’t gained a darn thing over the past decade.

Investors lost purchasing power

A decade ago, Mr. Carlson began warning investors that the biggest risk they faced was a period similar to 1966-1982. And what was wrong with those years?

“In that time,” says the editor, “the major market indexes were very volatile but ended the period at essentially the same levels at which they began it. After inflation, buy-and-hold investors lost purchasing power.”

Keep in mind that inflation made a huge dent in purchasing power following the oil crisis of the mid-1970s.

Still, we may be facing more of the same, says Mr. Carlson. “We have been in a similar period. Since 1998, the S&P 500 has generated about the same return as treasury bills, while subjecting investors to much higher risk.”

Casting a glance back over the past decade and all its peaks and valleys, it’s a little hard to grasp that stocks (at least those on the S&P 500) ultimately delivered no more and no less than U.S. treasury bills. Of course many investors made money in equities (while others lost), yet it seems like an underwhelming result. But it’s no fluke.

“Such extended bull and bear markets are not accidents or anomalies,” insists the editor. They are the normal valuation cycle of the markets.

Emotions dictate decisions

Ignore what’s been happening lately, he suggests, and look at longer cycles in the market. Extreme pessimism in the early 1980s gave way to optimism among investors from the late 1990s into 2000. This was not based on any logical evaluation of the market.

States Mr. Carlson bluntly: “Though conventional finance theory says that investors are rational and markets are efficient, the truth is otherwise. Investors make mistakes and sometimes let their emotions dictate their decisions.

“At times the majority of investors are prone to be either extremely pessimistic or extremely optimistic about an asset, resulting in extremely low or extremely high valuations for that asset.”

Extreme levels of pessimism usually mark the end of a long bear market. If we have indeed been in a decade that’s been more bear than bull, what should we be looking for now?

We get a better idea of what may lie ahead when we look back at the series of events, some easily remembered, others already forgotten, that have pushed and pulled at the markets since the beginning of the century.

More years of low returns?

When gloom began to take hold in 2000, stocks that had lagged in the bull market — real estate stocks, small caps and value stocks — started going up even as the indexes declined. The terrorist attacks then sent the market down toward what appeared to be a bear market bottom.

But in early 2002, new surprises were in store. A series of insider trading mutual fund scandals helped push the stock market to a bottom in late 2002 and again in March 2003. Then the market began the bull rally that lasted until late 2007. Yet despite that rally, the final tally for the past decade is: blah.

Here’s the question, from Mr. Carlson’s point of view: “Does a decade of low returns end the long-term bear market, or are we due for more years of low returns?”

By most historic measures of value and investor sentiment, he adds, we did not reach the extreme levels of pessimism in 2000-2002 that normally characterize the bottoms of long bear markets.

Are stocks really cheap?

The deep pessimism of January 2008 lasted for a short time, says the editor. But stocks are sending out mixed signals. Price/earnings ratios are low, indicating that stocks are cheap. But profit margins are near historic highs. “To say stocks are cheap, one has to assume margins and profits will stay high despite rising wages, rising commodity prices and global competition that makes price increases difficult to impose.”

Low interest rates may seem to be good, but it’s really only treasury rates that are low, the editor reminds us. Other interest rates have been rising, increasing the spread between treasuries and other types of debt.

What’s more, recent rallies on the stocks markets may not be cause for optimism. “Keep in mind that the nine biggest daily gains in U.S. stock history all occurred during the 2000-2002 bear market. Short-term gains are not a sign of a strong rally to come.”

There are positive signs. Corporations still have a lot of cash. Growth is still strong outside the U.S. and exports are propping up the American economy and its overall earnings. “Big investors such as Warren Buffett, Wilbur Ross and Bank of America are buying stocks. That buying, however, is selective, and for the long term.”

Levels of capital and levels of risk

In the end, it all gets down to how far home prices decline and mortgage defaults increase. So many financial institutions hold so much of their capital in mortgages that further erosion in the housing market will seriously affect the levels of capital they have to lend and invest.

If the credit agencies downgrade mortgages because they anticipate higher foreclosure and default rates, financial institutions must write down the mortgages they own. The economy and the stock markets subsist on a steady stream of capital. If the source starts to dry up, there’s more trouble ahead.

Mr. Carlson does not anticipate a steep recession, but he does not think the economy has hit bottom. That makes his choice of mutual funds for his core portfolio a matter of more than passing interest.

Two of his key holdings are Hussman Strategic Growth and Wintergreen. Here’s why: “I like both of these funds in this market environment for several reasons. Each is very flexible and not required to invest in specific assets or positions when they are in a free fall. Management at each fund is risk averse and always looking for values and opportunities.

“Each manager has demonstrated an ability to do better than the indexes and even make money in declining markets. They cannot profit in every market decline, but we have a better shot at preserving capital with them.”

In short, manage risk first, and the profits will come. It doesn’t get any simpler than that.