Posted by on Aug 27, 2015 in Articles & Advice, Blog, Columns |

Image Credit: “The Fall of Phaeton,” Hendrick Goltzius, 1588, Rijksmuseum

By Jason Zweig | 6:18 pm ET  Aug. 24, 2015

If you weren’t paying attention to the stock market before Monday, you are now. A 1,000-point drop in the Dow Jones Industrial Average will do that.

As the financial blogger Ben Carlson pointed out this past weekend, sharp drops in the market transfix our attention, with short-term losses overshadowing our awareness of longer-term gains.

Crimson arrows pointing down, pundits shrieking on financial television, stock-market charts flickering like monitors in a hospital emergency room: all these indicators make what is happening in the short term seem perfectly clear. But if you form long-term investing plans based on them, you will be sorry.

Being acutely sensitive to bad—or potentially bad—outcomes has probably helped the human species survive and thrive. So it’s no wonder that when people process data, they suffer from what economists Kip Viscusi and Richard Zeckhauser call “denominator blindness”—the tendency to focus on the top of the fraction, not the bottom—or the magnitude of bad outcomes, not on the total number of events from which those outcomes are drawn.

Experiments have shown, for instance, that people believe cancer is riskier when they are told that it kills “1,286 out of 10,000 people” than when they hear that it kills “24.14 out of 100 people.” Hearing “1,286” immediately brings a large number of victims to mind, while “24.14” is simply a much smaller number.

To notice that the first number is less than 13%, while the second is more than 24%, you have to focus on the denominators of the fractions and do some quick division. But your emotions will likely hijack your brain long before you get to that point.

Ask almost any investor if the stock market is more volatile than it used to be, and you will hear a resounding “yes.” That’s because the Dow routinely moves up or down at least 100 points in a day—a round number that sounds large and important.

But, even after the recent spike in volatility, the market has fluctuated less sharply in the last three years than has been typical in the past. And even after the market’s recent haircut, 100 points is only about a 0.6% change in the Dow.

A 1,000-point move, on the other hand, is a full 6.6% decline. But how significant is it, and what should you do about it?

Stocks are still not cheap. The best guide we have to the valuation of the stock market—the 10-year average “cyclically adjusted price/earnings ratio” or CAPE, popularized by Yale University economist Robert Shiller—says U.S. stocks are still above their historical average.

On Aug. 4, stocks were selling at a CAPE of 26.4 times, about 50% higher than their average since 1871 and about 10% higher than they’ve run in the past three decades.

At the depth of Monday’s drop, stocks were down to 23.6 times—far from a bargain based on past levels.

But investors who want absolute certainty will be utterly disappointed. To be realistic about the future, you have to recognize the limitations of the past.

Historical data might feel as unchanging as an exhibit in a museum, but the financial past is nonstationary. As St. Augustine pointed out more than 1,600 years ago, time is a continuum. Today’s returns will be in the market’s past results tomorrow, and the “long-term” return changes slightly almost every day as the latest increment or decrement of performance gets averaged into it.

So the belief that the long-term average for CAPE of roughly 16 times is the “right” value for the market is dubious, says Prof. Shiller. Because the past is forever in flux, determining the proper level of valuation “is so fuzzy,” he says. “It’s not a science.”

The lowest the CAPE ratio got during the financial crisis was 13.3, in March 2009—partly because the 10 years of data on which CAPE is based still included, at that time, the euphoric period of 1999 and 2000. That ratio of 13.3 was barely below the long-term average. So investors who waited for a definitive sign, in 2008 and 2009, that stocks had gotten to bargain levels never got one—and missed out on the ensuing bull market.

We all long for certainty, some kind of chime or singing telegram that would tell us exactly what to do. After all the drama of the past few days, stocks are a little cheaper than they were before. They could get a lot cheaper still before this is over.

But don’t let anyone fool you into thinking that history or mathematics can identify some exact entry point at which you can know you’re buying back into stocks at a bargain level. The future is uncertain, but so is the past.

In order to capture the potentially higher returns that stocks can offer, you have to reconcile yourself to the certainty of horrifying short-term losses. If you can’t do that, you shouldn’t be in stocks—and shouldn’t feel any shame about it, either.

Source: The Wall Street Journal