The Mother of all Rallies

For those who panicked last week, take heart…the stock market may have lurched forward yesterday, but it just as easily could have dropped once again. It only took Mitsubishi backing out of its investment into Morgan Stanley or maybe another hesitating weekend of inaction by the world’s finance ministers. That said, many investors learned a painful lesson yesterday: for relief in the moment, you may have chosen a path that could (or could not) have long term ramifications.

In Ron Lieber’s recent New York Times article “Switching to Cash May Feel Safe, but Risks Remain,” (October 8, 2008), he cites 2005 research conducted by H. Nejat Seyhun, a professor of finance at the Ross School of Business at the University of Michigan. Seyhun “tested the long-term damage that investors could do to their portfolios if they missed out on the small percentage of days when the stock market experienced big gains. From 1963 to 2004, the index of American stocks he tested gained 10.84 percent annually in a geometric average, which avoided overstating the true performance. For people who missed the 90 biggest-gaining days in that period, however, the annual return fell to just 3.2 percent. Less than 1 percent of the trading days accounted for 96 percent of the market gains.”

Let’s take a look at this in real time. Friday capped the worst week ever for US stocks. The major indexes plunged over 18% in just five trading sessions. Then yesterday, the Dow Jones Industrial Average soared 936.42 points, or 11.1%, to 9387.61. The S&P 500 soared 12% to 1003.35, with all its sectors climbing. The Nasdaq Composite Index rose 12% to 1844.25 and the small-stock Russell 2000 jumped 9.2% to 570.55. Stock markets around the globe put in similar performances. Of course stocks are still mired in a serious bear market, with the Dow still down 29% year to date and off 34% from its record close of 14164.53 hit just over a year ago on October 9, 2007.

Indeed, a good night’s sleep is a precious commodity. But it is also important to remember that emotional decisions often can have a payback. You may have felt better over the weekend after going to cash, but how are you doing now? Are you still comfortable knowing that you missed the biggest percentage gain in US stock history? As Lieber notes, “some retirees, or those close to leaving the work force, may be well-off enough to leave stocks behind for now. If the tumult in the economy and the decline in the markets have altered your risk tolerance, then it may make sense to move to a portfolio of Treasury bills, certificates of deposit and money market funds.” But if you are a long-term investor, you should try to avoid the herd mentality that is associated with bull and bear markets.

Burton Malkiel, the legendary author of “A Random Walk Down Wall Street,” reminds us that “the herd instinct works exactly the same way in bear markets. Nervous investors convince themselves that every "light at the end of the tunnel" is a train coming in the opposite direction. Panic is just as infectious as blind optimism. During the third quarter of 2002, which turned out to be the bottom of a punishing bear market, investors redeemed their mutual funds in droves. My own calculations show that in the aggregate, investors who moved money in and out of equity mutual-funds underperformed the buy-and-hold investors by almost three percentage points per year during the 1995-2007 period. Look at history: The market eventually bounded back from the damaging stagflation of the 1970s and the savings-and-loan crisis of the early 1990s, when a whole industry had to be rescued. Stocks also recovered from the Asian crisis of the late 1990s. Similarly, investors who held on after the more than 20% one-day stock-market decline in 1987 were eventually well rewarded.”

Whether or not last week was the bottom of the stock market move will only be known in retrospect. One way that you may know that your asset allocation is consistent with your risk tolerance is if you felt as calm last Friday and you are today. If that’s the case, the “Mother of all Rallies” was just another Monday.