How to View the Current Economic Situation

Last Updated Oct 11, 2011 9:45 AM EDT

As advisors and students of financial history, we know that investors hate uncertainty. While most of us understand that only legends in their own mind have perfect clarity as to the future, when presented with conditions that create a heightened sense of uncertainty, even investors with well-designed plans react, letting their emotions and stomachs take over. And stomachs don't make good decisions. Fear, and eventually panic, tends to set in.

Unfortunately, we can't remove the uncertainty that may have your stomach rumbling. While it seems to be an all-too-human need to believe that there's someone who can protect us from bear markets, the evidence from academic research demonstrates that no such person exists. All crystal balls are cloudy, including mine.

Instead, I'd like to provide some perspective on what has been happening and to prevent you from committing costly errors -- failing to differentiate information from insights you can use to outperform the market and engaging in what I call "stage one-thinking."

Information or Actual Insight Let's start with confusing information with insights that can be used to outperform the market. The wrong way to think about all the bad news is to believe that prices must go lower. The right way to think about all the bad news is to understand that prices are where they are because of the bad news. In other words, if the news was bad, but not quite so bad, prices would actually be higher. In addition, low current valuations mean that future expected (though not guaranteed) returns are high. So before you sell, you should ask yourself: "Does it make sense to buy when valuations are high because things look safe, and expected returns are low? And does it make sense to sell when things look dark and valuations are low and expected returns are high?" That doesn't seem very rational. Yet, that's exactly the behavior of most investors. Consider the following.

On March 9, 2009 the S&P 500 closed at 676. By the close of May 2, 2011, it had more than doubled to 1,361, and that doesn't count the return from dividends. How were investors reacting during the greatest bull market since the 1930s? They were withdrawing hundreds of billions of dollars from equity mutual funds. That's why it has been said that bear markets are the mechanism by which wealth is transferred from those without plans, or the discipline to stick to plans if they exist, to those with plans and the discipline to adhere to them. Those who stuck to their plans in 2008-2010, simply rebalancing, were able to buy at low prices, when expected returns were high, and then sell (at much higher prices) when markets had recovered, taking precious chips off the table. In addition, the gains for some were so great that they were able to lower their equity allocation and still be likely to achieve their life and financial goals.

As was noted earlier, we don't have a clear crystal ball as to the outcome of this or any other crisis. It's certainly possible that the uncertainty in Greece and other countries could drag on for months without a solution, in which case risk premiums would likely expand, creating the potential for a repeat of 2008 in terms of the depths of a bear market. It's also possible that we could quickly get agreement on a broad solution, including recapitalizing the banks. That would restore confidence, risk premiums would likely contract sharply, and all the losses could be quickly erased. There's simply no way to know what scenario will play out.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.