Running With The Bulls... With an Eye to 2008

"...They are determined as to the facts they will believe, and the opinions on which they will act.  Get by them, therefore, as you would by an angry bull; it is not for a man of sense to dispute the road with such an animal."  Thomas Jefferson (1762 - 1826)

With this week's running of the bulls event in Pamplona, Spain, I thought it fitting to take a look at the current bull market for stocks from a philosophical point of view and provide some logic for long-term investors...

While I will not attempt to diagnose the current level of investor rationality, one may safely assume that investors become increasingly irrational as the age of any bull market increases.  When will the current bull market end?  All we know with certainty is that we are currently in one of the greatest bull runs of all time.  Let's analyze human behavior and current macro-economic conditions while beginning our thought process of where to invest in 2008... 

Investors seem to be increasingly willing to accept greater risk for lower returns. A phenomenon in human behavior, known as choice shift, occurs when a group  decision is usually more extreme than a decision that would otherwise be made by members of the group on an individual basis.  This "shift" is generally toward more risky action.  Do you think that any one individual would run with the bulls without the "safety in numbers" provided by the crowd?

As related to the stock market, it can be equally foolish to bet against the crowd as it can be to "run along with it."  After all, the crowd is "right" most of the time.  With that said, however, long-term investors have the luxury of observing what may be irrational behavior without concern of the consequences of participating with the crowd.   If an investor so chooses to actively manage their portfolio, without the temptation of market timing, it is highly possible to lever short-term economic cycles for long-term benefit by staying "one step ahead" of the crowd.  Since the stock market tends to discount to present value the value of stocks approximately six months in the future, long-term investors should be looking at 2008 right now.  Here's what we have to look at now to base our asset allocation decisions:

• In the second quarter of 2007, stocks enjoyed the longest bull run in 80 years with gains in 24 of 27 sessions.  Is that a sign of more to come or a beginning to an end?
• Many Bulls argue that P/E ratios are still reasonable (around 17 times earnings); therefore, the bull market still has legs.  Is that rational?
• Those same P/E figures do not look so attractive when stocks are compared to their average annual earnings over the past 10 years, adjusting for inflation.  When using this method, which I find to be the most logical, the current P/E ratio for the S&P 500 has been higher only in the 1920's (just before the depression), and the late 1990's (just before the technology bust).
• In the 27 bull markets from 1900 through 2000 the average gain was 91.5%.  As of the writing of this post, the S&P (price gain) is over 97% since the previous low set on October 9, 2002.
• The current bull market is more than 4.7 years in age, while the average over the past 75 years is 3.7 years.  Since 1942, the average S&P bull run is 4.4 years.
• Research shows that the third year (2007) of a presidential term is typically 10 points above average for the S&P, while the fourth year (2008) is dead.

Also, uncertainty is no friend to stock prices.  As 2007 (and the six-month discount period) progresses, investors will increasingly look to 2008 to position portfolios. I try to balance optimism with realism but 2008 is shaping up to be a potential train wreck of uncertainty: 

• With no incumbent President or Vice President running, the uncertainty over an entirely new White House administration should prove a challenge to the equity markets.
• Looking forward on the political front, the first and second years (2009, 2010) of a presidential term are typically losers, especially for the riskiest of stocks.
• Furthermore, the Iraq war is increasingly looking like a 2008 problem as the current administration keeps pushing back the inevitable troop draw-down.
• Mid-east turmoil (Palestinian challenges, Iran struggles, and what lies ahead for Iraq) will stir more uncertainty for financial markets, compounded by Geo-political pressure and oil prices.
• On a totally different note, the oldest of the largest segment of the U.S. population, the "baby boom" generation turns 62 in 2008.  Will they begin to draw down stock positions as they begin to retire or in anticipation of retirement?  Whether or not boomers sell stocks en mass, the uncertainty over such an event may place more pressure on stock prices...

Whew!  Are we in trouble or what?  Not the prudent investor.  Ultimately, asset allocation is based upon fundamentals such as time horizon, risk tolerance, and investment objective.  More importantly, the "financial philosopher" must know themselves before deciding how to allocate.  For a refresher on on asset allocation and some more specific portfolio models, peruse through my "Invest Like a Philosopher" series of blog posts.

If you are into instant gratification, take a look at the Callan Chart.  Clearly, you may draw the conclusion that, within months of en economic cycle trough (see 1990, 2002) that bonds gain favor.

I do not condone "sector bets" as logical but, as you might imagine, I believe in using "excess in moderation."  If a prudent investor wishes to stay "one step ahead" they would now build health care (possibly consumer non-cyclical) positions for defensive purposes in addition to multi-sector bond funds by early 2008. 

In conclusion, prudent asset allocation allows an investor to minimize risk while maximizing returns.  As Mark Twain once said, "history does not repeat itself, but it does rhyme."  Predicting the market cycles with precision is a fools game but making incremental moves based on "the rhymes" of history is the path to being "right" more than being wrong.  The prudent investor will not run against or run with the bulls but, instead, will stay a comfortable distance ahead so as to avoid being trampled...

TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a 'fee-only' Registered Investment Adviser firm located in Mt. Pleasant, SC.