FOOL ON THE HILL

Which Way Will the Market Go?

Unless you can predict stock market direction, you need to select good businesses selling at attractive valuations. Low-expense, broad-market index funds are a great alternative to spending time and energy picking individual stocks.

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By Tom Jacobs (TMF Tom9)
October 7, 2002

Want to know which way the market will go? One indicator is said to be this: Negative market talk increases at market bottoms, just as investor enthusiasm waxes at tops.

The conventional wisdom is that the herd piles in too late and piles out too soon. In ye olden days, the herd indicator was odd lot trades, the number of shares traded in lots of fewer than 100. This was considered a proxy for the individual investor, who was believed to be wrong about market direction most of the time.

Yet if indicators such as this are so clear, where are all the people who grew rich from forecasting the market's direction? If you're reading, more power to you, and may you profit handsomely. But for most, a bull or bear market (defined as a 20% up or down move in a major market average), is only visible in hindsight.

Of course, the market's general direction is important, because the majority of stocks will be caught in the power of its prevailing winds. What does that mean for the individual investor? Two things:

1. You can predict market and stock movements and buy at lows and sell at tops.

2. You concentrate on buying businesses at attractive valuations that, given certain assumptions, will grow and enhance shareholder value, surviving bad times and prospering in good times.

I don't know how to predict market and stock movements, though perhaps it can be done. The Fool Community is full of investors trying all sorts of techniques, including technical analysis, to profit from general market and individual stock direction. Join them; discuss; profit.

But for now, and for a long time, we have followed the second rule above. We at The Motley Fool have said over and over that we focus on businesses, not market direction -- and not because it's morally better. If day trading were the best way for investors to make money, hey, we'd be the day trading website. If we could read stock charts profitably (I'm referring here to technical analysis), we would do it.

The best we can do is follow the research showing that the longer the term, the more a company's stock price will move in the direction of its wealth creation -- or destruction. The longer the period, the more a stock may disengage from the general market direction and follow its own breeze, its Zephyr, reflecting its unique business performance.

For a company that's defying the market's gravity this year, look at a chart for Jarden (NYSE: JAH), where new management has engineered a turnaround. For another since the bear market began, look at Berkshire Hathaway (NYSE: BRK.A).

Why five years?
This is what we mean when we say you shouldn't put money in individual stocks that you absolutely need in the next five years or so (nothing magic there -- maybe less, maybe more), because while short-term stock-market movements can kill ya, good stock picking will reward you the longer you can hold.

That's also why we repeat in our books, our newspaper column, on our website, and during our radio show that money you absolutely need over the next five years shouldn't be in stocks. That doesn't mean "stocks always do well if you hold them for five years." They don't.

It means that if you carefully select a stock and buy it at an attractive valuation, and if the management runs the business successfully in your interest over that period, then, on average, research shows the stock price will reflect that value creation the longer you hold.

If you're right, the longer you hold, the more chances you have to profit from being right. You might turn out to be wrong about a business in fewer than five years and sell.

"Carefully select a stock" and "good stock picking"? There are the rubs. You need to find stocks in well-managed companies with in-demand products, and whose shares are selling at an attractive valuation. If that sounds like work, it is.

That's what we write about every day on Fool.com, every month in The Motley Fool Select, and what David and Tom Gardner do monthly in Motley Fool Stock Advisor. We try to find good businesses at attractive valuations for investment long enough that the stock prices reflect value creation -- or, in the case of shorts, value destruction.

It's simple, but not easy. You only need basic math, but you need to study, practice, and learn. 

The beloved index fund
You don't have to invest in individual stocks at all. In fact, we're blessed with the opportunity to put our cash in low-expense, broad-market index funds. These funds aim to capture the performance of American businesses, on average.

Why are we all about index funds rather than managed funds? We do admire and discuss the occasionally well-managed fund -- the few that fall outside the general rule, according to Ibbotson Associates, that most actively managed stock funds fail to outperform the S&P 500 over periods of five years or more, and the longer the period, the more that percentage increases.

You might find it enlightening to read Robert Brokamp's (TMF Bro) surprising revelation that the S&P 500 index is actually actively managed, but for free. So buyers of a mutual fund that mimics the index receive a portfolio representing a broad-market segment, weighted for large-capitalization stocks, but there are people who decide what goes in and out, and dozens of changes are made a year. That's still a lower percent of turnover than your typical stock fund, though.

Growth forever?
There's no guarantee that the American economy will continue to grow. Past performance is no guarantee of future results. Look at Rome, Greece, France, Britain -- you get the idea.

It's absurd to assume something about the U.S. that gives it financial Manifest Destiny forever -- and saying that doesn't mean I'm not a patriot.

But all we know today is that participating in the wealth-creating possibilities of American business has beaten gold, bonds, real estate, or jewels, for periods of 20 years or more since the 1920s. Even now. It may not continue to do so. But if you follow that path, index funds let you participate in wealth-creating possibilities without investing the time to become an investor in individual stocks.

Whether we're at a market top or bottom, stick to your knitting.

Make sure you have skills that can survive in a tough job market; save more than you might otherwise; live below your means; and keep a rainy-day fund in as secure and ready a place as you can find.

Contribute to your 401(k) and Roth IRA, keeping more of that money in index funds the farther you are from retirement. Don't keep cashing out house equity for current consumption.

If you want to invest in individual stocks, take the time to study businesses to find those that, if you hold them, will perform the best and reward you the most.

Tom Jacobs (TMF Tom9) got voted off the island last week just in time to write this column. Phew! To see his stock holdings, view his profile. The Motley Fool has a disclosure policy.