I've been wanting to write about this concept, shamelessly pulled from Peter Lynch's One Up On Wall Street, for a long time. Heck, if you're going to shamelessly cop someone else's idea, Lynch is a pretty good source.
Lynch discusses the Mayan concept of the universe as it relates to investing. In Mayan mythology, the universe was destroyed four times, each time by a new scourge. So after each tragedy, the Mayans did something else. First flood, which the Mayans responded to by building their homes on higher ground, in the midst of a fire plain. Guess what happened next?
My favorite part of this story was Lynch's turn of phrase -- "the previous menace." I don't know if this was his original, or if he got it someplace else, but it's brilliant. When you take a look at how the average investor responds to market conditions, it's a spot on description. Whatever happened last, that's what he's preparing for next. And when something else comes out of left field, it just seems random. Mostly, it isn't.
In the 1920s, many people watched as the stock market grew and grew and their neighbors were getting richer and richer. They were missing out! They piled in, just in time for the market to collapse. For the 30 years following the Great Depression, these same folks had a simple mantra. "Market too risky. Leave for professionals." And what do you know, this stretch of time turned out to be a fairly fantastic time to get involved in stocks, with real companies with real earnings going through the process of building the greatest economy in the history of the world.
People came back into the market in the late 1960s following years and years of gains, just in time for another collapse. And around and around we go, through the most recent time of excess when anything called "e-", or "fiber", or "-.com" didn't even have to prove an ability to make money in order to be conferred status as a market darling. Anything with the highest level of earnings momentum was automatically anointed the next big thing, and folks bought like mad.
As a result of the excess, we're now three years into an overdose-triggered snarling bear market. In each of these years, a short-term rally has been met with massive inflows of capital from folks not wanting to miss out. Just in time for the next drop. We may be in another one of those moments at this time, with billions of dollars pouring into equities on the strength of a quick 30%+ move by the Nasdaq average.
Henry Blackstock, the Chief Investment Strategist at Southtrust Investment Advisors, points out in a recent article that since the bear market began in 2000, equity mutual fund net inflows have a nearly perfectly negative correlation with stock market returns as measured by the S&P 500.
In the second quarter of 2002, investors plowed more than $26.8 billion of new money into equity funds on a net basis. What happened the next quarter? The S&P 500 dropped 15%. So the next quarter investors redeemed more than $7 billion, and the market proceeded back up. Over the next three quarters, net investments into funds equaled $71.3 billion, while the S&P 500 dropped another 13%. As measured by investor enthusiasm for mutual funds, investors' collective ability to judge the short-term direction of the market is nothing short of abysmal, if this very selective and limited data is any indicator.
They get burned, vow not to make that mistake again, and walk right into the next mistake. History should be treated with its due importance, but no more than that. Folks who got burned in equities who have solved that problem by holding mostly bonds or mostly real estate may be no safer than if they had simply remained in equities. I don't really have much in the way of a prediction here, so please repress your desire to blast me on my "bearish stance on real estate," or whatever. But just as there are speculative bubbles in equities, there are speculative excesses in every other investment instrument. That bonds and real estate are touted now as being safer investments "in these uncertain times" suggests to me that they're about to cease to be.
Why writing about the market stinks
A confession: I don't like writing about "the market." I've said it in the past, that I like to focus on companies, and let the market itself just sort of run along in the background. Recognize this -- during the most blatant bubble in several generations, there were plenty of companies out there that were delightfully undervalued. Some of these were hidden in plain view. How many people were writing Warren Buffett off as a has-been in late 1999 as Berkshire Hathaway
The problem wasn't Berkshire, or Costco
That leaves 475 companies accounting for the remainder of the gains, about one-third of the total. And not 475 obscure companies, but rather 475 of the largest, most dynamic firms in the country. As it turns out, some of the best buys in years came in the months before the end of the bubble in March 2000. But you'd never guess by looking at "the market." It's too busy licking its wounds from having piled billions into PMC-Sierra
I'm convinced that the two concepts are related: those who are concerned about what "the market" is doing are more likely to be completely unprepared for the next menace. Focusing on whether people are buying stocks at a given moment and not whether they should be buying stocks at that moment seems a heck of a lot more useful. Focusing on whether you should be buying individual companies due to perceived value even more so.
Forget the previous menace. It may be back, but it's not what's going to get you the next time around.
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann's most previous menace was a woman driving 80 miles an hour on the interstate with one foot propped on her rear view mirror. Bill owns shares of Berkshire Hathaway and Costco. The Motley Fool is investors writing for investors .