Investors Are Terribly Myth-Guided

by | Aug 2, 2003

Lord knows where these things come from or how they get started. Another one of those emails is making the rounds — the kind that everyone seems to get and forward on to everyone they know, so you end up getting a dozen copies of it. So maybe you’ve already seen this list of “market […]

Lord knows where these things come from or how they get started. Another one of those emails is making the rounds — the kind that everyone seems to get and forward on to everyone they know, so you end up getting a dozen copies of it. So maybe you’ve already seen this list of “market myths.”

But be careful when someone tells you that something is a myth. Yes, when it comes to the market, there’s more myth than truth out there. But some things that pass as myths are the truth. So here’s a list of 25, scored by yours truly as truth or myth (but beware, there are a lot of them that fall in between).

1. Never try to time the markets.
Myth. Not everyone can succeed at it, and no one can get it right every time, but it can be done. If you have the guts to follow the simple rule of “buy when everyone else is selling,” and vice versa, you really can catch the big tops and big bottoms that come along every several years.

2. Bonds are safer investments than stocks.
Truth. Bonds have a lower expected return than stocks, but they really do have lower expected risk. And don’t get distracted by people who tell you that safe bonds cause you to risk not making enough money in the market — that’s not a risk, it’s a certainty. With bonds, it’s certain that over time you’ll make less in the market.

3. The economy always responds to interest-rate cuts six to nine months later.
Myth. And anyone who doesn’t know this one is a myth has been asleep the last two years. But beyond that, any statement about the market that has always in it is, of necessity, a myth.

4. Lower interest rates make stocks more attractive and justify higher price/earnings ratios.
Truth. I’ve written about this many times here, arguing that stocks aren’t as overvalued as a lot of people seem to think, thanks to today’s low interest-rate environment. Stocks should be valued based on the present value of future cash flows, discounted at the rate of interest. So when interest rates are lower, stock prices (and P/E ratios) can be higher.

5. The market is forward looking and predicts the economy six months later.
Truth. I don’t know if it’s exactly six months, but the market is at least trying to look forward to anticipate the economy in the future. But remember, while it may “predict,” it doesn’t always predict accurately!

6. A 20% rise in the market means a new bull market.
7. A 20% fall in the market means a new bear market.

Sort of. If you believe in the notion of bull markets and bear markets to begin with, then you have to set some definition for when you can say you are in one. The problem with whatever number you pick — 20%, 25%, whatever — is that once that number has been achieved, there’s no guarantee that the bull or bear trend will continue.

8. The baby boomers will drive the bull market until they begin retiring in 2008.
Myth. In the long run, stocks are priced by value, not by some particular group that holds them.

9. Economists and analysts are usually right about our economic and market future.
Sort of. Economists and analysts are almost always bullish, so just as long as the economy and the markets tend to move higher over time, they will at least generally be “right.” But in the short term, they are just as likely to get fooled by the prevailing fads and fallacies as anyone else.

10. Of the various earnings measures, “operating earnings” are the number to follow.
Sort of. As far as I’m concerned, all accounting numbers are bogus, because they try to capture in one-dimensional statistics a set of complex, dynamic and elusive realities. But at least operating earnings are relatively transparent and simple, so by using them you know what you don’t know. See my column here two weeks ago for some of what’s wrong with “reported earnings.”

11. Low trading volume is bullish during declines.
Myth. In a decline, I like nothing better than a huge volume day that indicates a complete wash-out. That’s what makes a bottom.

12. Low volatility indexes mean complacency and signal a market top.
Sort of. My research shows that low volatility is less reliable as a top indicator than high volatility is as a bottom indicator. But it’s certainly true that when the stock market is calm, you’re never going to be able to buy stocks at fire-sale prices — you need a fire for there to be a fire-sale.

13. Technical analysis doesn’t require a different approach between bull and bear markets.
Sort of. Suppose this was true. Then you’d need to know in advance when you were in a bull market and when you were in a bear market. How would you know that? Obviously you couldn’t use technical analysis to find out. And if you did know that, what more would you need to know to get rich quick? The whole problem is that one never knows for sure (in fact, one never knows for sure whether the whole notion of bull and bear markets even exists).

14. Low interest rates imply lower debt payments.
Sort of. Think about your mortgage. If it’s a floating rate, then this would be true. If it’s fixed, then this would be false.

15. America will always be the world’s lone economic superpower.
Myth. Remember what I said earlier about statements including the word always

16. The U.S. dollar will therefore always be the world’s safe haven currency.
Myth. As I was saying…

17. “Wall Street is like a casino — except the house wants the investor to be the winner.”
Sort of. Yes, Wall Street makes money when you come to play its games. And yes, it wants you to be a winner so you can keep on playing. But that doesn’t mean investing is gambling. It’s gambling if you turn your mind off and invest foolishly, but if you are thoughtful about it, it’s very much a game of skill.

18. Inflation is a given in our future.
Myth. We’ve just come through five years of deflation, not inflation. And what can happen once can certainly happen again.

19. When the Fed or Treasury increases liquidity, it increases lending to consumers and businesses and always results in stimulation of the economy.
Truth. But be careful — just because the Fed stimulates the economy, that doesn’t mean that the stimulus will have the result you expect or desire. Sometimes the stimulus will be too little, sometimes too much. The Fed almost never gets it just right.

20. Higher highs and higher lows indicate a bull market.
Sort of. If that’s how you define a bull market, then it’s true. But does it have any predictive value that you can make money on? I doubt it.

21. Put/call ratios are always meaningful.
Myth. Here’s another one that uses the word always. But I’m not convinced that put/call ratios are ever meaningful. In options, for every buyer there’s a seller — so the volume or open interest of options, be they puts or calls, can’t imply anything but a perfect balance of sentiment.

22. Gold rises in anticipation of inflation.
Truth. Among economists, gold is as unfashionable as the fedora. But there’s no better indicator of the market’s best guess about the future direction of inflation. Gold remains the closest thing there is to money without being money — so it’s the best thing to judge the value of money against.

23. A growing economy is synonymous with a rising stock market.
Sort of. Stock prices can rise even when earnings don’t grow, provided that they were modestly valued to begin with and that companies are retaining their earnings rather than paying them out. But for stocks to really make meaningful gains, there must be an upward change in expectations about economic growth. Stock prices reflect the value of all future cash flows; when expectations about the growth of those cash flows rise, so do stock prices.

24. Average annual returns are the best way to judge mutual-fund returns.
Myth. The best way to judge the return of anything is to measure it in relation to its risk. Returns alone are nearly meaningless.

25. Index funds are the best and safest long-term investment in equities.
Sort of. It is theoretically possible to beat the market. But if you don’t think it’s you who can do it, then index funds really are probably the best. They’re diversified, and have low fees and transaction costs.

Originally published on July 25, 2003 on SmartMoney.com, where Luskin is a Contributing Editor.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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