Dow 6000?

A new client recently said she thought the markets weren't done shaking off the ills of the credit crunch and that she expected to see the Dow Jones Industrial Average drop to 6000 before this bear market is over.

She asked what I thought was going to happen. Coincidentally, I recently read a professional publication which quoted renowned technical analyst Louise Yamada as also calling for Dow 6000, so I had specific answers for this question:

1 - I don't know.

2 - Neither does anyone else.

3 - With the DJIA currently hovering at about 8000, if these guesses of Dow 6000 do prove true that would represent a 25% loss. In the long run (which, of course, is the only time frame that makes any sense for investing in stocks), the upside potential is limitless.

To paraphrase financial behaviorist Nick Murray "If you have an investment opportunity which has a potential of losing 25% with a potential for infinite gains, and you do not put your long-term money there, you are clinically insane."

We don't need to know what's going to happen next week, next month, or next year in order to be successful investors. Now, as ever, we need to keep focused on our long-term goals and ignore the financial soothsayers.

What the Pros Said

Recently this blog quoted John Bogle's lesson advising investors not to trust market prediction, even by experts and I posted Scherer's corollary to that lesson:

Don't trust market predictions, especially by 'experts'.

Let's take a look at some 'expert' predictions from a year ago. In a December 2007 article, BusinessWeek surveyed a half-dozen market strategists with "a cumulative 175 years of experience" to help us "think about investing for 2008." (Actual 2008 results in parentheses.)

One money manager, known for advising clients to sell just before the 1987 stock market crash, predicted a 20% gain in the S&P 500. "Our models show the S&P 500 is undervalued by 25%. Our indicators are extremely bullish." Her recommendations: Lehman Brothers (2008 return = -100%), Bear Stearns (2008 return = -100%), and Merrill Lynch (2008 return = -77%).

Another 'expert' who is famous for challenging academic research about index investing was very bearish, and advised riding out the storm in a portfolio holding 50% in bonds and 20% in cash. (Maybe he did know something.) He was in favor of using utilities, TIPS and commodities for a defensive, inflation-wary portfolio. (Utilities = -30%, TIPS = -7.5%, Commodities = -39%. Oops.) And predicted a "marvelous recovery" in financial stocks in the second half of 2008. (Ah well.)

Another market analyst who has been in finance for over 35 years predicted Dow 15,000 by the end of 2008, and saw "pockets of value" in such stocks as Google (-56%), Deere (-58%), Tiffany (-48%), Nordstrom (-63%), J. Crew (-75%) and AIG (-97%).

An academic who has spent forty years analyzing technical indicators on Wall Street predicted a drop of 10% to 20% by mid-year and looked for markets to move up in the second half of the year. His advice: "Stick with large-cap growth stocks that are currently in favor." (Morningstar Large Cap Growth Index = -42%).

Tergesen, Anne. "What the Pros Are Saying." BusinessWeek, December 20, 2007.

Was 2008 an Unprecedented Surprise?

Certainly, the stock market losses last year were severe and painful in asset classes all across the board, but they shouldn’t have been completely off of our risk/return radar. Historical market returns suggest that we anticipate an average return of about 10% with a one-year standard deviation (STD) of about 20.

If you remember your statistics course, one standard deviation (plus or minus) from the mean should cover about 2/3 of the expected values, two standard deviations (+/-) from the mean should cover 95% of your experience, and three standard deviations (+/-) are expected to include 99% of expected values. We would then expect 2/3 of future stock market returns to be between 30% and -10%; 95% of the returns to fall in the 50% and -30% range; and 99% of returns to be between 70% and -50%.

So while last year’s returns certainly were not common, neither were they a so-called ‘Black Swan’ outside of the realm of consideration from a historical basis.

Gluck, Andrew. “A Decade of Pain.” Financial Advisor, January 2009.

Tax Changes in 2009

Several key tax changes became effective over the holiday season. Some, like the increase in estate tax exemption and increase in retirement plan contribution limits, we have known will happen for some time. But some were included in newly passed legislation signed into law by President Bush late in December.

Among the noteworthy changes for 2009:

Required Minimum Distributions Suspended

In 2009 taxpayers over 70 ½ who have been required to make distributions from their IRAs and other qualified plans will not be forced to do so in 2009. This could be significant for people who have adequate assets to live off of outside of their IRAs. For 2009, at least, those people won’t have to take withdrawals from accounts that have seen their values drop steeply.

Retirement Plan Contributions

Employees can contribute $16,500 in 2009, up from $15,500 in 2008. Employees over age 50 can put in a ‘catch-up’ contribution of up to $5,500 for a total of $22,000 in 2009, up from $20,500.

IRA contribution limits for both regular and Roth IRAs remain at $5,000 ($6,000 if over age 50). IRA contribution limits will be indexed in future years, but only in $500 increments when the CPI mandates an increase.

Mileage Rate

The standard mileage rate for deducting business travel is 55 cents per mile, which is down from the 58.5 cents in place for the last half of 2008 but up from the 50.5 cents in the first half of last year. The rate for medical or moving expenses moves to 24 cents per mile in 2009. The rate for driving on behalf of charitable organization remains at 14 cents per mile – this rate is set by law, not by the IRS.

Estate Tax Exemption

The basic estate tax exemption climbs to $3.5 million in 2009, up from $2 million in 2008. So a married couple, with proper planning, can transfer $3.5 million each to their heirs ($7 million total) free of estate tax if they die in 2009.

This change was part of a 2001 tax law which raised the exemption amount from then until now, then eliminates the estate tax altogether in 2010, THEN brings it back in 2011 and drops the exemption back to the pre-2001 $1 million level.

Words of Wisdom from John Bogle

John Bogle, investment icon and founder of the Vanguard Group of Mutual Funds, wrote a fine op-ed piece in the January 8 Wall Street Journal titled ‘Six Lessons for Investors’. The opening line is a classic - “There is almost no limit to the ability of investors to ignore the lessons of the past.”

The six lessons are:

1. Beware of market forecasts, even by experts.
“Strategists aren't always wrong. But they have been consistent, betting year after year that the market will rise, usually by about 10%.”

2. Never underrate the importance of asset allocation.

3. Mutual funds with superior performance records often falter.
After listing several prominent funds which severely underperformed the market in 2008 – “Only time will tell whether the disappointing shortfalls experienced by these and other funds will be recovered in the future, whether the skills of their managers have atrophied, or whether their luck has run out. Whatever the case, chasing past performance is all too often a loser's game.”

4. Owning the market remains the strategy of choice.
“Indexing won in 2008 by an especially wide margin. Low-cost, low-turnover, no-load S&P 500 index funds outpaced nearly 70% of all equity funds, and (admittedly a fairer comparison) more than 60% of all funds focused on large-cap U.S. stocks.”

5. Look before you leap into alternative asset classes.

6. Beware of financial innovation.
“Our financial system is driven by a giant marketing machine in which the interests of sellers directly conflict with the interests of buyers. The sellers, having (as ever) the information advantage, nearly always win.”

I would go further with Bogle’s Lesson 1:

“Beware of market forecasts, especially by experts.”

We’ll look into proving the ‘wisdom’ of some market experts in future posts.

Beware of Benchmarking Games

According to Jason Zweig’s “Intelligent Investor” column in the December 20-21 weekend Wall Street Journal, many mutual funds choose benchmarks which do not closely match the fund’s underlying stock composition which makes it easier to report performance which exceeds their ‘target market’. Zweig cites a study done by financial scholar Berk Sensoy which shows that 31% of US stock funds compare their performance to a benchmark that doesn’t closely reflect what the fund actually owns.

Zweig suggests watching closely to catch if your funds have changed their benchmark for comparison in 2008. Large cap stocks (defined by the S&P 500) have performed worse than small cap stocks in the past few years, so many funds benchmarked themselves to the S&P 500 to show outperformance. Last year, small cap stocks are down as much or more than large caps, so keep an eye out for a change of benchmark to a smaller cap benchmark to attempt to show better relative performance.

Just another of the games that active managers play to keep investing complicated and justify their substantial fees.