As decision makers we spend a lot of time wallowing in the past. We project recent trends forward, expecting things will pretty much go on as they have been. Unfortunately, this tendency, termed “recency bias” by cognitive psychology, often does not give you a good guide to the future.
Nowhere is this more true than in the investment markets. Here are two recent trends that investors are keying on:
- Gold has been on a 10-year run that will continue as investors come to realize it is a store of value that will protect them from the devaluation of paper money due to excessive government debt.
- The stock market has not yet hit bottom because price earnings ratios must hit single digit levels first.
Gold has been on a roll for 10 years. A decade ago it hovered under $300 an ounce. By the end of September it had surpassed $1,300 an ounce – a gain of over 16% per year. Gold bugs see all kinds of arguments why the yellow metal will keep increasing: government deficits, devalued currencies, worldwide financial collapse. But many buyers now are looking at momentum: they see that gold has gone up for 10 years now so they expect it to continue. As the price has climbed to daily record highs, more interest is aroused and more buyers jump into the game.
However, investment prices tend to revert to a mean. Gold is no exception. The last time it rose – from $33 an ounce up to $850 in the 1980s – it crashed and endured two decades of declines. Gold’s return since 1933 has only been 4.7 percent per year. It is true that current trends can continue for quite a while, but the idea that gold – or any other investment (remember real estate? Dot-com stocks?) – will continue to rise without fail is a dangerous thesis for any investor to follow.
U.S.stocks have fallen over the last 10 years, but price to earnings ratios – which compare a stock’s price to the profits of the company issuing the stock – have not hit the single-digit levels they did after the 1982 bear market. Those who avoided buying stocks last year while waiting for even lower ratios missed out on big gains.Yet stocks today trade at cheaper valuations than just about any time in the last decade. Dividends paid on solid common stocks are well above yields on U.S. Treasury securities.
Some continue to predict the next 10 years will resemble the last. Two bear markets and a decade-long string of losses have convinced them that this is now the way equity markets work. Those waiting for another big decline in stock prices seem to ignore the differences between now and 1982.
Back then inflation was very high and both short and long-term interest rates had soared. Today interest rates and inflation are very low and the world economy is very different. The bears also ignore reversion to the mean, which could suggest that the next 10 years will see above-average stock returns that will bring long-term market averages back up to their mean.