Why You Shouldn’t Break Up With a Secular Bull Market, Even If Everyone Is Telling You To

On this episode of The Long View, Barry Ritholtz, co-founder, chairman, and chief investment officer of Ritholtz Wealth Management and creator and host of the podcast Masters in Business, breaks down bad investor behavior, what we know and don’t know about the markets, and how investors should be investing from his latest book, How Not to Invest: The Ideas, Numbers, and Behaviors That Destroy Wealth—and How to Avoid Them.

Here are a few highlights from Ritholtz‘s conversation with Morningstar’s Christine Benz and Amy Arnott.

It’s Not the Market Cycle—It’s Your Faith In It

Amy Arnott: Despite your underlying principle that “nobody knows anything,” you also have a section in the book that discusses secular market cycles, and it sounds like you think they are worth paying attention to. Can you unpack that a bit? How do investors know when we’re in a secular market cycle?

Barry Ritholtz: Sure. So, “nobody knows anything” refers to the expert forecasts. I love the Paul Graham quote, “All experts are experts in the way the world used to be.” And when you’re making a forecast, you are kind of predicting that the future will be like the past. And as we’ve seen, that is not always the case and is often not the case.

What I like to do when I look at market cycles is to think about not when this is going to start or when this is going to end, but what are the underlying drivers of what takes place in the economy, the market, and society. So, the concept of these longer-term secular markets—and I didn’t invent this term; this has been around for a century. There are a lot of books from back in the day, they talk a little bit about the difference between cyclical and secular. I’ve kind of personally expanded it to include society and the economy.

But let me give you a couple of my favorite examples. So, World War II ends, 1946, 10 million to 15 million GIs returned home. They get the GI bill, which is the equivalent, inflation-adjusted, of a few thousand dollars a month. They get to pay for college. And after five years of being on a wartime footing, there’s all this pent-up consumer demand, and we shift from military spending back to consumer spending. At the same time, we see the buildout of the interstate highway system. We see the rise of automobile culture. We see the rise of suburbia. Civilian aviation begins to take off. The electronics industry begins to take off, which is the predecessor to semiconductors. And so, you start this postwar period of this boom where markets go up and down, recessions come and go, but the overall trend is upward, and it’s a huge, huge move higher.

Generally speaking, a couple of things accompany a secular market. We tend to see consumer sentiment get better and better over the course of that period. More people are getting hired, unemployment rates come down, and wages go up. Just generally a positive economic boom.

And the way that shows up in the market is kind of fascinating and has a lot to do with valuation questions later. But historically, these secular bear markets start out with markets relatively cheap compared with average prices in equities and compared with what the bond market is doing, and they tend to end relatively expensive. And when they end, it leads to a secular bear market. And so, by the way, the secular bull market starts with a low PE and finishes with a higher PE. While most people focus on earnings—in fact, think about how much of our time and energy is focused on earnings—the biggest driver of the bull market is not so much earnings as it is earnings multiples.

So, my favorite example, 1982, the bull market begins and ends in 2000. We start with a PE of around 7 on the S&P and end with a PE of around 32. And that period of time was marked by the increased willingness of investors to pay more and more for that same dollar of earnings. And 75% of that gain from ‘82 to 2000 wasn’t earnings improvement; it was multiple expansion.

Now, look at the flip side of that. The market kind of peaked 20 years after the end of World War II in 1966. The Dow kissed a thousand, didn’t get over a thousand on a permanent basis until 1982. And the whole time, the earnings multiple compressed. And that’s the psychology of investors willing to spend less for each dollar of earnings as the bear market takes its toll.

Bull markets tend to go longer and further than anyone expects, and they tend to be longer than bear markets. But these are just rough outlines and squishy things. I hate the “plus 20% is a bull and minus 20% is a bear.” Those numbers are just useless for investors. There’s no data that backs them up. It’s just a rule of thumb. We have 10 fingers and 10 toes. Someone in the media made that up. I have yet to see a quantitative study that says, “If you’re in the market when we’re plus 20%, you’ll do better than when we’re in the market when we’re minus 20%.” Just look at Q1 of 2020. You were minus 19% one day, and the next day you were minus 27%. What are you supposed to do with that? Sell. Three days later, the market bottomed and took off on a 69% rally.

So, I always look at these rules of thumb and say, “What advice, what guidance do they provide for investors?” The 20% bull and bear market number is meaningless and actually destructive to investors. There’s been a ton of times where the market falls 20% and kind of finds a bottom a month or two later, and if you sold in that 20%, not only did you incur giant taxes from the previous gain, then there is a question of how do you buy back in when everybody is panic selling, and the answer is most people can’t. They lack the discipline. Again, we’re social primates. We want to do what the crowd does. We don’t want to be ostracized. We don’t want to be tossed out of the group, and it is really hard to fight what the crowd is doing. That’s why noticing the secular bull market hopefully prevents your emotions from leading you to tapping out just because the market is down 15%, 20%.

Why Timing the Market With Valuations Can Leave Returns on the Table

Christine Benz: I wanted to ask about the role of valuations. You write in the book that valuation matters less than we tend to believe. And even when it does matter, we tend to make the wrong decisions related to valuation. Should investors pay attention to valuations at all in your view?

Ritholtz: You can pay attention to valuation, but you probably shouldn’t act on it most of the time. By the way, people hate these shades of gray answers. They want a black and white, up or down answer. And the world is much more complicated than that.

So, let’s take ‘82 to 2000. Perfect example. People hated stocks. Remember, “The Death of Equities” a few years before on the cover of BusinessWeek. You were getting 10% on your bonds, not 10% real because inflation was so high in the ’70s, but stocks over that ’66 to ’82 period lost 75% of their value in inflation-adjusted terms. And so, stocks were cheap in the mid-1970s. They got cheaper in the late ’70s. They got even cheaper in the early ’80s. If you’re a long-term investor and you were buying through that terrible period, and very few people were, you killed it over the next 20 years. And the same thing happened in the 2000s, from 2000 to 2013. If you were a buyer, you crushed it in the 2000s, even though you had to live through the global financial crisis, you crushed it in the 2010s.

So, what does valuation have mom-and-pop investors pay attention to? For my whole career, I’ve been hearing how expensive the market is on a Shiller CAPE basis, the cyclically adjusted PE ratio. If you got out of equities because the CAPE was high, you left untold millions on the table. If you look at stocks and say, “Hey, you know, the long-term average PE of the S&P is 15, and we’re at 18 or 20, so I’m going to get out,” it’s just an incredible amount of missed opportunity. Valuation is not a timing signal. Valuation is a reveal of where we are in a market cycle.

And I don’t know if that’s all that actionable. If you only buy stocks when they’re cheap, you get these narrow windows every decade or so. And my colleague Ben Carlson—and I write about this in the book—did an analysis that said, “What happens if you only bought stocks when they’re at their lows?” It turns out dollar-cost averages do much better because of the advantage of compounding, whereas only buying stocks when they’re cheap, only buying stocks when they’re close to their lows, or both, underperforms simply dollar-cost averaging into a broad index.