The Prescience of Stock Markets: Implications for Investors: Vaishnava Stock Market, Investing, Finance Series

Chand Prasad, Ph.D.

key words: ISKCON, Srila Prabhupada 

Introduction

The material world is inherently unstable, continuously plagued by upheavals and catastrophe.  The late Barton Biggs, a preeminent global investment strategist, examined the behavior of financial markets in times of crisis.  His book titled, Wealth, War and Wisdom focused on the great battles of the 20th century, particularly those fought during World War II.  He found strong evidence that financial markets show wisdom in ways individuals alone simply cannot.  Many market indices appeared to predict key turning points in the war, even when changes in  military fortunes were not at all clear to the military leaders who themselves were completely immersed in strategizing and executing these pivotal battles.  “That market prescience is all the more impressive given pervasive secrecy about military matters and the rudimentary communications equipment available at the time.”

World War II Examples

It could be argued that the London stock market predicted the United States would come to Britain’s aid before it was too late:   “The London stock market deduced in the early summer of 1940, even before the Battle of Britain at a time when the world and even many English despaired, that Britain would not be conquered. Stocks made a bottom for the ages in early June although it wasn’t evident until October that there would be no German invasion in 1940 and until Pearl Harbor 18 months later, that Britain would prevail.  It almost seems that throughout 1941 the London stock market intuitively sensed and responded to the growing and deepening alliance between Britain and the United States. It was more confident of America’s entry into the war than even Churchill. Certainly there was no good war news to celebrate because Britain was suffering defeat after defeat.”

Before anyone else, the German stock market recognized that the war had turned decisively against Hitler: “Similarly, the German stock market, even though imprisoned in the grip of a police state, somehow understood in October of 1941 that the crest of German conquest had been reached. It was an incredible insight. At the time, the German army appeared invincible. It had never lost a battle; it had never been forced to withdraw. There was no sign as yet that the triumphant offensive into the Soviet Union was failing. In fact, in early December a German patrol actually had a fleeting glimpse of the spires of Moscow, and at the time Germany had domain over more of Europe than the Holy Roman Empire. No one else understood this was the tipping point.”

The above-mentioned examples are just 2 of many, demonstrating that the combined knowledge of all participants buying and selling financial assets creates an accurate bellwether.  

Coronavirus

Although Barton Biggs died well before the covid pandemic, the stock market’s ability to see beyond the valley lives on.  In early 2020, major indices fell sharply with the onslaught of the coronavirus.  The stock market bottomed on March 23, 2020 before staging an explosive, unbelievably powerful upswing.  During much of the spring and summer, many experts argued the market bounce was only temporary, to be followed by a massive collapse, pummeling equities below the March lows.  However, this dismal prediction never materialized, as the market continued to climb.  When the S&P 500 surpassed its pre-coronavirus level and successively hit new highs, individuals and professional money managers expressed disbelief and confusion—the economy was in the midst of a severe contraction, and yet the stock market not only recovered but also made new highs.  

Financial firms and individuals who sold at the wrong time complained uselessly that equities had become irrationally unhinged from the economic realities of a pandemic, millions unemployed and businesses shuttered.  In reality, stocks predicted the emergence and widespread distribution of vaccines even before their efficacy had been verified.  The market looked ahead and sensed the turning point, further underscoring the point that the market knows more than individual experts. 

Perils of Market Timing and Stock Picking

Since the market is smarter than any individual (however brilliant he may be) Barton Biggs recommends that investors reject market timing and refuse to follow strategies based on security selection, i.e. selecting individual stocks or stock picking.

Stocks are often characterized (incorrectly) as illusory paper assets that are inferior to hard assets such as real estate, and precious metals and other commodities. Far from being illusory, stock purchases provide partial ownership of a corporation—you actually own a piece of a business. Although stocks provide us with a share of the profits generated by publicly traded companies in the economy, they also expose an investor to considerable risk and volatility because that is simply the nature of business.

Through diversification, one can avoid unnecessary risks. When individuals invest in a total stock market index, they have achieved a high degree of diversification because they own a piece of every publicly traded company.  Of course it is not necessary for an individual to make separate purchases of thousands of different stocks—imagine the exorbitant commission costs. Indexed portfolios that contain all publicly traded stocks can be purchased from reputable mutual fund companies (e.g. Vanguard) for as little as 0.07 percent in annual fees, which is much less than an investor would pay to buy and hold a large list of thousands of stocks.  By buying and holding the entire market through a passively managed or indexed fund, you guarantee that you will own all of the winning companies and thus get all of the market return.

One may object to index funds because you will also own all of the losing companies in the economy. This objection is essentially groundless. The worst outcome for any one losing stock is that it would lose 100 percent of its purchase value (in which case it would drop out of the index). In contrast, the winners can easily make 1,000 percent, and exceptionally 10,000 percent, within a decade or two. If an investor misses just one or two of these winning stocks, his entire portfolio will suffer.

The total market index is dynamic. Companies compete intensely with each other. Firms that are stronger and more efficient drive the weaker firms out of business while also driving them out of the total market index. New companies are born, and if they are successful, then they enter the total market index and replace the dying companies. The index does not remain static. The total market index is analogous to a living species in which firms that are stronger replace those that are weaker. The index is self-cleansing.

An investor need not attempt to predict which firms will be winners or losers because that determination will be made by the dynamics of competitive interactions which forces weaker firms out of the total market index. In the long run, the total stock market index is driven higher along a strong upward trend because of survival of the fittest—the maximum loss for the weaker firms is that their stock prices will drop to zero, while in contrast the upside potential of the winners is enormous. A combination of limited downside and almost unlimited upside potential means that on average, the total stock market index trends higher.

By now it should be clear to the reader that this article defines stock investment as long term ownership of broadly diversified stock indexes that charge minimal fees. We reject the all too common, expensive, and inferior, practice of selecting and trading individual stocks.  An investor may attempt to achieve a rate of return that exceeds the total stock market index by selecting individual stocks. In this form of “active management”, one devotes a great deal of time and resources to evaluate vast numbers of individual companies, with the goal of predicting which firms will “beat the market”.

Although a stock index contains both winners and losers, active management strives to create a portfolio that only includes the former.  The resulting portfolio is relatively concentrated, with fewer holdings than the index.  The active manager sacrifices diversification in the futile hope of outperforming the market.  The empirical evidence shows that well-connected and highly informed financial professionals have little success at predicting winners, despite the fact that they employ the brightest and best analysts. With the benefit of hindsight, it is not difficult to devise stock picking strategies that would have worked well in the past.  Unfortunately, strategies that delivered impressive results within a given historical timeframe tend to underperform in the future. Predictions and forecasts are inherently risky—90 percent of investors and fund managers cannot pick stocks.

Stock market participants typically attempt to increase their profits and outperform indexes by anticipating when the market is about to move higher and when it is due for a downturn.  In contrast to long term investors that remain steadfastly invested as the market exhibits oftentimes extreme gyrations, market timers hope to hold stocks when they are going up and sell them before they go down (buy low, sell high).  The empirical evidence reveals that this hope is an illusion.  Specifically, market timing is even worse than stock picking.  Rather than following the advice of market-timing newsletters and strategists that seek to divine the market’s moves through analyses of economic, political, and investment data, in almost all cases investors would have been better off flipping coins as a means of deciding when to buy and when to sell.

Missing the Best Days  

When traders sell because they are afraid the market is about to fall, they more often lose out on capturing significant advances.  After selling out, “investors” typically sit on the sidelines waiting to confirm that the market has actually bottomed before getting back in.  By the time individuals decide it is safe to move their money back in to stocks, they have already missed some of the best days the market has to offer—returns tend to occur disproportionately early in a recovery. 

Missing out on just a few of the best up days is destructive of wealth accumulation.  The best days often occur after the worst downdrafts when individuals tend to fearfully sell out and exit the stock market in despair.  As shown in the following chart, $10,000 invested in the S&P 500 grew to $41,100 from 12/31/2005–12/31/2020, if the portfolio remained fully invested over the entire time period.  That is to say, a straightforward, non-speculative buy-and-hold approach resulted in a 9.88% annualized total return, including reinvestment of dividends. 

$10,000 invested in the S&P 500

(12/31/2005–12/31/2020



However, missing just the best 10 days is devastating to investment results, as the annualized return is only 4.31% from 12/31/2005–12/31/2020.  An individual would have been much better off if he or she had simply ignored the volatility that is inherent to stocks and stayed fully invested all throughout.  Wild fluctuations induce fear.  It is not uncommon for risk-averse persons to miss the 30 best days, in which case they lose money: a $10,000 investment falls to $7,526.   

How could anyone have lost money, given that the S&P 500 grew 9.88% per year from 12/31/2005–12/31/2020?  The answer is simple.  Stocks do not climb in a straight line; whenever the market collapses, it induces fear, panic, and irrational behavior.   The failure to remain disciplined causes “investors” to miss the best up days the market has to offer, which incidentally, often occur after the worst down days.  The old adage holds true: far more money has been lost by investors trying to anticipate downturns, than lost in the downturns themselves.   

Further Reading

Enduring Value of Stock Market Indexes and Land:Vaishnava Stock Market, Investing, Finance Series

Srila Prabhupada on the Stock Market: Vaishnava Stock Market, Investing, Finance Series

Enlightened Investing: Vaishnava Stock Market, Investing, Finance Series

Austerity and Financial Independence: Vaishnava Stock Market, Investing, Finance Series

Saving is Superior to Speculation: Vaishnava Stock Market, Investing, Finance Series

A Place of Worship: Vaishnava Stock Market, Investing, Finance Series