Dow 18,000: Who Knew?

Dark Clouds, No Rain This year began ominously. The S&P 500 dropped 5% in January (so much for the January effect), after declining during four of the previous six months. Commodity prices were eroding, with the IMF Index of Primary Commodity Prices reaching its lowest level in more than a decade, below its late-2008 trough. Given how accurately plunging commodity prices had presaged that year's stock market, "We're due" for a recession, said University of Virginia professor Alan Beckenstein during his annual economic forecast. "If there is a recession, this is how it will happen," wrote Neil Irwin in The New York Times. "Is the economy headed for another recession?," asked U.S. News & World Report. "With recession lights amber, brittle markets vulnerable to all shocks," headlined Reuters.

Six months later, commodity prices have recovered, the developed economies are chugging along, and stocks are up. The next downturn will arrive--because the next downturn will always arrive--but the sell-off will occur at a different time, and for different reasons, than the forecasters had expected.

Many Species of Bear It all seems so obvious in hindsight. How could we not have seen the impending stock-market crash in 2008, seven years into an economic expansion, when demand was waning? But the task is anything but simple. This winter, the U.S. was once again seven years into an economic expansion, with demand for commodities waning. The same apparent picture … but a very different result.

As I have written before, the problem with calling bear markets--or recessions, for that matter--is that each one is different. The 1987 crash came out of nowhere. It not only wasn't because of a slowing economy, it did not signal problems to come. It just happened. In 1990, geopolitical problems (Iraq's invasion of Kuwait, spiking oil prices) were the trigger. The markets were down almost before one knew it. The technology sell-off from 2000 to 2002 was an another animal altogether. It was predictable in a sense, as speculation was rampant, but one could have anticipated it five years earlier. Many did.

The Hated Bull Market(s) Happy families, in contrast, are all alike. The current upturn, The Wall Street Journal recently told us, is "the most hated bull market" on record. Previously, CNBC, The Financial Times, Forbes, Fox Business News, Bloomberg, CNN, and CBS Marketwatch had used the same term of "most hated," dating back several years. Such are bull markets. Alan Greenspan, famously, had no use for the "irrational exuberance" of the 1990s. Before that, in the late 1980s, much of the so-called smart money dismissed the post-1987 rebound as a sucker's bet.

It's tempting to regard the current skepticism about the stock market as a positive sign, indicating that the rally will continue, but that subject, too, is not so simple. Bull markets don't typically end when the naysayers capitulate, as is the common lore. Disbelievers are always around.

(Sometimes that is because they are correct in their analysis and have the fortitude to withstand bad relative performance when they are early. Other times, it is because they become caught in a "bear trap." They were short on stocks when the market gained, and now can never catch the competition by joining them. Those bears must continue to sit on the sidelines, hoping for a market crash to reverse their relative fortunes.)

For example, Jeremy Grantham stumped against technology stocks through the late 1990s into the New Millennium, right up until their demise. He was not alone. Most hedge funds were also negative on the sector when it peaked, as were the more value-oriented of mutual fund managers. (So, too, were Morningstar's stock analysts--which earned them some choice comments from the readership.) It would have been difficult indeed to call that market's top by seeking the sign of capitulation.

When Contrarianism Fails Contrarianism is a fine investment principle. It makes sense when putting new cash to work, by sifting through the sectors that have had poor relative performance during the previous few years, or which are suffering heavy redemptions from mutual fund investors. (Of course, those two items often come together, as most fund investors follow trends rather than buck them.) It's also a useful exercise to look hard at a portfolio's biggest winners. Would one truly hold those securities at today's prices?

But … I don't know how to make contrarianism work for market-timing. I don't know how to use either investor sentiment or the market's performance numbers to yield a useful signal for investing. The math of stock investing appears to be exceedingly basic. Stocks rise most of the time; there doesn't seem to be any reliable method for determining when those exceptions will occur; thus, the optimal approach is to hold the same percentage of stocks no matter what the current conditions or the current headlines.

That, unfortunately, is not a fertile subject for an investment columnist. Better that the advice would need to be changed from year to year or season to season. Well, such is the nature of the beast. As Jason Zweig likes to say, good investment writing means publishing the same column about investing, over and over again, while finding a way to make that article feel new. There are worse callings.

Hey, It Works Tuesday's column, on the topic of mutual fund managers owning shares in the funds that they run, was not popular. Several Morningstar colleagues agreed with most readers that, yes, managers should do so, and the reason is obvious: Shareholders' interests should be aligned with the interests of those who serve them.

It's not so obvious to me, but we'll continue that conversation another time. What needs to be said now is that the evidence supporting the benefits of manager ownership are stronger than the column suggested. My main focus was about the underlying logic for the practice, not its results. Thus, I quickly glided through that section, stating that Jack Bogle was a firm believer, and that American Funds had demonstrated some advantages in a study from two years back.

What I should have mentioned was that Morningstar's Russ Kinnel showed more than just some advantages, in an article published last year. He looked up manager ownership levels for mutual funds as of December 2009, tracked their returns during the next five years, and found a strong relationship between manager ownership and subsequent performances. As a general rule, the more money that a manager had invested in his funds entering the time period, the likelier that fund was to survive the next five years without being merged or liquidated, and the higher its returns if it did survive.

I might still question the commonly used logic, but I do not dispute the results. Fund manager ownership is a good thing.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.