5. The Cyclic Nature of Markets
We have had a lot of economic crashes in our history of economics. Crashes happen because prices have steadily been diverging from the real value, and, suddenly the market corrects itself (Malkiel, 104). In this post we will list a few historical crashes, some ups and downs of Bitcoin, argue why it’s unlikely that we can time it, and see why the crypto currency industry likely will see more crashes.
There is no basis either in logic or experience for assuming that any typical or average investor can anticipate the market movements more successfully than the general public, of which he is himself a part — Graham
Historic bubbles
There has been bubbles, or market corrections, in the past. They appear partly because of the “madness of the crowds”, because humans are easily influenced by our surroundings, and because we believe we are better than average (Graham, p. 39, 437)(Malkiel, p. 233). Combined these variables makes us overestimate the upside and take huge gambles on market environments that in hindsight have been ridiculous. All books talk about historic market bubbles and impossible security valuations that ruled the market. Some ridiculousness that the world, for a short time, agreed upon to be fair pricing is for example..
Japanese Housing Market
In 1990 the japanese housing market was valued to astronomical levels. It had increased by more than 75 time since 1955 and to an estimated $20 trillion, more than 20 percent of the entire worlds wealth and about double wealth of the sum of all stock markets. American is twenty five times bigger than Japan in terms pf physical acreage, and yet japans property in 1990 was appraised to be worth five times as much as all American property. At the height in the end of the 1980s, the Nikkei index was at 40,000. By mid august 1992, it was down to 14.309, having lost 63%.(Malkiel, 76)
US Dot Com Bubble
Cisco was valued at a PE of above 100. Even if it would grow with 15% per year for 10 years, it would still trade at above average price to earnings. And if it continued to grow with 15% per year for 25 years, while the market grew with 5% per year, it would overtake the entire US Economy in value. Clearly, the prices of these securities were vastly overvalued. And the market corrected itself. (Malkiel, p. 81). $7.4 trillion was lost between March 2000 and October 2002, 50.2% of the US stock market value. The hottest companies, AOL, Cisco, Lucent, Qualcomm, Amazon, lost far more. Up to 99%, (Graham, p. 14) (Malkiel, p. 83)
And there exists many more. Some of the more famous ones are The Tulip Craze, The South Sea Bubble, The Great Depression, The Japanese Housing Market Bubble, The US Dot Com Bubble and The US Real Estate Bubble.
One important thing to notice here is that the bubbles exist because the market acts upon it. You, as an average investor will also join the crowd and these bubbles. Even if you can manage it once, you will on average be very unlikely to repeat it continuously. It is very hard to make any active choice of staying out of these market environments. And the downside, i.e. the risk you agree upon when you are making active purchasing decisions in a bubble, is huge. The best you can do is not to have to make any active decisions by having an investment plan that you stick through, in both bull and bear markets.
Bitcoin Market Corrections
As there is currently very limited data of cryptocurrency we look instead at Bitcoin. Since it’s birth it has corrected itself many times with a price drop of more than 30% not less than 12 times since January 2012 to February 2018.
Will Bitcoin drop again?
According to Malkiel a market crash is nothing but a market correction (Malkiel, p. 104). Will the market correct itself again? Considering it’s history it seems to be without question. It moves quicker than normal markets, is more volatile, the technology new and exciting. In addition we have no way of measuring the actual worth of the securities. In the stock market we can say that “A price-to-earnings-ratio of around 20 is normal”. Here... we simply do not know. We are unlikely spot on, and since market always sharply correct themselves downwards, we assuming that it will not dip again seems to be pure folly.
As Bitcoin at the time of writing makes up ~40% of the total crypto currency market, the chances of the correction also happening in the crypto market seems plausible.
The difficulty of timing the market
But if we know it will happen, would we not be able to predict these corrections and profit on them?
As mentioned earlier, one thing that defines an investment is to limit loss of principal. That is, to make sure that you do not lose the capital that you put in. This could very easily happen if you happen to enter the market at the wrong time. For example, investing $10k around the height of the market in 1929 would have netted you $7,223 the year 1939, ten years later. A loss of $2,773. (Graham, p. 131). And as seen below, investing at the peak of crypto at the end of 2013 would have made you void of gains until January 2017.
How easy is it then to enter the market at the right time?
In January 1973, the New York Times featured an interview with one of the nations top financial forecasters who urged investors to buy without hesitation: “It’s very rare that you can be as unqualifiedly bullish as you can now”. That forecaster was named Alan Greenspan, and it’s very rare that anyone has been so unqualifiedly wrong as the future FED chairman was that day. 1973 and 1974 turned out to be the worst years for economic growth and the stock market since the great depression. (Graham, p. 180)
The very same future FED chairman had speech in December 1996 named “Irrational Exuberance” where he predicted negative long-run equity returns. From that date to December 2013, the stock market averaged an annualized 7.5% return through two bear markets. (Malkiel, p.285)
The conclusion is that it is only retrospect that we know market prices in 1999 and 2000 were “too high”. No one can help you time the market so that you avoid being invested when the market reaches a temporary top. (Malkiel, p. 285)
This conclusion, as most of the conclusions presented in these books, is supported by thorough data.
A study by two finance professors at duke university found that if you had followed the recommendations of the best 10% of all market-timing newsletters, you would have earned a 12.6% annualized return from 91 through 95. But if you had ignored them and kept your money in a stock index fund, you would have earned 16.4%. (Graham, p.180)
We wish to strike home the point once more by reiterating the opening statement.
There is no basis either in logic or experience for assuming that any typical or average investor can anticipate the market movements more successfully than the general public, of which he is himself a part. (Graham, p.190)
The importance of being in the market at the right time
It is very hard to time the market. In addition, it is a punishing game to be out when you should be in. Professor Negat Seybun found that 95% of the significant market gains over a thirty year period came on 90 of the roughly 7500 trading days. If you happened to miss those 90 days, just over 1 percent of the total, 95% of the generous long-run stock-market returns of the period would have been wiped out.
Studying a longer period, Laszlo Birinyi, in his book Master Trader, has calculated that a buy and hold investor would have seen one dollar invested in the Dow jones Industrial Average in 1900 grow to $290 by the start of 2013. Had that investor missed the best five days each year, however, that dollar investment would have been worth less than a penny in 2013. That is a 29000% vs -90% gain (Malkiel, p.157).
Summary
It is clear that we have to be in the market, and we can’t know when to enter it. Entering at a peak might bring years of strained returns. Luckily, there is a solution. Next up we will discuss how Dollar Cost Averaging can be used in great effect to make stable returns over time in bull and bear markets alike.
