No guarantees aggressive rally will continue into 2014

MarketWatchDecember 4, 2013 

The smell in the air this holiday season is not turkey and apple pie. It’s aggression.

With the stock market nearing the end of a year that is much better than was expected — a year that has the major indexes sitting either at record highs or at their loftiest levels in years — even the worrywarts seem to have come out of the woodwork, and the expectations for 2014 seem to come in just two sizes, big and bigger.

In short, investors appear to be excited at just the wrong time.

Wall Street still has enough concerns so that the market can continue to climb the proverbial wall of worry for a while, potentially several years.

But one of the biggest problems investors have when it comes to setting their expectations is known as “recency bias,” the idea that what has happened recently is likely to happen again.

Thus, investors who look at 2013 as a great year for the market — and it has been — are expecting the same kind of thing for 2014.

For proof, consider how at the recent American Association of Individual Investors biannual conference in Florida, there was a panel discussion that had a great long-term investor with a top newsletter track record over the last two decades — and a gain of more than 20 percent this year — at one end of the dais, and a relatively new, young editor whose letter portfolio is up over 60 percent this year at the other.

When the session ended, there was a huge crowd gathered at one end of the podium, and it wasn’t the steady veteran who had drawn the crowd.

Expecting the market to continue rising is not a mistake, expecting things to be better than they have been is.

Sam Stovall, chief equity strategist for S&P Capital IQ noted this week on my radio show (www.moneylifeshow.com) that history indicates that “Good years tend to follow great years. … Whenever we had the S&P up by more than 20 percent in one year, it rose an average of 10 percent in the following year versus an average of about 8.5 percent in all years … and instead of rising 70 percent of the time, it was up 80 percent of the time. You end up having momentum as you carry into the new year that at least lasts long enough that you end up with a positive performance in that following year.”

In short, that means that the odds are good that the market can continue its climb in 2014, but not good that it will continue at its 2013 pace.

Unfortunately, that’s not the bet that investors are making right now.

“They expect the same thing to happen next year, but that’s usually not the case,” said Stovall. “Looking also at those good years that follow great years, believe me they do not escape volatility. Of all of those years since World War II, they experienced declines of anywhere from 6 percent up to 20 percent and more. The good thing is if it happens early enough — if the slippage, the decline, the digestion of the prior year’s events happens early enough in the market’s second year — then the market has a chance to recover and post a positive performance rather than remaining in the red.”

The problem for investors is that they are repeating one of the most common errors of the past, getting excited by recent returns, buying in at or near market highs.

If the market “digests” those gains, per Stovall, with a decline of more than 15 percent, studies show that will be enough to trigger a panicky sell-off, particularly among the late-comers to the party, the ones who had to see the big 2013 rally to finally be convinced that it was safe to get back into the water.

They sell on the downside volatility, and lock in losses before there is the rebound to the “good year.” Even then, they come away disappointed because they experienced a) the volatility and b) a year that failed to live up to its predecessor.

There’s an old saying that the most dangerous words in investing are “This time it’s different.”

That may be true, but it’s almost equally dangerous to say “This time it’s the same.”

In the past few weeks, I have seen experts compare the current market to 1986, ’87, ’96, ’97, 2003, 2005 and ’09, either as being different, or the same. Those years, coincidentally, either were very strong or better than expected, and the follow-up was either continuing the trend or “good instead of great.”

It’s not hard to see potential catalysts that could throw the market past the correction stage and into a real setback, but there is no clear clue as to when those dangers actually will show up.

But those danger signs have been on the horizon for a long time now. They should not have been ignored in the past — when investors were nervous more because of past performance than imminent danger — and they should not be ignored now, just because the indexes are up so sharply. Think of like this: Congress could mess up the market with everyone digging in their heels on key issues, or it could leave it alone by smoothing things over until 2015 … but you might not want to wager on either side of that potential outcome.

In the end, there’s not enough rampant optimism to suggest that the end of the rally is near, but there’s enough to know that investors who are turning up the heat now — and ramping up expectations to go with it — are positioning themselves to get burned by getting to the end of a great year and expecting that it means there’s another one coming.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com or at P.O. Box 70, Cohasset, MA 02025-0070.

The News Tribune is pleased to provide this opportunity to share information, experiences and observations about what's in the news. Some of the comments may be reprinted elsewhere in the site or in the newspaper. We encourage lively, open debate on the issues of the day, and ask that you refrain from profanity, hate speech, personal comments and remarks that are off point. Thank you for taking the time to offer your thoughts.

Commenting FAQs | Terms of Service