There is near unanimous consensus amongst all in the investment community that stocks are currently very cheap. Having said that, there is little agreement on whether or not now is the time to get back into the market; sure, stocks are cheap, but will they get cheaper still? And that’s the 64 million dollar question: when is the right time to position ourselves for a recovery?
There are solid arguments on both sides of the debate, but for the pragmatic investor able to afford a longer term view it doesn’t really matter too much who is right. Indeed, once you consider all the possibilities, buying now appears to be the most reasonable option.
Broadly speaking there are three possible scenarios:
- The market has already bottomed and will continue to recover
- The market will more or less track sideways for a while before experiencing a slow recovery
- The market will drop lower and carve out new lows
If the first scenario turns out to be true, then we have already missed the bottom, but should still buy up as much as we can now to gain exposure to future gains. Alternatively, we have the possibility that the market essentially moves sideways for a prolonged period before finally experiencing a steady recovery. If this turns out to be the case then it means that now is still a good time to invest. While a side trending market wont allow for any major capital gains, dividend income will provide attractive, and highly tax efficient, returns in the meantime. Given that dividend yields are well above the norm, investors won’t find better income returns anywhere else.
Finally, if the market reverses direction and drops below the March Low, we would of course be better off avoiding making any investments for the time being. The question then becomes how low will things get before the actual bottom is reached?
Let us take a worst case scenario, and assume that the market behaves just like it did in the great depression. The chart below shows how the Dow Jones performed after hitting its high in 1929. This is overlaid with how the ASX 200 has performed since the all time high in November 2007.
click to enlarge
If hypothetically the market continues to follow this trajectory, then we have a lot further to fall, with the ASX 200 dropping all the way back to 1200 over the next year or so. That’s a drop of over 70% from present levels!
To illustrate this, let’s see how the Dow performed after the first 440 days of the crash.
click to enlarge
Needless to say, if the current market does continue to emulate the Dow, the next 300 odd days is going to be very rough. But let’s say that you do start buying stocks now and continue to buy at regular intervals as the market continues to fall – is it really a disaster?
For the sake of example, let us assume that an investor purchases $10,000 now and contributes an extra $1000 every 3 months. If the market experiences the same performance as the Dow did after the first 440 days, the portfolio is still looking very attractive after 5 years. (see below chart)
click to enlarge
Although it took 400 days for the portfolio to move into profit, after 5 years the investor has generated a 45.8% return (The total invested amounted of $24k has grown to $35k). Of course, it would be even better had you picked the exact low, but the point is that even if you jumped in almost a year prior to the bottom, your long term returns are nonetheless very attractive.
When you consider all of this, long term investors are best off just forgetting about timing the bottom and instead just take the plunge. Should the market continue to recover, or even move sideways, this is undisputedly the best option. But even if it turns out that a purchase today is premature, so long as you expect an eventual recovery, even if things play out exactly as they did following the great depression, your investment will still generate a great return.
The worst case scenario, especially for investors who have suffered most from the recent downturn, is that they procrastinate so much that they miss out on the most significant part of the recovery. Remember, while there is a risk that the market could still see new lows, it is less of a risk than staying on the sidelines and missing out on the substantial gains that are usually observed after a crash.
Make the markets work for you