What a Long Strange Trip It's Been. . .
Where We Have Been

by John Hanahan

The 1990s were the kind of bull market every investor dreams about. Even with the markets well off their all time highs, the Dow and Nasdaq are each up over 228 percent and the S&P 500 up over 172 percent. It is easy to see why investing in stocks over long periods of time pays off even in the midst of a bear market.

The 90s were about asset allocation (a mix of stocks, bonds and cash) since studies show that 90 percent of your success as an investor is a direct result of this decision. By maintaining an asset allocation over time, investors can reduce risk and increase chances of success.

This strategy worked great during the first half of the 90s, however, a funny thing happened along the way. Around the '95-'96 time frame investors got tired of rebalancing their portfolios only to see their stock allocation continue to appreciate. They thought to themselves, "If I would have only left my stock allocation alone, I would have made even more money." Since the markets had no down years for most of the 90s, investors became complacent.

As the tech bubble hit its stride in the late 90s and early 2000, investors became even more complacent by not only forgetting to rebalance their asset allocation but becoming obsessed with technology stocks. They made the fatal mistake of over-weighting this dangerous sector and not recognizing the risks only to be punished over the past two and a half years.

Where We Are Now

Even after the market's dramatic rally from the Oct. 9 lows, we are still down--almost 74 percent on the Nasdaq, over 42 percent on the S&P 500 and almost 29 percent on the Dow from their all time highs.

According to calculations from First Call, the S&P 500 peaked in March of 2000 at 70 percent overvalued. Contrast that with the peak selling of investors cashing in their mutual funds in July 2002 with the markets being undervalued by 40 percent.

What does this tell us? It tells us that most investors buy high and sell low! Why? Investors like following the herd. They like to buy stocks when everything seems great and sell stocks when the sky seems to be falling. Why do they do this? Because they operate out of fear and greed.

According to AMG Data Services, which tracks the flow of funds into and out of different categories of mutual funds (e.g.: equity, fixed income and international), for the third quarter, a record $51.1 billion was drawn out of equity funds, both U.S. domestic and international, and a record $43.5 billion was deposited into bond funds.

What happened in October? Equities rallied and bonds fell. In essence, millions of investors, I'm assuming with some degree of intelligence, sold low and bought high. Isn't that the opposite of what investors are supposed to do?

Where We Are Going

Since we are in the longest bear market since 1938, investors are losing patience with stocks. Can you blame them? Why invest in stocks now when they may be lower in two months? It's easy to buy what everyone else is buying and it's very uncomfortable to be selling what everyone else wants.

One of the best statements of contrarian investing is in the Berkshire Hathaway 2000 Annual Report: "I will tell you now that we have embraced the 21st century by entering such cutting-edge industries as brick, carpet, insulation and paint. Try to control your excitement." Can you imagine bragging at a cocktail party in 1999 about your Old Economy stocks? Warren Buffett can, and that's why he's a billionaire.

With continued worries about terrorism and a pending war with Iraq, an economy that is not growing as fast as people want and widespread pessimism among business leaders, it's easy to shy away from stocks. But the Fed has cut interest rates 11 times and we have the lowest interest rates in 40 years with low inflation. The consumer continues to spend at a brisk pace and we have the lowest stock market valuations since 1998 with many solid companies trading at or near 52 week lows.

Unless you think the United States is headed towards a second rate country, you will be very sorry if you sell stocks now and look back on this time as a golden opportunity.