Stephen is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It’s hard not to follow the crowd, especially when it seems like every one in the crowd is profiting while you sit on the sidelines. As a buy and hold investor I consciously avoid opportunities because I’m uncertain of the time-horizon of the investment. I have little faith in my ability to anticipate market or macroeconomic trends, nor do I have the desire to dedicate my time and energy to even attempt such a feat. In hindsight these investments can turn out to be very profitable, but only if you are on the right side of the trend. Market bubbles are usually defined in retrospect, when after the crash everyone can look back at charts and point out how obvious it was. Somehow the obvious signs eluded most when the times were good.
Take for example the following chart of the NASDAQ before and after the “Dot-com” bubble.
From 1971 to 1990, the NASDAQ returned 311%, a respectable annual growth rate of 7.7%. Between 1990 and 1994, the index gained another 64%. The party really started in 1994, when the index doubled in three years, only to be outdone between 1997 and 1999 when the NASDAQ grew at a 45.5% annual rate. From 1994 through 1999, the total return was an eye-popping 420%, while the lowly Dow Jones Industrial Average returned 200%. The eventual crash of the index was equally as impressive. Over the two year span from 2000 to 2001, the NASDAQ lost almost half its value while the Dow lost only 13%. The net result was that both indices had virtually the same return between 1994 and 2001, except investors who bought into the Dot-com hype at the wrong time suffered great losses.
Investors can use historical data as a guide to help them identify potential moments of irrationality in the market. There are plenty of reasons why particular stocks are soaring in price, many are legitimate and well deserved. However, different rules should be applied to the aggregate market. Investors in Amazon (NASDAQ: AMZN) are paying a high price for its current earnings, but this can be justifiable for a company that has tripled revenues over the last 4 years. Most companies in the market are not growing at that kind of rate, so it stands to reason the overall price investors are willing to pay for the entire market should fluctuate between a normal band. For the most part, it does, and exceptions stand out like sore thumbs. This isn’t about market timing; it’s about understanding current trends in a historical context. Robert Shiller’s website is a treasure trove of information, including historical data of the price to earnings ratio of the S&P as depicted below.
A popular Warren Buffet quote, “be fearful when others are greedy and be greedy when others are fearful” is often taken out of context. These words were advice he was giving to market timers, if they insisted on neglecting his opposition to their futile endeavor. Regardless, its wisdom still applies to regular buy and hold investors who would prefer to avoid buying into bubbles. A good indicator to be fearful in 2009 would have been David Elias’s book Dow 40,000 a guide to investing with the anticipation the Dow would reach 40,000 by 2016. For the next five years after the book’s release, the Dow was flat.
Speculation is not investing, but unfortunately speculation often leads to dramatic market shifts that make us all feel like intelligent investors. My advice is to keep a level head and a questioning attitude. I permit myself a very small single digit percentage of my personal portfolio to buy speculative stocks, but I would not recommend going all-in on temporary market exuberance. You're almost guaranteeing yourself a strategy of buying high and selling low. My favorite companies are dividend stalwarts whose boring business models render them free from speculation. I don't know the future of solar energy or natural gas vehicles, but I'm more certain that in a decade McDonald's (NYSE: MCD) and Yum! Brands (NYSE: YUM) will still be selling their products to an ever expanding global customer base. McDonald's has seen positive U.S. comparable sales growth for nine years in a row, not bad for a ubiquitous restaurant chain during a recession. Yum! is making great strides in its International and China segments, while bolstering its American sales with new innovations. I laughed at the Doritos Locos Taco concept when it was announced, but over the last quarter Taco Bell enjoyed a 13% increase in comparable sales growth. These investments won't be as exciting as those volatile small-caps who lose or gain 20% in market cap with each quarterly earnings surprise, but your ulcer-free stomach will thank you down the road.
drfrank1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and McDonald's. Motley Fool newsletter services recommend Amazon.com, McDonald's, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.