The Independent Market Observer

9/24/12 – Failing to Plan Is Planning to Fail

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 25, 2012 11:26:09 AM

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So the U.S. markets are at their highest point since 2007. In 2007, the markets were at their highest since 2000. In 2000, the markets were at all-time highs. In 2000, values were driven by the bubble, as we now know. In 2007, spending and growth were driven by unsustainable growth in housing values and consumer borrowing, as we now know. In hindsight, those valuations were not supportable. We are smarter than that now.

Now, of course, we have a solid economy, well-supported economic growth, and strong corporate earnings performance. Current valuations, of course, are well supported. As opposed to the last two times market valuations hit this level, this time is different. Right?

I had a good discussion with one of our advisors, Bob Haley, not that long after the 2008 crash. In light of the 2008 market failure, he asked me an excellent question: “What do you see as the principal failure of advisors?”

I did not have a good answer then, but I gave it a lot of thought and eventually came up with what I thought was a pretty good one. The failure of imagination.

At any given point, the consensus opinion is so pervasive, and so seemingly firmly rooted, that it is almost impossible to imagine that things could be otherwise. The housing market in 2007 and the Nasdaq in 1999 are two good examples: even though there were some people yelling about the problem, it was very difficult to imagine how those isolated voices could be right and the rest of the world wrong. This is the failure of imagination.

Now is perhaps a good time to pull out our imaginations and see what they come up with regarding current market valuation levels. What do these valuation levels depend on? Can we imagine a situation where the market turns out to be not just overvalued, but significantly so?

I find that all too easy. Look at the world economy and geopolitical situation. Look at corporate profit margins, implied overall growth rates, and various valuation metrics, including the Shiller P/E and the Tobin Q ratios. All of these imply that the market might well have a fall in the future—maybe a big one.

Where imagination meets practice, of course, is in planning. If you can’t imagine something, you can’t plan for it. If you can imagine a significant market decline under reasonable circumstances, shouldn’t you be planning for it? Even if the plan is to hold your current positions and maybe buy more, a plan lets you approach the decline more calmly, take advantage of what you have decided are the opportunities, and, in general, weather the storm better than if it had come as a surprise.

By the way, planning is not only for downturns. Wouldn’t it have been nice to have a buying plan in place when the last downturn started to turn up?

Let me say that this is by no means a prediction either way—just a thought experiment. Early is the same as wrong, and you can mess up just as much by being too cautious as by being too aggressive. No matter what you do, though, it makes sense to be aware that conditions can change, and to have a plan for when and if they do.

So, what’s your plan?

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