Bad Advice From A (Very) Good Economist

Bad Advice From A (Very) Good Economist
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On February 17, 2017, the Dow Jones Industrial Average closed at 20,624. It is up 4.36 percent for so far in 2017. In 2016, when adjusted for dividend reinvestment, the DJIA returned 16.47 percent. Given these extraordinary gains, it’s not surprising that investors are nervous about a bubble that might soon burst.

In his first weekly column as the successor to Scott Burns (who retired), Laurence Kotlikoff, a highly respected economist who teaches at Boston University, didn’t mince words. Here’s his recommendation: “Sell your stocks (and your long-term bonds, too) until the dust settles.”

Here’s why this is bad advice.

No one knows

Professor Kotlikoff has sound reasons underlying his sell recommendation. He correctly notes that the bull market is long in the tooth, having lasted for 8 years. The price of stocks is “very high relative to profits”. The possibility of unsettling news (like a trade war or a boycott of U.S. goods, among other possibilities), given the turmoil caused by the policies of the Trump administration, could cause the market to crash. He correctly notes that “uncertainty and the stock market don’t mix.”

The harsh reality, as Professor Kotlikoff candidly acknowledges, is that “smart economists never predict the stock market” because the market is random and unpredictable. Why then does he make an exception? Because “economic theory is not perfect” and “...bubbles ... can burst at any moment because they aren’t based on fundamentals.”

He could be right....or wrong. No one knows.

A poor track record

The track record of economists who predict the direction of the market is not encouraging. Larry Swedroe, the Director of Research for The BAM Alliance, summarized the data in this blog post.

Remember the Great Recession in 2008? A survey of professional forecasters thought the chance of a recession was only 3 percent. Swedroe noted that “since 1990, economists have forecasted only two of the 60 recessions that occurred around the world a year in advance.”

Even if someone could tell you when to get out of the market, can they also predict when you should get back in? Stock markets tend to recover very rapidly. For example, in 2008, the S&P 500 index (dividends included) lost 37.2 percent. Let’s assume you relied on an economist and went to cash in 2007.

For the two-year period from 2009-2010, the S&P 500 index gained 46 percent. It’s been on an upward trajectory since that time. What are the chances the “guru” who predicted when to get out was also able to provide the optimal time for reentry?

A better way

There’s a better way to deal with current market conditions. Take a hard look at your asset allocation (the division of your portfolio between stocks and bonds). Given the run-up in stock returns, your portfolio has probably increased significantly in value over the past 8 years (assuming you have stayed the course and ignored most of the financial media!).

Do you really need to take as much risk? If not, reduce your allocation to stocks. Be sure you have enough short term, high quality bonds in your portfolio that you wouldn’t need to sell stocks at a loss for a 2-3 year period to fund your expenses.

The market may take off or tank. Intelligent investors focus on factors they can control, like their asset allocation, low fees and deferring or eliminating taxes. While I have a high regard for Professor Kotlikoff, relying on his predictions (or those of anyone else) about the direction of the market, is not a responsible way to invest.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

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