“I’m waiting for a pullback”

A common refrain I frequently hear from current and potential investors who are thinking of adding or initiating an investment is that they are “waiting for a pullback” in the markets before doing so.

This is understandable. After all, nobody wants to be the sucker who makes an investment, only to see the stock market decline the next day. Better to wait for a pullback first!

“I’ll know the bottom when I see it”

Timing the bottom is of course devilishly difficult, if not impossible. The financier Bernard Baruch famously warned, “Don’t try to buy at the bottom and sell at the top. This can’t be done—except by liars.”

When markets do have a pullback, as they invariably do, pundits and journalists race to find stories to justify falling stock prices. This is the result of a well-known phenomenon, the narrative fallacy, which tricks our brain into believing a cause-and-effect story that sounds just right.

For instance, at the time of writing, the S&P 500 is down 6 percent this month (although still slightly positive for the year), and many stocks are down much more. For example—to pick some well-known names—American Airlines is down 23 percent, Caterpillar 21 percent, Harley-Davidson 16 percent, and Hilton 14 percent. Just this month.

Around the world, stock markets are down quite a bit more year-to-date. European indices are down anywhere from 9 to 15 percent in local currency. Chinese stock indices are down between 10 and 20 percent in local currency. 

There is a saying in journalism: if it bleeds, it leads. Put another way: bad news sells. The headline, “The world today is a bit better off than it was a year ago” is really boring. Nobody’s going to click on that. But a headline like “Caterpillar drops the most since 2015 after industrial giant says costs are rising from tariffs” sounds scary and gets clicks. Clicks generate pageviews and advertising revenues. Cha-ching.

And so, as you would imagine, journalists are having a ball. Now, if you actually go and read Caterpillar’s earnings release, you’ll learn that sales were up 18 percent in the quarter. Costs are expected to rise because of tariffs, but price hikes and efficiencies are “expected to more than offset” those cost increases. The company maintained its outlook and stressed that “nothing material has changed since we updated the outlook in July.” (These details are from the company’s conference call.)

This is a classic case of biased assimilation: stocks are down, and we selectively absorb stories that justify our fears. The process is accelerated by availability cascades, or stories that get repeated because they sound like plausible explanations.

Searching the news right now, “tariffs”, “rising interest rates” and “China slowdown” seem to be easily available stories to justify just about anyone’s pessimism.

This is summarized in one of my favorite cartoons:

 

“I’ll wait until there’s more certainty”

So here we are, in the middle of a pullback. Most investors will say, “I’ll wait until there’s more certainty.” This is understandable. Nobody wants to be the sucker who invests, only to see stock prices go down further. There might be a recession just around the corner; isn’t it obvious investors should wait?

Again, this is a narrative fallacy. Stock market pullbacks have not been good at predicting recessions. By now, you can see where this is going. Investors will trick themselves into thinking there is more certainty when prices are going up, and pundits will choose stories to justify those price movements. Biased assimilation will kick in, and instead of focusing on the negatives (tariffs, interest rates going up), those stories will focus on the positives (consumer confidence, historically low unemployment).

Dollar-cost averaging is the way to go

Because the future is unknowable, the humble way to approach this problem of whether to invest now or wait is to split the difference, and invest over time. This is also known as dollar-cost averaging. Since we don’t know the direction of markets, adding a bit every month, or every quarter, is the sensible play.

Just tell me what’s on your crystal ball

Everyone wants to know what’s going to happen over the next few months, but the economy is a complex-adaptive system: nobody knows. The economist John Kenneth Galbraith smartly observed that, “The only function of economic forecasting is to make astrology look respectable.”

That’s true in the short term. Over long periods of time, it’s important to think in terms of base rate probabilities. In simple terms, this can be stated as, “what’s the most likely outcome”? And the most likely outcome is that the economy will continue to grow, as it has done since the dawn of the industrial revolution. Why must it grow? Because capitalism, entrepreneurship, technological progress and innovation are incredible wealth-creating engines.

But don’t take my word for it. Here’s a handy chart of world-wide wealth over the past couple thousand years. The explosion you see around 1870-1900 was the result of the technological innovations of that era:

 

In the short term, nothing about the economy seems off. Yes, interest rates are rising from historical lows, but the 10-year Treasury bill is still under 3.2 percent, and the 30-year is under 3.4 percent. In comparison, in October 1999 (to pick a date at the end of a bull market), both the 10- and 30-year Treasury bills were quoted over 6 percent. Valuations today are also very reasonable; they were stretched in 1999. This matters because very high interest rates can bring down stock prices, but we’re nowhere near that vicinity. China is still growing its GDP over 6 percent, if that number is to be believed, and consumer confidence in the U.S. hit an 18-year high just last month.

There is little short-term predictive value in all of this, because stock markets can go bananas at times; for all we know, the market could go down 20 percent or more for little reason, as has happened before.

We are entering earnings season, and it’s possible that more companies will become cautious—some certainly will simply because of the headlines swirling around—and that this pessimism drags consumer confidence and brings about a recession. 

But over the long run—and this is where base rates come in handy—the market goes up, because corporations innovate, invest, grow profits, and stock prices follow.

And here’s the kicker: with the current pullback, investors are buying all that future growth and innovation at a discount. As Buffett explained earlier this year, even a “dumb” index-buying strategy can generate astonishing results over long periods of time. A well-executed, more focused portfolio should do even better.

Waiting for pullbacks is expensive

I’ll leave you with one last story. Peter Lynch was an extremely successful investor, having generated double the S&P 500 returns between 1977 and 1990 at the helm of the Fidelity Magellan Fund.

This is what Lynch had to say about waiting for pullbacks:

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.

In a 1994 talk, Peter Lynch cited some market statistics at the time:

There have been 93 years this century. The market’s had 50 declines of 10 percent or more. Of those 50 declines, 15 have been 25 percent or more. If you’re not ready for that, you shouldn’t own stocks. And it’s good when that happens. You take advantage of these declines.

Now you might think this is all bluster, but it’s not. Lynch lived through the 1987 market crash. At the time, he was on a golf vacation in Ireland:

On Monday the market went down… and my fund went from $12 billion to $8 billion… that gets your attention… there was nothing I could do about it.

About other garden-variety pullbacks, he noted,

I was very consistent. In the 13 years I ran Magellan, the market went down 9 times, and every one of those 9 times, Magellan went down.

Finally, in terms of staying the course, Lynch wrote in one of his books:

Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stockpicker. The skittish investor, no matter how intelligent, is always susceptible to getting flushed out of the market by the brush beaters of doom.

***

Putting it all together

Markets are unpredictable over the short term, but will do well over the long term because they’ll follow the underlying wealth creation of the economy. We humans are always creating stories to justify the short-term wobbles of the market. When markets go down, it’s usually a good time to invest.

We’re in a pullback. Investors should take advantage.