Markets & Finance

In Today's Market, the Wisdom of Standing Pat


Since the financial crisis sent U.S. stocks to a 13-year low in March 2009, the market has staged its biggest two-year bull run since the Great Depression. The rally has persisted despite high unemployment, the European debt crisis, and a devastating oil spill. Even popular uprisings across the Arab world, which sent oil prices higher, and Japan's earthquake and tsunami on Mar. 11, which led to the threat of a nuclear meltdown, couldn't stop it. After dropping 4 percent over the course of three days, the market recovered. By the end of business on Mar. 21, the Standard & Poor's 500-stock index was up 3 percent for 2011 and 27 percent since July 2. For investors, the whole episode seemed to verify Vanguard founder Jack Bogle's maxim: "Don't just do something, stand there!"

Markets move up, down, and sideways, and it's usually useless to try to gauge the day-to-day meaning of it all. Individual investors often "react on fear, panic out at the wrong times, and always miss the market swing back up," says Joshua A. Scheinker, a wealth manager at Janney Montgomery Scott in Baltimore. Indeed, some investors responded to the Japan news by fleeing the market. Shareholders pulled $8.2 billion from equity mutual funds in the week up to Mar. 16—the biggest outflow since July—while steering a modest $535 million into bond funds.

The resilience of U.S. shares is a testament to both the health of the global economy and the merits of disciplined investing. "If someone had told me that the U.S. was invading Libya, you have uprisings throughout the Middle East, the price of oil itself was over $102 a barrel, there was major devastation in Japan, and an unstable nuclear situation, there is no way I would have said the S&P would be up for the year," says Scheinker.

The market squall came after a period of unusual calm. There has not been a decline of 10 percent or more since July. "Investors are tired of being told to hedge against risks that have not emerged," Citigroup (C) currency strategists led by Steven Englander in New York wrote on Mar. 10, the day before the quake. Valentijn van Nieuwenhuijzen, a strategist at ING Investment Management, says investors couldn't have anticipated the disaster. He referred to the event as a "black swan," a term coined by author and investor Nassim Nicholas Taleb in 2007 to describe rare occurrences that aren't predicted by conventional market models. "You prepare yourself for gray swans that are unlikely, but at least you can imagine them." While the earthquake may have caught investors off guard, the effect on the U.S. market came and went so quickly it's not clear what hedging would have accomplished.

As for assessing the longer-term impact on a global economy, the earthquake has to be viewed in perspective. In the mid-1990s, Japan's economy represented 18 percent of global output. In 1995, Japan took a 10 trillion-yen ($103 billion at the time) hit to its economy when a 7.2-magnitude quake struck Kobe, then one of the world's busiest ports. Even so, the U.S. economy continued to chug along, and its stock market had one of its best years. Today, Japan's share of global output has fallen to less than 9 percent, and the nation of 127 million has ceded its rank as the world's No. 2 economy to China. Goldman Sachs (GS) estimates that even after the quake, the global economy is on pace to grow 4.8 percent this year, almost a point and half higher than the two-decade average.

In the U.S. several factors point to a continued rally. The Federal Reserve has allowed some banks to resume paying dividends or raise them. Corporate bond defaults have fallen sharply. Earnings for companies in the S&P 500 are expected to grow 13 percent in 2012, according to Bloomberg data as of Mar. 23. With many investors sitting on the sidelines, there's no shortage of cash ready to pile into the market. While the market has almost doubled since its 2009 lows, investors have seemed wary of stocks. They have added a net $582 billion to bond funds and withdrawn a net $117 billion from U.S. stock funds, according to the Investment Company Institute.

According to a sentiment survey by MFS Investment Management, 72 percent of advisers think U.S. equities are an excellent or very good place to invest; only 35 percent of individual investors agree. If historical patterns hold, the latter figure is bound to go higher as the market keeps gaining. "We are in the early innings of a massive asset allocation shift away from cash and fixed income and toward equity," says Jason DeSena Trennert, managing partner of Strategas Research Partners, in a note. "This is true for both the retail and institutional investor alike. This makes selloffs short and shallow."

The bottom line: The stock market's response to recent news events illustrates the strength of the global economy and the virtue of ignoring headlines.

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Farzad is a Bloomberg Businessweek contributor. Follow him on Twitter @robenfarzad.

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