n The Peer-Group Trap. While the long-term results in the market when viewed from a distance may look smooth, the long term is composed of a connected series of medium-term cycles that are anything but smooth. These medium-term cycles which can last anywhere from 3-10 years all have the same five stages where each stage dictates a specific bond-stock allocation. The Five Stages conform to the stock market which is a forward-looking discounting mechanism which rewards early adopters. The problem/opportunity is that most investors prefer the comport and safety of their Peer Group which, by definition, is backward looking and one stage behind the stock market. Avoiding the Peer-Group Trap and moving in-synch with the market will make an investor feel lonelier but it will also significantly enhance returns.

n The Ego Trap.  Most investors do not have the confidence to perform brain surgery, fly an airplane or try a case before the Supreme Court unless they have had specialized training, but people regularly think they can pick a fund manager who can outperform the averages.  This strategy has two major pitfalls:
 -- Both the academic evidence of the Efficient Market Theory, which says that all stocks relative to each other are properly priced, and the overwhelming statistical evidence of long-term results show that trying to outperform the market by picking individual stocks is an extremely difficult task.  In fact, the statistical evidence demonstrates that only 13% of all managers match or beat the averages. 
 -- In addition, because the individual investor has his ego/judgment behind the decision that the manager he picked will be successful, he does not object to the high fees. 

Trying to successfully pick individual stocks for performance is an Expensive Fool’s Errand. The solution is to utilize low-cost Index Funds which will both give impeccable diversification and nicely put your performance in the top quartile.  (For more information, please see The Ego Trap button.)

n Long term the stock market is driven by increases in productivity. Productivity is the only source of real financial gains. Productivity drives the increases in real earnings gains and dividends. The key to productivity is innovation and the body of technical knowledge. Due to the confluence of the Internet and the ever increasing power of computers, the body of technical knowledge is growing exponentially. Thus, the outlook for productivity and, perforce, the stock market has never been brighter.

n The Five Stages of the Stock Market and the corresponding investment action are:

n The cyclical nature of both the business and stock market cycle is caused by the ever-shifting emotions of fear and greed by consumers, businessmen, and investors.

n Investors want to1) maximize their financial return and 2) enjoy the safety and comfort of their peer group. Unfortunately, these two goals are mutually exclusive. The stock market is a forward-looking discounting mechanism that rewards early adopters. On the other hand, a peer group is like a committee which relies on consensus to create its power. Consensus building takes time which almost guarantees that the peer group’s opinions will be one phase behind the market.

n Thinking in terms of The Five Market Stages will materially add to your investment performance. Better performance even comes from asking the simple question: Are we closer to the beginning or the end of the market cycle?

n Trying to add to performance by picking individual stocks is an Expensive Fool’s Errand. There is compelling statistical evidence to prove the Weak Form of the Efficient Market Thesis which states that, within any given market, all stocks relative to each other are properly priced. As it turns out, the net performance over time of a group of portfolios is inversely related to the size of the management and trading fees. Index funds provide both impeccable diversification and low costs.

n Long term, the stock market can be explained by productivity; the Five Stages of Stock Market Cycles explains the medium-term. Unfortunately, we know of no explanation for the short term in the stock market. From numerous statistical tests that we have done, we know what does not work. The first person to solve this riddle will rather quickly end up with most of the money.

n If the stock market does not keep you humble, you are either new to the profession and/or you are a master of self deception.

n Over the long term, these simple statements (equations) tie stocks and bonds to each other and to the economy:
1. The GDP per capita is equal to the growth of productivity + inflation.
2. The yield on two-year government bonds is the growth of productivity + inflation.
3. The Operating Earnings of the S&P 500 is equal to the growth of productivity + inflation.
4. The total return for stocks is equal to the growth of productivity + inflation + the dividend yield.

n It further turns out, as those miserable math teachers used to say:

1. The growth rate of the Operating Earnings for the S&P is equal to the average yield on the two-year government bonds which, in turn, is equal to the GDP per capita growth rate.
2. Since equities have more variability and greater risk, the total return of the S&P 500 is equal to the yield of the two-year Treasury bond + the dividend yield.

n The best model for the stock market is the earnings power of the S&P 500 times the inverse of the two-year Treasury yield. The Treasury yield provides the best market estimate of the future outlook for inflation which is inversely related to the price-earnings multiple: high inflation equals a low multiple and low inflation equals a high multiple. Moreover, the stock market sells on the basis of earnings power, not on the basis of either peak or trough earnings.