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Will You Cash Out Before the Market Crashes?

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  • Will You Cash Out Before the Market Crashes?

    Will You Cash Out Before the Market Crashes?
    By Tim Hanson February 15, 2008

    Six -- count 'em, six -- major financial firms now declare that the United States is in recession. That list includes heavyweights such as Goldman Sachs, Merrill Lynch, and Morgan Stanley.

    Several other financial institutions, while not yet using the "r" word, are nonetheless pessimistic. The Wall Street Journal quoted a Wachovia report that said, "There is no question that the economic news has taken an unusual and disturbing turn for the worse."

    Of course, the stock market has done nothing to contradict this outlook. The S&P 500 is already down nearly 8% year to date.

    If the worst is yet to come, you'd be daft not to sell ... right?

    "An adverse feedback loop"
    After all, every part of our economy seems to be spiraling downward together. Federal Reserve official Janet Yellen called this "an adverse feedback loop -- that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution."

    Students of American history will remember that a similar feedback loop prolonged the Great Depression -- and it took a world war to break the cycle.

    So if the stock market does tank this year, we're all going to look back and say we saw it coming. Why not sell and wait for safer times?

    Not so fast
    My Foolish colleague Paul Elliott called this way of thinking "the real threat facing investors today." But he advises you to stick it out -- as do I. Two key points apply:

    1. Recessions do not last long. Since 1945, none of the 11 recessions on record lasted more than 16 months -- and none longer than eight months since 1982.
    2. Stocks do not all go down during recession. In reality, you can make a lot of money by investing when economic confidence is weak.

    Take our last recession (March 2001 to November 2001), for example. During that time period, the market had nearly the same number of gainers as decliners (2,000 or so on each side). While bellwethers such as ExxonMobil (NYSE: XOM), General Electric (NYSE: GE), and Cisco Systems (Nasdaq: CSCO) were down (8%, 16%, and 17%, respectively), Intel (Nasdaq: INTC), Genentech (NYSE: DNA), and UnitedHealth (NYSE: UNH) were all up (12%, 10%, and 21%, respectively).

    The killer stat, though, is this: Since the 2001 recession began, 826 stocks have tripled. Eight months of contraction simply cannot stop innovative operators with wide market opportunities such as Apple and Amazon.com (Nasdaq: AMZN).

    An aside to all of this optimism
    It should be noted that stocks dropped substantially in 2000 leading up to the recession -- just as they've dropped of late. Those examples, however, just go to show how the stock market does not move in lockstep with economic realties. Instead, it's an imperfect prediction machine with millions of analysts, institutions, and individuals trying to incorporate the information they know into daily trading decisions.

    All that dynamism makes the market impossible to time, and if you're only starting to worry about recession as we may or may not be entering one, you are way late to the game. To get ahead of the curve, you should start thinking about buying and holding for the long term.

    Don't just take our word for it, though. There's also brand-new research from IESE Business School professor Javier Estrada.

    Javier who?
    Mr. Estrada's recent paper "Black Swans and Market Timing: How Not to Generate Alpha" is one of the most persuasive cases I've read for a disciplined buy-to-hold investment philosophy.

    Estrada studied 15 major global stock markets for periods ranging from 31 to 79 years, with the full data encompassing more than 160,000 trading days. What he found is "less than 0.1% of the days considered" actually matter to long-term returns, which means that "the odds against successful market timing are staggering."

    So ... don't try to time the bottom
    Now, this is a dangerous article to go on record with. If the market does tank this year, I'm going to get plenty of profanity-laced emails telling me that I'm "the real fool now" (seriously, you'd think people would be over that joke by now).

    But even if we lose money this year (yes, I'm staying invested myself), we're all going to make a lot more money down the line not by trying in vain to time the market but by adding new money to great companies on a regular basis.

    That way, rather than run from the lows, we'll double-down on them ... and supercharge our returns in the process.

    Buy the best companies instead
    That's the tack Fool co-founders David and Tom Gardner are taking today in our Motley Fool Stock Advisor investment service, and we believe that today is offering some of the best buying opportunities since the 2001 recession -- which, remember, produced 826 triples in less than seven years.

    "There's one way to find out if a man is honest-ask him. If he says 'yes,' you know he is a crook." Groucho Marx