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It's been shown time and time again (e.g. in Stocks for the Long Run) that the most profitable time to buy stocks is when sentiment is poor and that stocks usually recover very quickly at the end of a recession. Similarly, Robert Schiller notes in Irrational Exuberence that stocks fluctuate much more than the present value of future dividends (or, I would note, future earnings).

If the market is reasonably efficient, why wouldn't this become a self-defeating prophecy, with the eventual recovery priced in throughout the whole recession? Given that the business cycle isn't predictable and owning stocks with a short time horizon is generally a bad idea, why would anyone buy stocks in the first place if they weren't prepared to ride out a recession if one happens?

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"why wouldn't this become a self-defeating prophecy, with the eventual recovery priced in throughout the whole recession?" Just a thought: perhaps to some degree it has. I feel that the stock market at 11,600 today--with this unemployment and housing softness--is kind of high given that's where it was in Sep 2006 when housing and employment was more robust. –  Chelonian Aug 31 '11 at 22:18
    
@Chelonian: True, but: 1. This is pretty far off the March 2009 lows, the economy has recovered somewhat and P/E ratios are still at or below historical norms. Actually, when I posted this I was thinking of how/why the market ever got all the way down to its 2009 lows instead of dropping more modestly initially but still ending up about where it's at now. 2. 2006 was a long time ago. All else being equal, stocks should be more expensive now purely due to inflation. –  dsimcha Sep 1 '11 at 0:50
    
By my measure, PEs are still high. Perhaps a number of people here have simply calibrated to the dot com era valuations? –  jldugger Sep 1 '11 at 4:57
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@jldugger provides an example of why, even in an efficient market, these correlations won't be neat and tidy. There will be various interpretations of the available information. –  George Marian Sep 1 '11 at 6:08
    
@jldugger: Average S&P 500 P/Es are around 14, only slightly below their historical average. However, transaction costs, capital gains taxes and inflation are lower than they have been throughout most of history, meaning that all else being equal a higher P/E is justified. Furthermore interest rates are low so you don't have risk-free bond returns competing for capital, and the economy is still pretty bad, so by regression to the mean earnings could get better more easily than they could get worse. –  dsimcha Sep 1 '11 at 15:20
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The satisfaction from gains packs less of an emotional impact than the fear of loss. It's very difficult for many people to overcome this fear, so when prices begin to fall, many investors sell to minimize their potential loss. This causes a further drop, which can lead to more selling as other investors reach their emotional threshold for loss.

This emotion-based selling keeps the market inefficient in the short term. If there aren't enough value investors waiting to scoop up the stock at the new discount, it can stay undervalued for a long time.

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similarly if there is nobody left to sell to then prices can spike on low volume causing shorts to cover which can cause stocks to spike on high volume –  CQM Oct 23 '11 at 17:36
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If the market is reasonably efficient, why wouldn't this become a self-defeating prophecy, with the eventual recovery priced in throughout the whole recession?

Eventual, but when? That is a big unknown. In fact, even a recovery is not guaranteed. Japan's long deleveraging process is brought up often enough with regard to our current long and painful economic downturn.

Given that the business cycle isn't predictable

This is one of the big issues. If things were predictable, investing would be easy and there probably wouldn't be as much money to be made in it.

owning stocks with a short time horizon is generally a bad idea

Agreed. However, it does not mean that this does not happen. In fact, it happens every day. It's called day trading. Also, it is possible to make money that way, else it would not occur. So, strictly speaking, whether it is a good or bad idea comes down to specific situations.

why would anyone buy stocks in the first place if they weren't prepared to ride out a recession if one happens?

These things tend to happen at the worst times and they have a way of compounding or piling-up. E.g. you overextend yourself, the economy goes south, you find yourself jobless and unable to pay the mortgage, you are forced to liquidate some of your positions because you need cold, hard cash.

Benjamin Graham is widely quoted to have stated that the stock market is a voting (opinion) machine in the short term and a weighing (fact) machine in the long term. This may not feel very satisfying to you: but, it is just the way it is.

While the dissemination of information may be relatively efficient, the interpretation of that information is quite variable. It is not easy to put a number to most events. (By "put a number" I mean determine the impact to the balance sheet.)

It is a complicated system, with many inputs and many actors, which have varying goals. While there may be an effective, Zen-like approach to investing, the markets cannot actually be simplified to "buy low, sell high" in practice. Or, more specific to your question "buy and hold" is a simple idea, that is not necessarily easy to implement.


Prompted by JoeTaxpayer's comment, I went searching for one of my favorite quotes regarding the markets:

"Markets can remain irrational a lot longer than you and I can remain solvent." -- John Maynard Keynes

And, I came across this one, which I think applies quite well to this question:

"The long run is a misleading guide to current affairs. In the long run we are all dead." -- John Maynard Keynes

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Good counter-example on Japan, except that given the P/E ratios the Nikkei was trading at in the late 80's, its collapse was arguably more about a bubble bursting than a reaction to a downturn, and the bubble bursting probably caused the downturn, not the other way around. The same thing could be said about the NASDAQ in the early 2000s bear market. Anyhow, such situations are the exception not the rule. –  dsimcha Aug 31 '11 at 19:59
    
Also, your point about more selling because people need the money is a good one. This would imply that if you don't need cash, it's a good buying opportunity. –  dsimcha Aug 31 '11 at 20:01
    
@dsimcha I'm not just talking about the Nikkei, I'm talking about the entire economy. Read up on Japan's deleveraging and deflationary issues. As to your second comment, read up on being a contrarian. When people are panicking and selling, that is typically a good time to do some judicious buying. –  George Marian Aug 31 '11 at 20:09
    
+1 for nice Ben Graham quote. –  JoeTaxpayer Aug 31 '11 at 20:16
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@dsimcha - Some of the companies that positioned themselves well proir to and during the financial collapse are the ones that are growing and capitolizing on that in this down period. CAT was trading at around $25 in 2008 (Undervalued but it was) its up around $100 now and its business is growing. JD Rockafeller said he preferred to invest during a down economy as it was cheaper to grow the business then. –  user4127 Aug 31 '11 at 20:30
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By definition, a downturn in the business cycle will push some companies into bankruptcy.

What's worse, a downturn in the business cycle will trigger "bankruptcy fears" for a LOT of companies, far more than will suffer this fate. So the prices of MANY candidates go down to levels that reflect this fear. This aggregate impact produces the "overreaction" you're talking about. It's called "fallacy of composition"; some of these companies will go under, but not all.

Then the prices of the survivors will bounce back strongly during the early stages of an upturn when it becomes clear which companies WON'T go bankrupt.

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Interesting take. In theory (though not necessarily in practice) a risk premium is supposed to exist only to the extent that the risks can't be diversified away. Of course, if a few companies go belly up during a recession, but you have a diversified portfolio that also includes a lot of companies that didn't, your losses are small. OTOH, for someone focusing on the risk of holding a single company instead of the bigger picture the risk looks a lot larger. –  dsimcha Sep 1 '11 at 15:16
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