Should I cheer for the bear or bull?

Question

In Australia, ~10% of our salary goes into a compulsory retirement savings scheme. I have chosen the default option for young people, which involves a relatively balanced split between stocks, investment in property and a bit of cash.

I have been working for 2-3 years, so have a small balance in my super account.

I am not sure whether I should cheer on the stock market going up (increases the value of my existing 2 years worth of investments), or when it goes down (allows my fortnightly contribution to buy more units of stock, which will/may then go back up later.

I suppose ultimately, this boils down to "If a stock index deviates from its long term average, would a rational economist forecast that:

a) The rate of change of the index will eventually return to the long term average, meaning I should cheer the bull.

b) The value of the index will eventually return to where it would have been if the deviation did not take place and the rate of change stayed at the long term average the entire time (cheer on the bull)"

P.S. I am aware of the common theory in economics that crossing one's fingers does not impact the future direction of the stock market either up or down. I simply refuse to accept this as truth ;) But feel free to pretend this is a question for interest's sake only without any actual implications.

Also, apologies if this belongs in personal finance. I don't believe it does, because it is more intended as a theoretical question around general trends in stock markets and economies than as actual advice for someone's stock choices.

Answer 1

First off, I think it would be deeply against the rules here to give investment advice. Don't take this answer as investment advice.

For the answer to a) and b)

There is no reason why an index must return to the long term average, income or price wise. Whether it does or does not depends on the economic situation as a whole and as such relying only on historical statistics may not be productive. The western economy is going through difficult times right now, where growth and interest rates are low, and there are many structural problems to be concerned about. I would not be so sure that the market is undervalued to begin with (it might have been overvalued before - but possibly less so than some other western exchanges).

In general, you should not decide upon retirement savings based on bets on short term market fluctuation. Especially not, if you are not a professional investor.

As for the general retirement savings advice. Younger people should invest in stocks, since the investment has a long tail. As such the higher standard deviation of the investment is not as relevant as the higher expected return. When getting older, less deviation is preferred, as more certainty regarding the retirement savings is preferred. As such some nations with funded schemes have decided to invest overwhelmingly into stocks for young individuals, and progressively more to bonds for older individuals. This is a sound strategy.

Answer 2

One mechanism that holds fixed the prospects of the firm and your own preferences, but changes stock prices is to change the market's discount factor. If discount rates are everywhere higher than before than stock prices must be lower. Is this good for you? Do you want the market to discount the future at a high rate or a low rate?

Subject to several caveats, I'd say you'd want to the market to discount at a high rate. A high discount rate will mean that stock prices will be low relative to the price you would place on their discounted profits and therefore you would be getting something you value at high price for a low one.

Some critical caveats are as follows:

1. Firms look to their market cost of capital for determining if projects are profitable. If the discount rate goes up the cost of capital will go up too and this will mean many previously good projects will not happen. This means a poorer society and less capital to combine with your labor
2. Why is it exactly that the discount rate when up? If discount rates go up because everyone wakes up tomorrow with different preferences then how to these preferences change the world more broadly when people discount the future more heavily and risk is more feared. Perhaps this world is dull and shallow and worse to live in. If discount rates change because the distribution of expected future shocks has changed then we haven't held much fixed and you are likely worse off from the larger shocks.
3. What do firms do to their capital structure in response these changes besides hold less capital? Do they pay out more dividends (great, who cares what others think when you get the cash) or less (terrible, now you are more dependent on the reselling your shares to recoup your investment).
4. Why are you exempt? What's special about you and are there any other consequences of these differences?

Perhaps another way to put this is to ask, is there a stock price at which you would buy shares even if you could never sell them or borrow against them? I say generally speaking yes. Dividend yields are about 2.1 percent. If equity prices fell 80% you could make so much money off they dividends that you'd make more than the historical return on equities from the dividends alone. But in practice, you can borrow against your shares and you can sell them, so you don't need prices to fall nearly as far to be a good value.

Unfortunately, and I think you understand this, equities prices generally go down when economic prospects are poor, and so low prices are a negative wealth shock more than a buying opportunity.