FREE NEWSLETTER
STEIN’S LAW STATES that, “If something cannot go on forever, it will stop.” It’s named for Herbert Stein, an economist who was influential in the 1970s and served as chair of the president’s Council of Economic Advisors.
Stein first made this comment when he saw government debt growing to what he felt was an unsustainable level. While half-joking in the way he put it, Stein was making a serious observation: Trends rarely last forever.
In some cases, that’s because the trend has become unsustainable for one reason or another. In other cases, it’s because attitudes or preferences change. Stein, in other words, was cautioning against what today we’d call recency bias—the tendency to extrapolate recent trends into the future. Given all of today’s uncertainty, it’s a good time to take a closer look at this idea.
As I mentioned last year, the investment industry loves stories, sayings and aphorisms. For virtually any situation, there’s a wise-sounding maxim that can be invoked to either support or argue against a particular investment decision. When it comes to Stein’s law, there are at least three such sayings—and they’re seemingly contradictory.
The first saying: “Trees don’t grow to the sky.” Investors like to cite this idea when a company appears unstoppable. Today, that might apply to Apple or Amazon. Yes, these companies are on a roll. But just as trees don’t grow to the sky, history indicates they probably won’t maintain their dominance forever.
This is one of the financial industry’s favorite aphorisms, and it squares with Stein’s law. But investors have two other expressions that make precisely the opposite argument: that trends sometimes do continue. When a stock is falling, some will caution investors against “trying to catch a falling knife.” And when an investment is rising, they’ll say, “It’s an elevator, and it’s going up.”
On the surface, these sayings appear inconsistent and thus not terribly helpful. If trends sometimes continue and sometimes don’t, how should we think about the issue? The answer—as with many things in finance—is that it isn’t a binary choice. Each of the three aphorisms contains elements of truth.
We need only look back to past market leaders, including Xerox, Kodak and BlackBerry, to appreciate that market trends—especially in technology—don’t last forever. Amazon founder Jeff Bezos himself has talked about this. In a 2018 speech to employees, he said, “I predict one day Amazon will fail. Amazon will go bankrupt.” Why? “If you look at large companies, their lifespans tend to be 30-plus years, not 100-plus years.” While there are exceptions to this rule, it’s generally been the case, and it supports Stein’s law. Product and technology trends eventually fade or change course.
But data also point in the other direction. While it’s true that trends rarely continue forever, the data show that market trends sometimes continue longer than one might expect. According to research by investment firm AQR Capital Management, “The past 12-month excess return [of an investment] is a positive predictor of its future return.” In other words, what’s done well over the past year is likely to continue doing well.
For how long? AQR finds that, “This time series momentum or ‘trend’ effect persists for about a year and then partially reverses over longer horizons.” Of course, trends sometimes continue for much more than a year. Apple and Amazon, along with the rest of today’s stock market leaders, have been going strong for about a decade.
Frustrating as it might seem, the reality is that any investment trend we observe might keep going or it might not, or it might continue for a while longer before fading or even reversing. What useful lessons can we draw from all this? I have four recommendations:
1. Choose index funds. At any given time, there will be companies, industries, market “factors” and national economies that look dominant. It’s hard to know, though, how long any trend will persist. To take the most recent example, I have yet to meet the investor who predicted that almost four years ago a virus would arrive out of the blue and cause the stock market to drop more than 30%, but then rally back within weeks and go on to reach new highs.
Similarly, I don’t know any investors who predicted the war in Ukraine, prompting a rally in energy stocks after years of going sideways. You could find similar examples throughout market history. That’s why I recommend steering clear of stock-picking and instead favor index funds, which allow you to benefit from whatever trends happen to be underway.
2. Rebalance slowly. In managing your investments, it’s important to have asset allocation targets and to rebalance periodically. But it’s also important not to be too quick to rebalance. That’s because the market does exhibit momentum over shorter periods. If the market is trending down, it’s likely to continue trending down for some number of months. And when it’s on an upswing, that trend is also likely to continue for a while. Result: It’s beneficial to wait a bit before rebalancing so that, if you’re selling, you sell a little higher and, if you’re buying, you buy a little lower.
3. Stay diversified. With bond yields hitting 15-year highs, more than one investor has asked me whether it would make sense to sell stocks and allocate everything to bonds. As I discussed last week, this strategy might make more sense than it did a few years ago, when bond rates were much lower, but I still don’t think it’s advisable. Current trends could reverse. A better approach, in my view, is to maintain a diversified portfolio. I recognize that this can be hard when current trends seem obvious. But as we’ve seen, trends can reverse unexpectedly.
4. Avoid extreme opinions. When inflation was very low, a school of thought known as Modern Monetary Theory (MMT) emerged. Counter to hundreds of years of economic history, MMT argued that governments like ours could print as much money as they wished without any fear of inflation. They invoked the age-old argument that, “This time it’s different.” Economic history, they argued, had entered a new era, and inflation was no longer a concern.
The theory, of course, was quickly proven wrong, but for a while it had its adherents. The lesson: Be careful of extreme views. Wherever possible, opt for a down-the-middle approach. To be sure, sometimes things do change, so we should never entirely ignore market trends. But since trends are so unpredictable, we should be more inclined to stay the course than to react to each new development.
A footnote: Economists may not be known for their comedic skills, but Herb Stein was an exception. While working in the White House, he shared this observation: “Economists do not know very much. Other people, including the politicians who make economic policy, know even less….” Stein’s son, Ben, who is also an economist, inherited his father’s sense of humor. If you’re of a certain age, you may remember his memorable role in Ferris Bueller’s Day Off.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
Nice article. Thank you, Adam.
Ben Stein is a bit of a nutcase. He once lost a job because the company didn’t want to associate with him after he denied climate change because “god controls the weather.” Who knew people still imagined lightning was caused by Zeus throwing lightning bolts.
Another keeper. You’re probably my favorite contributor here but you forgot one: Those who claim they can predict the future are either fools or lying. This is another reason to favor index funds.
Thanks for article. Isn’t tip #2 a form of market timing? How do you time how much is high enough to sell or how low is low enough, given it’s hard to tell when the momentum reverses course? Do you have a set rule that you live by?
Market-timing involves making a market prediction and then using it to guide a big market bet, such as going from all cash to all stocks, or vice versa. By contrast, what Adam is advocating is simply using a sense of market history to guide what’s really a marginal investment decision. Indeed, I sense the label “market-timing” is too easily used. If you get your year-end bonus and you don’t immediately invest the money, but rather wait until you get back from vacation, are you market-timing? If you inherit $200,000 from your Aunt Joan and you opt to invest it slowly over three months, are you market-timing?
Thanks for clarifying. Love this community and everyone’s feedback. Agree not everything is market timing (certainly waiting to come back from vacation is not), but when markets are really choppy it’s hard to discern an inflection point. I’m actually have been doing what Adam advocates (stock purchases, Roth conversions), but still find it hard to find an entry and exit point and DCA with the momentum for psychological comfort.
For example, in the case of Aunt Joan’s inheritance or your year-end bonus, where would you say we are at in the market. Only two weeks ago the market was trending down, only to reverse course sharply with a nearly 6% rise in one week. Conventional wisdom and data points to the hits to your portfolio if you miss out on the several biggest days of the year, etc etc.
I.e.: In the case of Roth conversions, you might plan, say $100K or $200K conversion for the tax year in Jan, but in 2023, what would have been the wisest course of action? I couldn’t say that in Jan or Feb that market was on the upswing, nor see the AI craze/magnificent 7 that took markets on a wild ride up March – July. If you missed that boat, then you could have caught the -10% correction Sept-Oct, but certainly all the market noise and articles were contradictory as to trend for SPY.
Any insight greatly appreciated how you use market history to guide. Keep up the good work!
I think you’re searching for something that can’t be known — where the market will go in the short-term. That said, I believe there are two notions worth keeping in mind:
1) If the market is off from its highs, you should be more inclined to buy stocks — and the bigger the drop, the more enthused you should be. If I had a large lump sum to invest and stocks were off 20%, I wouldn’t have any qualms investing it right away, even though there’s risk that the 20% decline might become 40%. This, incidentally, is not market-timing: You’d be reacting to what the market has already done, not acting based on some prediction about the future (other than the prediction that stocks will be a good long-term investment and that buying when they’re cheaper is better).
2) As Adam notes, markets do display momentum on both the upside and the downside. That suggests you shouldn’t be too quick to rebalance. I’m currently overweighted in stocks and I need to rebalance back toward bonds. Market history suggests the past year’s rally — spluttering as it may be — has further to run, so I’m not inclined to rebalance just yet. Could I be wrong? Absolutely. But it’s a risk — a modest one — that I’m willing to take.
Appreciate the context and your personal position. That’s what’s great about Humble Dollar. I have done exactly as you have stated…came into a big lump sum (and will continue to) and as a young-ish retiree (52), I’ve jumped in earlier in the year and in this latest correction since I’ve got a longer runway ahead and need equities to keep up. At the same time, on the fixed-income front, I’m contemplating for the first time in my life getting further out into longer durations because it feels like we’re at the end of the hiking cycle and can see potential upside there.
And in terms of both moves, you don’t know whether prices will get worse — but you do know that prices are better than they were.
Maybe that’s only modest market timing as opposed to extreme? I think I remember Robert Shiller in his financial markets course arguing that there is little benefit to dollar cost averaging since the market generally trends slightly upward. Any time out of the market is more likely than not to be a loss, even at the very beginning.
I think Adam’s point, though, is that while there are first order trends (reversion to a mean), there are also second order trends (falling knives tend to keep falling, rising elevators are more likely than not to keep going up).
That was my question as well. Perhaps dollar cost averaging is the approach
“Something D-O-O Economics…anyone?…anyone?”
The power of the purse is very valuable and as you can see, nations without it can lead to adverse consequences. Look at economies around the world that issue in their local currency but borrow in another, they are impacted by rates. Hence Venezuela, Greece (drachma prior to euro), Italian (Lira prior to Euro), and a number of others.
there are only a handful of nations that have the true power of the purse, Japan, UK to name a few. The true question we should be asking, will the dollar remain the global reserve currency? If that somehow decouples, we would be in for a world of hurt.
Adam,
I enjoy your articles and consider them among the best on HD. I have much respect, but I believe your statement on MMT is just not correct. I don’t believe the true proponents of MMT say that currency issuers “can print as much money as they wished without any fear of inflation.”
Quite the contrary, MMT typically warns that inflation is definitely a risk when printing money. In Stephanie Kelton’s book The Deficit Myth, chapter 2 starts by saying the myth is that “Deficits are a sign of overspending” but the reality is “For evidence of overspending, look to inflation.” That’s quite different stance than you present.
They key, as I understand it, is identifying times when deficit spending makes sense and when it doesn’t. One statistic (among many) they would look at is unemployment. In times of low unemployment, like now, printing money can be inflationary, but not so much when unemployment is high. According to Kelton, during a recession people may lose jobs and companies may cut production and, in that environment, spending can safely increase. She points out that, “…the $787 billion fiscal stimulus passed in 2009 didn’t cause an inflation problem.”
I know plenty of experts reject the theory, but has it been proven wrong? I’m not advocating for MMT. I’m not an economist and don’t claim the level of understanding of such complex systems to make that judgement. I have my doubts about some aspects, but a lot of it makes sense to this layperson. It doesn’t feel like an all or nothing proposition to me.
I do find the MMT perspective interesting and realize that one must maintain a different perspective and an open mind when considering budgets of a currency issuer as opposed to budgets of a currency user. Thinking the two are the same is a mistake. The federal government is playing a very different game than we are with our household budgets.
Thanks again for your articles. I appreciate your contributions.
Great book and also great explanation. MMT “never” stated they could print money without fear of inflation.(you are entirely correct) Quite the contrary, it actually stated, “absent” inflationary pressures when you have the power of the purse, increasing the money supply would benefit the overall economy, as has been done for decades.
Furthermore, MMT became relevant back in the 1990s and gained esteem during the financial crisis. I quite often have this discussion with my colleagues and we banter back and forth.
Adam – As alway, a wonderful column. Thank you. It brings to mind the paradoxical quote “Everything in moderation, including moderation.” (Oscar Wilde…. I think…).