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.