A favorite concept in economics is Stein’s law. It 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 the government’s debt load 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 have changed. Stein, in other words, was cautioning against what today we would call recency bias—the tendency to simply extrapolate from recent trends into the future. Given all of the uncertainty in the world today, 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 either to support or to 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 is, “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 to Amazon. To be sure, they’re on a roll, but just as trees don’t grow to the sky, history indicates they probably won’t maintain their dominance forever.
That’s one of the 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, according to these aphorisms, trends sometimes continue and sometimes don’t, then how should we think about this? The answer—as with many things in finance—is that it’s not a binary choice. Each of these ideas has some truth in certain situations.
We need only look back to past market leaders, including Xerox, Kodak or BlackBerry, to appreciate that market trends—especially in technology—don’t last forever. That’s mostly intuitive and hard to dispute. In fact, Jeff Bezos himself has talked about this. In a 2018 speech to Amazon workers, 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 a hundred-plus years.” While there are exceptions to this rule, it has generally been the case, and it supports Stein’s law. Product and technology trends eventually fade or change course and don’t go on forever.
What’s perhaps less intuitive is that there is clear data pointing in the other direction. While it’s true that trends rarely continue forever, the data shows that market trends sometimes continue longer than one might expect. According to research by investment firm AQR, “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 market leaders, have been going strong for about a decade.
Frustrating as it might seem, then, the reality of the investment world is that any trend we observe underway 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” or international economies that look dominant. It’s very 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 three years ago a virus would arrive out of the blue, cause the market to drop more than 30%, but then rally back within weeks to go on to reach new highs. Similarly, I don’t know any investors who predicted the war in Ukraine, and how that would prompt energy stocks to rally, for a period, to a market-leading position after years of going sideways. You could find similar examples throughout market history. That’s why, repetitive as it may sound, I recommend steering clear of stock-picking. When you own index funds, you 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 important to not 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. And since that’s the case, 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 whether it would make sense to sell out of stocks and instead 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. Among other reasons, it’s because 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. For a period of years 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. That, of course, was quickly proven wrong, but for a while it had its adherents. The lesson, in my view: 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.
P.S. Economists may not be known for having too much of a sense of humor, 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.
