Why Warren Buffett's advice to 'be fearful when others are greedy' is timely now

By Mark Hulbert

What goes up must come down: Stocks face a 'lost decade' after a record run

To everything there is a season - and the one coming doesn't look good for U.S. stocks.

The so-called Joseph Effect suggests the U.S. stock market will produce a below-average return over the next decade - and perhaps even an outright loss.

The Joseph Effect is the creation of mathematician Benoit Mandelbrot, and refers to the biblical Joseph's dream interpretation in the Book of Genesis that seven years of famine would follow seven years of feast. Mandelbrot found that in many areas, including the financial markets, periods of above-average performance are likely followed by below-average performance - and vice versa.

This tendency is evident in the U.S. stock market, as you can see in the chart above. It plots the stock market's trailing 10-year annualized inflation-adjusted total return. Notice the ebb and flow of stocks' 10-year returns. Your eyes don't deceive you: The correlation coefficient between trailing-10 and forward-10 returns is a statistically significant minus 30.3%.

Understand that the Joseph Effect's implied forecast for the stock market isn't based on valuation or any of the other indicators on which market timers typically focus. It also has nothing to do with the narratives that have captured Wall Street's attention. It is simply based on the tendency for periods of feast to be followed by famine, and vice versa.

Stay contrary to popular beliefs

This analysis illustrates the perils of setting future return expectations by extrapolating the past. Such an approach risks being most optimistic at precisely the times you should be most pessimistic, and vice versa.

Ben Inker, co-head of GMO's asset-allocation team, made this point in a recent report about what he called "lost decades." These are periods in which the traditional 60% stock/40% bond portfolio "either broke even relative to inflation or, even worse, lost money in real terms." By Inker's count, there have been six such periods in the U.S. since 1900, averaging 11 years each. To put Inker's finding another way, half the years since 1900 have occurred during one of these "lost decades."

That's sobering enough, but there's more. Inker found that these lost decades "all followed exceptionally strong periods of return" for the 60/40 portfolio - the Joseph Effect, in other words. Inker calculates that this portfolio over the past decade has produced a return about double its long-term average, and that's why he believes prospects for the next decade are so poor.

None of this discussion translates into short-term market-timing advice. Even if the next decade lives up to the historical pattern and is a below-average performer, the Joseph Effect doesn't help us project the path the market takes along the way. Therefore, you should not try to pick the exact day on which you move completely out of equities, but instead reduce your equity exposure gradually as the stock market's trailing 10-year return rises above the long-term average - just as you would want to increase your equity exposure as the market's trailing return drops below average.

As is often the case, Warren Buffett said it best when he argued that our job as investors is to be fearful when others are greedy and greedy when others are fearful. That's likely why Berkshire Hathaway's (BRK.A) (BRK.B) cash position is at a record high.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

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-Mark Hulbert

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10-02-24 0735ET

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