“Everybody has a plan until they get punched in the mouth.”
– Mike Tyson
In last month’s article, we rung in the New Year as we do every year by re-publishing our annual reminder of the importance of avoiding surprises in our investing efforts. This month, we explore the many ways in which Mr. Market can punch investors in the mouth if we are not careful.
Growing Wealth Effortlessly
At the risk of “beating a dead horse,” we begin this month by repeating the point that remains the primary theme of this newsletter series and our investing philosophy here at Concentus. That is, mainstream equities are by far the most reliable and perfectly effortless method of slowly but inevitably achieving life-changing growth of your wealth.
We highlight the words perfectly effortless because, really, all an American investor has had to do to earn a long-term return of just about 10% is to buy a diversified portfolio of mainstream equities and continue to hold them despite the regular gyrations in their market prices. As we have suggested many times in the past, great investors “earn” superior investment results by doing nothing, even when the volatility of equity prices creates an emotional rollercoaster ride.
Like many things in life, this task is simple but not necessarily easy. It is also the primary skill that any great investor must possess.
As our latest demonstration of this fact, consider the following “scoreboard,” which depicts some key equity market performance statistics achieved over the lifetime of a new retiree in America today. Someone turning 62 this year and preparing for retirement has seen the following results in the financial markets. As you can see, over their entire lives, mainstream equities have been the simplest and most effortless way of building real wealth and increasing their purchasing power over time at a far greater rate than inflation has eroded it.
The Serpent Strikes
For as easy as it has been to effortlessly clip an annual return of 10% over time by simply holding a diverse portfolio of companies, for some unknown reason, the prospect of multiplying wealth inevitably and effortlessly is just not enough for so many investors. They want more: they want to outperform the market.
It is almost as if effortless compounding in equities is an earthly paradise of wealth creation, where all we need to do is patiently hold our equity portfolio over time and watch it inevitably grow larger. However, being only human, we begin to hear the voice of the Serpent of Markets, who whispers in our ear:
“You can beat this thing. You don’t have to be tied to old-school disciplines like asset allocation and diversification, and you certainly don’t have to sit there like a victim when markets are down. You’re smart, and you can see where the action is. You can outperform.”
When we bite into the apple of outperformance, taking the focus of our investing efforts off of our long-term goals and placing it on the temporary gyrations of the market itself, we commit the original investing sin. And every classic, return-destroying behavioral mistake that our human nature will make comes rushing into our financial, and even our emotional, lives. The serpent offers you the illusion of consistently superior outperformance, but in reality, he has come to punch you in the mouth.
One of the most common ways he tempts us is through the illusion that we can figure out the volatile ups and downs of equity prices and can successfully jump in and out of equities at the most opportune times, based on current events. He offers us the apple of fool-proof market timing, which will allow us to participate only in the market’s ups, without having to expose our capital to its inevitable drawdowns.
And the most common time he will whisper this promise in our ear is when things are not going well when the economy is in recession, and markets are struggling. Times like right now.
Two Critical Decisions
Successful market timing requires the investor to make two critical decisions correctly. First, you have to have the correct timing when you exit your equity positions – the stock market has to keep going down after you sell. More importantly, you have to buy back your equities at some point when the stock market is still lower than your exit point – you have to get back in at a cheaper point than you sold. Even if you make the first decision right, if you don’t get this second decision correct, the whole exercise was all for naught.
The first of these two decisions is easier than the second, although it is by no means easy. When an investor decides to sell her equities in anticipation of some future market decline, she must do so knowing that the odds are much greater than the future will bring higher equity prices instead of lower ones. She may be forced to buy her portfolio back at a higher price than she sold. As the chart below demonstrates, equities go up most of the time, and most market timers’ risk being “punched in the mouth” when equities begin rising soon after they decide to sell and go to cash.
Various Rolling periods with positive returns (Dividends Reinvested) for the S&P 500 from 1926 through 2022
However, even for those who are lucky enough to make this first critical decision and get out of equities correctly, the second decision is just about impossible to execute correctly.
When an investor makes a plan to time the market, it is usually driven by the emotion of fear: her logic is that she expects equities to decline further in the future, and she fears that she will experience a loss of capital, and so she is motivated to avoid that loss by selling her equities. However, it is this same emotion of fear which causes the investor to lack an effective plan for getting back into the market. Typically, since fear was the reason she planned to sell, the average market timer plans to buy back in when the fear is no longer there or when the current source of investing volatility is no longer as much of a concern.
Typically, this plan is expressed with some version of the statement that “I’d like to sit on the sidelines until things settle down.” or “Let’s just go to cash until the market looks better.”
A Shade Less Black
In our last newsletter, we offered the following insightful quote from famed investor Jeremy Grantham, who said right before the market bottom in 2009:
“Be aware that the market does not turn when it sees the light at the end of the tunnel. It turns when all looks black, but just a shade less black than the day before.”
It is this reality that makes successful market timing almost impossible. When equity prices recover from bearish conditions, they almost always begin to recover before the light appears at the end of the tunnel and when things still “look black” in the world and the economy. It is enough for things to simply appear “a shade less black” to spark a powerful recovery in equity prices.
Therefore, the market timer who sold her equities in fear that things were “looking black” and is planning to buy her stocks back cheaper when “things look better” is almost guaranteed to buy her portfolio back for more than she sold it. When the market begins to recover from a decline, it will inevitably do so when things still look terrible in the economy, and by the time “things look better,” equity prices are nearly guaranteed to have already recovered to higher levels, and any investor who predicated her getting back in on waiting for things to settle down is bound to miss it.
For example, consider the following major equity market recoveries in recent history:
In March of 2003, the US economy was still struggling to shake off the recession which had been sparked by the bursting of the tech bubble, and confidence in corporate America was seriously shaken thanks to a series of high-profile bankruptcy and accounting scandals. The U.S. was also on the brink of a war in the Middle East. However, somehow the bear market suddenly turned on March 14th of that year, and the S&P 500 was up roughly 37% a year later.
Likewise, in March of 2008, the global economy was still reeling from the Great Financial Crisis, and the gloomy headlines of the day spoke of recession, stagnation, and bankruptcy. Yet somehow, the equity market noticed some “green shoots” among the dead underbrush and began to rally. A year later, the S&P 500 was 38% higher, on its way to one of the greatest bull market runs of all time.
Finally, in March 2020, the S&P 500 experienced a free fall as stocks fell by roughly 35% in 30 days. By April 1st of that year, the bad news about Covid was just getting started, but stocks shrugged off this dark news and began to rally. A year later, the S&P 500 was roughly 75% higher.
Punched in the Mouth
Today’s current conditions provide a perfect case in point for why it is only natural to believe that we can “figure out” the equity market and make a plan to beat it.
After all, by the end of 2022, equities were enmeshed in a grinding bear market that had lasted almost a year and caused stocks to decline as much as 27%. Most analysts were calling for a recession in 2023 to go along with a continuation of bearish market conditions. What’s more, thanks to Federal Reserve interest rate hikes, there was finally a safe alternative to equities—the yield for a guaranteed 1-year Treasury Bill had risen to almost 4.8%. It seemed almost impossible that equities would outperform that guaranteed rate over the next year, and perfectly logical to sell one’s stocks for a little while, hide out in Treasuries, and wait for things to get better.
As if one needed more reason to follow this logic, on December 10th, the lead headline on Yahoo Finance announced that the “World’s top stock strategist says an ‘Earnings Recession’ is coming for the economy, and it could be similar to what happened in the 2008 financial crisis.” Indeed, Morgan Stanley’s chief strategist Mike Wilson, who had been named the world’s top stock strategist in 2022 by Institutional Investor magazine, suggested that in 2023 the S&P 500 would visit lows in the range of 3,000 to 3,300. Given the fact that the S&P 500 closed at a level of 3,934 that day, this was a scary forecast indeed.
Things certainly “looked black” in the economy and markets on December 10th, and it seemed perfectly logical to want to “hide out in cash” for a little while until the coast clears later this year.
Although this plan may have appeared logical, Mr. Market has had other ideas. Since December 10th, the S&P 500 has not actually continued to decline but instead began to rally and closed on February 2nd just about 6% higher than it was on December 10th.
However, this increase in value over the past two months doesn’t mean anything in particular. Mr. Market could be throwing us a head fake, on his way to taking the S&P 500 back down to Mr. Wilson’s target of 3,000. Or, this latest rally in stocks may be the sign that equities are finally ready to emerge from the bear market of 2022, and experience the kind of powerful rally that has followed other bear markets in history.
In either case, the investor who decided to “hide out in cash” two months ago is now in the unpleasant situation of having to make a high-stakes prediction about which is which. Should she stay in cash, and risk missing out on a recovery of 30% or more in equities? Or buy back her portfolio now, at a higher price than she sold it, and risk experiencing another significant dip in equity prices? How much sleep do you think she is missing at night as this decision plays on her emotions?
This investor has been officially punched in the mouth by Mr. Market.
Having a Plan
The very best investors have a disciplined approach to making portfolio decisions, and always stick to their plan, no matter what the rest of the world is doing. They are able to live through the peaks of euphoria, as well as the depths of terror, with a healthy understanding that a well-designed written investment and financial plan will get them through both.