“The time to do lifeboat drills is not after the ship has struck an iceberg.”
– Nick Murray
At Concentus Wealth Advisors, we collectively possess roughly 150 years of experience in managing investments and advising clients. Over that time, we have come to learn quite a bit about the behavioral mindsets of a great investor, which we share in this monthly series.
In last month’s article, we focused on the value of perspective when it comes to investing. This month, we ring in the new year as we do every year, by re-publishing an updated version of our annual reminder of the importance of avoiding surprise in our investing efforts. We hope this article will help you in the year to come.
The Year That Was
Let’s go back to 2018, a dramatically outstanding year for the American economy – and for corporate earnings and dividends. However, the equity market couldn’t get out of its own way, and it ended on a terrific downbeat, declining by more than 19 percent in the fourth quarter.
2019 was the exact opposite. It was an exceptionally good year for the market— the S&P 500 returned 31.5%. Even though the economy slowed somewhat, manufacturing went into decline, and the earnings of the S&P 500 almost certainly ended down slightly year-over-year.
Without laboring the market’s course over the entire year, there were three key takeaways. First, it made up all of 2018’s drawdown and broke out at the end of April. It then corrected sharply, about which I’ll have more to say in a moment. Another series of new highs followed in June and July, which consolidated into the fall. The third and most dramatic breakout took place at the end of October, driving the S&P 500 to a series of new highs.
These three successive waves have been accompanied by a slowly growing realization that widespread fears of major disaster—trade wars tipping the economy into recession, a significant year-over-year downtick in earnings, and a constitutional crisis regarding impeachment – were overblown. This was particularly true with respect to the late October breakout and the virtual melt-up that followed. That upswing was ignited by a third-quarter earnings decline that proved far milder than almost anyone had forecast, and not one but two successive blowout monthly jobs reports.
With all of those rather dry facts out of the way, let’s return to the aforementioned May to June drawdown, which lasted about a month and took the S&P 500 down about 7%. Technically, this can’t even be classified a “correction,” as the Index didn’t close anywhere near 10 percent down. It was, nonetheless, a full-blown panic attack, set off by one of President Trump’s most bellicose tweets regarding China.
It is the way investors reacted to this relatively brief, relatively shallow drawdown that captured our attention. Simply stated, net liquidations of U.S. equity mutual funds and ETFs – absolutely, and especially contrasted with bond fund inflows – soared to levels not seen since 2008. Yes, it’s true: a one-month, 7% drawdown set off a flight from equities similar to the most existential financial crisis of our time.
Indeed, although the figures are incomplete as we write, 2019 almost certainly saw the greatest equity fund net liquidations on record, going back to 1992, according to the data provider Refinitiv/Lipper. This, mind you, after 10-plus years of 16% compound annual returns for the S&P 500. It is difficult for us to regard this information as anything but a powerfully suggestive contrary indicator.
Set aside momentarily, if you can, the headline issues of the day: the geopolitical situation with Iran, the trade situation, an aging economic expansion, impeachment/election uncertainty, and the like. These are not merely imponderable, they’re irrelevant to long-term, goal-focused investors.
Instead, we would invite you to focus on what seems to be the default setting of the investing public, which we would describe as pessimism verging occasionally into sheer panic. Our experience at Concentus suggests that very meaningful market setbacks have not historically occurred during huge waves of public pessimism and fear. Quite the contrary.
This is not to be taken as any sort of market forecast – we are planners not prognosticators. It is simply an invitation, as we look to 2020, to take some comfort from the rampant fear abroad in the land, even after a decade and more of stellar returns.
Having written all of this, although we do not expect a significant market decline this year, we will certainly not be surprised if one comes along.
Surprise Is The Mother Of Panic
Great investors understand that all good investing requires the control of our emotions in the face of uncertainty about the future. There is an inverse relationship between the intensity of emotion that we may be experiencing at any given moment, and our ability to think and act rationally. As our emotions crank up, our ability to act effectively begins to deteriorate. As a result, emotion is the enemy of sound investing policy.
This is particularly true of the emotion of fear. When fear and panic set in, it is almost impossible to understand reason and act rationally, and we are most susceptible to our worst and most regrettable mistakes. For evidence of this, we need look no further than the millions of investors who liquidated their entire investment portfolios in the Fall of 2008, in hopes of avoiding the global financial meltdown they were terrified was coming. Instead, as it turns out, that period may have provided investors with the greatest buying opportunity of a generation, as stock prices plummeted far below their real intrinsic value.
So how can we engineer our investment philosophy in a way that avoids the possibility of panic?
A good place to start is by understanding the nature of fear, and what makes us experience panic. In particular, it is our belief that fear does not necessarily spring from the news of some economic or geopolitical “crisis,” or even from the fact that the stock market is in decline. Fear comes because we are surprised by these events – we are blindsided by a reality for which we are not prepared, causing us to lose our bearings and our ability to make sense of the world around us. As a result, we become fearful and uncertain about what will come next.
The best way to prevent fear and panic from sabotaging our investment program is thus to prevent ourselves from being surprised by events. In the simple wisdom of Nick Murray, we must do our lifeboat drills before the ship sails out of port and has any chance of striking an iceberg.
A New Year Resolution
January is the time of year we all make our resolutions for better living in the coming year. We would recommend that you adopt a resolution to become a better investor by not allowing surprise to creep into your investing strategy.
The good news is that this resolution is relatively easy. The best way to avoid surprise is to understand both the possibility, as well as the probability, that our investments will experience volatility this year, as well as the severity of that possible volatility. In other words, let’s remind ourselves of the difference between volatility (the normal incidence of temporary decline) and risk (the historically nonexistent chance of permanent loss) in our portfolio strategy.
So, as 2020 begins, let us resolve to understand the historical incidence of stock market corrections, as well as full-blown bear markets.
Stock Market Corrections
We define a “correction” in the stock market as a short-term, relatively shallow (20% or less) decline in stock prices. While a 10 to 20 percent decline in the market may not feel “shallow” while it is happening, we use that number as a way to differentiate from a full-blown bear market, which takes prices down by 20% or more. In fact, such a “shallow” decline can bring forth every ounce of fear and panic among ordinary investors, as corrections are usually accompanied by news of some pending geopolitical or economic crisis.
Fortunately, such corrections tend to be relatively brief, and they usually last for only a month or two before they burn out and markets recover. They are also very common – in fact, it is not uncommon to experience one or more such corrections during the course of a year, even when the stock market advances overall. It is very important to remember that such corrections happen all the time and should be expected on average at least once a year. To make a recent example:
Between 1980 and 2016, the average yearly “intra-year” decline in the S&P 500 exceeded 14%. This means that, on average, the stock market declined by 14% at least once a year! However, during that period of 36 years, the stock market produced positive annual returns 29 times, and the index moved from 106 to 2,506 in that span.
The lesson from this data is that market “corrections” are to be expected roughly once a year, even in bull markets, and even during years in which the stock market as a whole advances.
We define a “bear market” in the stock market as a more extended, steep (20% or more) decline in stock prices. Bear markets are the common birthplace of full-blown panic, and they can test the emotions of even the most-seasoned investors. They are scary because they almost always occur during a time when the whole world is convinced of some geopolitical or economic catastrophe, which is certain to tear down the fabric of our lives and economy as we know it. Anyone who remembers what it felt like in the Fall of 2008, when it seemed that the world economy and capital markets were on the verge of collapse, knows this feeling of terror.
Bear markets take a little longer to unfold, and usually last for a year or two before they burn out and markets recover. In fact, the longest bear market since World War 2 came in 1946-1949, and it took 36.5 months for the S&P 500 to travel from its peak to its trough. Fortunately, bear markets happen less frequently, and should be expected on average about every five years. In fact, the following is a recent history of bear markets in the post-war era through 2017.
Please note that we include here three episodes during which the S&P 500 declined by slightly less than 20 percent, simply because they felt like bear markets too. In addition, this chart does not include dividends in the S&P 500 return, which makes these bear markets appear worse than they really were. As a result, this chart brings the investor closer to the actual emotions experienced in real time when the bear actually strikes.
The takeaways from this chart are:
Although we are not predicting a bear market this year, we should be prepared that one can spring up any time. Bear markets happen all the time, about once every five years on average.
Historically, bear markets can cause temporary declines of 20 to 50 percent of equity capital.
During this period of 70 years, the stock market moved from 19 in May of 1946 to 3,230 by the end of 2019. The patient investor over this period returned over 160 times his or her money.
Although we do not necessarily expect a bear market in 2020, we must keep in mind that bear markets happen, and they can be painful. However, historically, they have always been temporary setbacks in the context of a long-term uptrend – the declines are temporary, the advances are permanent.
Empowered vs. Victimized
There is a transformative insight that can be drawn from truly understanding this data. When we understand and come to peace with this data, we can begin to see equity volatility as a positive phenomenon, and, in fact, the reason for the premium return from equities. The term “volatility” refers to the relatively large and unpredictable movements of the equity market, both above and below its permanent uptrend line. If we accept that the long-run returns of equities will approximate the past return, we begin to understand that these periods of downside volatility must likewise be corrected by a period of upside volatility at some point, greater than the long-term average of roughly 10% per year.
The premium returns of equities are, therefore, the efficient market’s way of pricing in adequate compensation for tolerating such unpredictability. Volatility is the reason equity investors are rewarded over time with premium returns, as long as we have the emotional strength to live through it. Volatility is not to be survived, it is to be embraced and thrived upon.
For the wise and patient investor, it also provides a unique opportunity to accumulate more equities during a time when prices are temporarily depressed…kind of like a big sale.
Having A Plan
It’s worth restating our overall principle of investment advice, which is goal-focused and planning-driven. This is sharply distinguished from an approach that is market-focused and current-events-driven. Long-term investment success comes from continuously acting on a plan. Investment failure proceeds from continually reacting to current events in the economy and the markets.
We are long-term equity investors, working steadily toward the achievement of our most-cherished lifetime goals. We make no attempt to forecast the equity market; we accept that the equity market cannot be consistently timed by us or anyone. We believe that the only way to be sure of capturing the full premium return of equities is to ride out their frequent, but ultimately temporary, declines. As the numbers in this article prove, at least historically, the permanent advance has triumphed over the temporary declines.
The only benchmark we care about is the one that indicates whether we are on track to accomplish our financial goals. Risk is measured as the probability that we won’t achieve our goals, and investing should have the exclusive goal of minimizing that risk.
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.