“The time to do lifeboat drills is not after the ship has struck an iceberg”
In last month’s article, we reflected on an important anniversary in American economic and financial history. This month, we ring 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. We hope this article will help you prepare for the investing markets this year and avoid unpleasant surprises.
We here at Concentus don’t find much value in the tsunami of “forecasts” issued this time of year by various market strategists and economists. We learned a long time ago that nobody can consistently predict the markets or economy with any kind of accuracy, and this exercise usually makes a fool of the “expert” who has issued the forecast. We believe that there is little value in predicting what will happen, but there is great value in being prepared to think clearly and act appropriately no matter what happens.
As we enter 2022, there remains more than enough uncertainty to go around, but in general, we think it is most likely that in the coming year, the following may occur:
- The lethality of the virus continues to wane
- The world economy continues to reopen
- Corporate earnings continue to advance
- The Federal Reserve begins draining excess liquidity from the banking system, with some resulting increase in interest rates
- Inflation subsides somewhat
- Barring some other exogenous variable (which we can never really do), equity values continue to advance, though less than the blazing pace of the last two years
As you know, we believe that equities, with their potential for long-term growth of capital—and especially their long-term growth of dividends—seem to us the most rational approach in any environment, including the coming year. We believe that investing in cash, or bonds, with their lower fixed return, seems to be an irrational investment, particularly in today’s low-rate environment.
Please don’t mistake this for a forecast, but instead a list of the outcomes that seem most likely to us. We are fully prepared to be wrong on any or all of these points. If or when we are, our recommendations will be unaffected since our investment policy is driven entirely by the plan we have made, not by current events.
Surprise is the Mother of Panic
Having written all of the above, although we do not expect a significant market decline this year, we will certainly not be surprised if one comes along. We have learned to avoid surprises in our investing efforts because surprise is the “mother of panic.”
All good investing requires 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 rationally begins to deteriorate. Emotion is the enemy of sound investing policy.
This is particularly true of fear. When fear and panic set in our minds, it is almost impossible to act rationally, and we are most susceptible to our worst and most regrettable investing mistakes. For evidence of this, we need look no further than the millions of investors who liquidated their entire investment portfolios in fall 2008, or March 2020, in hopes of avoiding the global financial meltdown they were terrified was coming. Instead, as it turns out, those periods may have provided investors with the greatest buying opportunity of a generation, as stock prices plummeted far below their actual 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 what makes us experience panic. We believe that fear does not necessarily spring from the news of some economic or geopolitical crisis, a deadly virus, or even the fact that the stock market is declining. Fear comes because we are surprised by these event—we are blindsided by a reality for which we were not prepared, and it causes us to lose our bearings. This surprise causes us to lose our ability to make sense of the world around us, so 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.
A New Year Resolution
January is the time of year we all make our resolutions for better living in the coming year. As your investment advisors, we would recommend that you adopt a resolution to become a better investor by not allowing surprise to creep into your investing strategy this year.
The good news is that this resolution is relatively easy. The best way to avoid surprises is to understand the possibility that our investments may experience volatility this year, as well as the severity of that possible volatility. In other words, we must vigilantly school ourselves in the history of markets so that we can constantly 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 2022 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% decline in the market may not feel “shallow” while it is happening, we use that number to differentiate from a “full-blown bear market,” which takes prices down by 20% or more.
Fortunately, such corrections tend to be relatively brief and 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 for the year.
By way of 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 37 years, the stock market produced positive annual returns 28 times, and the index moved from 106 at the beginning of 1980 to 2,250 by the end of 2016.
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 birthplace of full-blown panic and can test the emotions of even the most seasoned investors. They are so scary because they almost always occur when the whole world is convinced of some geopolitical or economic catastrophe that is certain to tear down the fabric of our lives and the economy as we know it. Anyone who remembers what it felt like in fall 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 start to recover. In fact, the longest bear market since World War 2 occurred during 1946-1949 and 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 every five years. In fact, the following is a recent history of bear markets in the post-war era through 2021.
Please note that we include three episodes during which the S&P 500 declined by slightly less than 20%, 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% of equity capital.
- However, during this period of 75 years, the stock market moved from 19.3 in May of 1946 to 4,778 by the end of 2021. The patient investor over this period returned over 245 times her money.
Although we do not necessarily expect a bear market in 2022, we must keep in mind that bear markets happen, and they can be painful. Historically, however, they have always been temporary setbacks in the context of a long-term uptrend; the declines are temporary, and the advances are permanent.
Empowered vs. Victimized
Before we leave the topic of volatility, it is also important to point out a transformative insight that can be drawn from truly understanding this data, and which can allow the investor to use market declines as opportunities to remain confident, while everyone else around us is screaming in terror and uncertainty.
When we understand and come to peace with this data, we can begin to embrace equity volatility as a positive phenomenon and the reason for the premium return from equities. The term “volatility” refers to the equity market’s relatively large and unpredictable movements, both above and below its permanent uptrend line. Equities can, and frequently are, up over 20% one year and down 20% the next, and vice versa. However, if we believe that the long-run returns of equities will approximate the past return, we begin to understand that these periods of downside volatility must likewise at some point be corrected by a period of upside volatility, greater than the long-term average of roughly 10% per year.
Therefore, the premium returns of equities are the efficient market’s way of pricing 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. 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.”
CONTACT US TODAY
Preparing for the Future
Bear markets are the birthplace of full-blown panic and can test the emotions of even the most seasoned investors. Historically, however, they have been temporary setbacks in the context of a long-term uptrend. CONTACT US TODAY