“The time to do lifeboat drills is not after the ship has struck an iceberg”
– Nick Murray
In last month’s article, we reflected on events over the last 1,000 days since the onset of the Coronavirus pandemic. 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 to be prepared for the investing markets this year and to avoid unpleasant surprises.
The Year In Review
As we finish 2022, there remains more than enough uncertainty to go around after a year in which the financial and geopolitical chaos of our “post-Covid” world continued.
The central drama of the year—and, it seems likely, of the coming year—was the Federal Reserve’s belated but very aggressive efforts to bring inflation under control, which in turn sparked bear markets in both stocks and bonds. After rising seven-fold in the nearly 13 years between the trough of the Global Financial Crisis (March 9, 2009) and last January 3, the U.S. equity market sold off sharply in 2022. At its most recent low point in October, the S&P 500 was down over 27% from its high in January of last year. Bond prices also swooned in response to sharply higher interest rates.
It seems to us more than a little ironic that, after the serial nightmares through which it’s suffered since the onset of the pandemic early in 2020, the equity market managed to close out 2022 by about 19% higher than it was at the end of 2019. Not great, but not all bad for three years during which our entire economic, financial, political, and geopolitical world blew up.
If anything, this tends to validate our core investment strategy over these three years, which has simply been to stand fast, tune out the noise, and continue to work on your long-term plan. Needless to say, that continues to be our recommendation and in the strongest possible terms.
The burning question of the hour seems to be whether and to what extent the Fed, in its inflation-fighting zeal, might tip the economy into recession at some point—if it hasn’t already done so. Over the coming year, how this plays out may determine the near-term trend of equity prices. Our position continues to be that this outcome is simply unknowable and that one cannot make a rational investment policy out of an unknowable. That said, we continue to believe strongly that whatever it takes to put out the inflationary fire will be well worth it. Inflation is a cancer that affects everyone in our society; if recession proves to be the painful chemotherapy required to destroy that cancer, so be it.
Although this may be hard to remember every time the market gyrates and financial journalism shrieks over some meaningless monthly economic datum, we are not investing in the macroeconomy. Our portfolios largely consist of the ownership of enduringly successful companies—businesses that are even now refining their strategies opportunistically to meet the needs and wants of an eight-billion-person world. We like what we own.
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 recommend that you adopt a resolution to become a better investor by not allowing surprise to creep into your investing strategy this year because we have learned that “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.
When fear and panic set into 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 the fall of 2008, or March of 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 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 what makes us experience panic. Fear does not necessarily spring from the news of some economic or geopolitical crisis, like higher interest rates or recession fears. Fear comes because we are surprised by these events – we are blindsided by a reality for which we were not prepared and which 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.
The good news is that this resolution is relatively easy. The best way to avoid surprises is to understand the possibility that our investments will 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.
As 2023 begins, let us resolve to understand the historical incidence of bear markets such as the one we are experiencing right now.
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 during a time 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.
Bear markets 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 came in 1946-1949, which 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 2022.
Please note that we include here five 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 there is no way to predict future market conditions, we should be prepared that equities may continue to struggle this year. The current bear market has lasted 12 months, while the longest bearish period on this chart was 36 months. There is no telling how long a bear market might last.
- Historically, bear markets can cause temporary declines of 20% to 50% of equity capital, and the worst on this chart was down 57%, which is more than double the current decline.
- However, during this period of 75 years, the stock market moved from 19.3 in May of 1946 to 3,839 by the end of 2022. The patient investor over this period returned over 198 times her money.
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. Historically speaking, 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, 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. 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.
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.”
We here at Concentus don’t find much value in the tsunami of “forecasts” that are issued at this time of year by various market strategists and economists. We learned a long time ago that nobody could 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 whatever happens.
As you know, we believe that equities, with their potential for the 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 historically lower fixed return, seems to be an irrational investment— especially in a year after equities have declined like they did in 2022.
Having said that, we do think it is worthwhile to make the following observations about the current situation in comparison to similar bear markets in the past:
- The S&P 500 is now in a bear market that began almost exactly one year ago when the S&P hit a high of 4,819 on January 4th of 2022.
- The low point (so far) for this bear particular market was established on Oct. 13th, when the S&P 500 traded at 3,492, which represented a decline of just over 27% from the January high.
- Ironically, based upon the chart shown above, the average bear market since 1946 took just over 12 months to travel from peak to trough and experienced a total drawdown of just about 30%.
- There is no telling how much longer this bear market will last or how much lower the S&P 500 may go before it is over. However, compared to other bear markets in the past, this one has already experienced the same duration, and similar drawdown, as the average bear market of the past.
Just before the S&P 500 bottomed out in March 2009, a famous investor named Jeremy Grantham was quoted as saying:
“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.”
On Thursday morning, October 13th, the S&P 500 opened trading on a down note, declining to its lowest level of 2020. Then suddenly, the market experienced a massive rally and ended trading up 2.6% for the day. This “Intra Day Reversal” was the 5th largest such rally in the history of the S&P 500. The reason for this big day for equities is that there was an inflation report published that appeared to be just a tiny bit better than expected. In fact, it was just “a shade less black.”
Since that day, the S&P 500 continued to rise for the rest of the year and was up roughly another 7% by year-end.
Then again, on Friday, January 6th of this year, an unemployment report was published that appeared to be just a little bit better than expected, also just “a shade less black.” Once again, the S&P 500 responded by trading up by 2.28% in a single day.
That’s how a “turn” in equity prices always happens- when things still look bad but just a tiny bit better than they looked yesterday. And the worse things looked yesterday, and the more widespread investor pessimism was just prior to the “shade less black” day, the more explosive the turn will be.
We are, of course, not predicting that either of these trading days represented the inflection point that will signify the beginning of a new bull market. Only time will tell, and we will only know that in retrospect. However, that also means that by the time we can be sure, the market will already have gone up much more than it has so far.
Maybe a recession is still looming out there and will cause another serious decline in equity prices. And maybe that means that the bottom when it inevitably comes will be from even lower lows. But when the bottom comes, this period of October 13 to today is what it will look like. Keep in mind that back in March of 2009, when it seemed only faintly possible that “green shoots” were developing in the world economy, the equity market doubled in a year and never again looked back. Then again, at the end of March 2020, when it became clear that the Coronavirus was only just getting started, equities bottomed out on March 20th and were up by 73% just one year later.
Equity prices tend to behave like a rubber band: The deeper the market declines, the more violently it will snap back. Thus the long-term investor holding a meaningful cash position in the hope of investing at lower prices is taking a risk that we could never accept. We are much too conservative to make a big bet like that.
Please don’t mistake this for a forecast or a prediction about when equity prices will begin their next inevitable bull market. We have no idea when that will happen. But instead, think of it as simply a reminder that when the turn does, in fact, come, one would be ill-advised to be waiting in cash for some meaningfully lower level to get in on the action.
Having a Plan
As we launch into the excitement of a new year, It will be worth restating our overall principle of investment advice. It is goal-focused and planning-driven, as 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.
The unforeseen and indeed unforeseeable economic, market, political and geopolitical chaos of the three years since the onset of the pandemic demonstrates conclusively that the economy can never be consistently forecast nor the market consistently timed.
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; since 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.
Our essential principles of goal-focused portfolio management remain unchanged. The only benchmark we should care about is the one that indicates whether we are on track to accomplish our financial goals, and Risk should be measured as the probability that we won’t achieve our goals. 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 plans, 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.