If you deploy long-term cash now, and the equity market continues to decline, you will experience some short- to intermediate-term regret. If you continue to hold cash, waiting for a clear signal, one fine day the market will explode, and you will never catch up with it. This will engender regret that lasts a lifetime. And the most powerful emotion in investing is long-term regret.
The risk of owning equities now is not that you will get caught in a further decline of, say, 20% or whatever. The risk is that you will get caught out of the next 100% advance, an eventuality which your retirement plan can never survive.
– Nick Murray
In last month’s article, we exposed the fundamental “unknowability” of the future. This month, we once again revisit the best approach to a Bear Market: Buy more equities before the “Sale” is over.
The Bear Returns
As we detailed in our June commentary, the equity market officially broke into “bear market” territory on June 14, 2022. After hitting an all-time high of 4,796 on January 3rd, the S&P 500 closed on June 14th at 3,749, for a total decline of almost 22%, which officially qualifies this decline as a bear market.
Soon after reaching that low point, the S&P 500 experienced a powerful upside rally for the next two months, recovering by almost 15% to 4,305 by the middle of August and inspiring hopes that this bear market was already over.
Unfortunately, such hopes have been disappointing, as rising inflation and interest rates have caused a new wave of recession fears and a corresponding slump in equity prices. As we write this on October 12th, the S&P has lost all of those recovery gains and declined even below the June low to a level of 3,589—a fall of almost 25% from January’s market high. Clearly, the bear market is not yet over and may have longer still to run.
As we detailed in our June commentary, which we strongly encourage you to read once again, history has shown quite definitively that a Bear Market is:
- A terrible time for a long term investor to sell the equity portfolio that you currently own.
- A wonderful time for a long term investor to add to your equity holdings, while stocks are still on sale.
There are no exceptions to these two rules in the history of the American stock market. To underscore this point, we once again offer the same chart, and pose the same question, which we asked back in June.
First, the chart:
Second, the questions:
Imagine that you were somehow granted the use of a time machine and could go back in time to any of the dates shown on the chart, during which the S&P experienced a peak just before the occurrence of a vicious bear market. Knowing where the S&P 500 is trading today, would you welcome the opportunity to return to any of these dates and invest your capital at that peak? Would you further seize on the opportunity to invest at any of the troughs shown on the chart?
The Lizard Brain
Lizard brain (noun; anatomy, psychology)
The most primitive part of the brain; the brain stem. (by extension) Any part of a person’s psyche or personality is dominated by instinct or impulse rather than rational thought.
No rational investor could ever answer no to the questions posed above. After reviewing the long-term price chart of the S&P 500, any logical investor would see immediately that a bear market in stocks is a great time to load up on more equities while they are cheap and that selling stocks while they are in temporary decline is a terrible idea.
Yet, this is precisely when we all feel a powerful urge to panic and “get out while we still can.” It is the moment of maximum fear, when our rational brain is short-circuited, our “lizard brain” kicks in, and we are inspired by a powerful impulse for self-preservation. In our emotional fog of fear, the only way we can see is by selling our equities immediately to stop the pain of loss.
We are all hard-wired to do this, which is why human nature is a failed investor.
Why on earth do we do this? Why do we allow our emotions to hijack our reason and cause us to throw rational decision-making out the window? After 50 years of advising families about their investments, we have come to believe it is some combination of two illusions that somehow take hold in our brains.
The Extrapolation Fallacy
When things are going poorly in the world economy and the markets, we tend to fantasize about how the current troubles—despite all historical evidence to the contrary—are somehow capable of fatally wounding the private economy and, thus, our personal wealth. This fatal vision is usually fueled by our tendency to extrapolate the current undesirable trend all the way to the horizon, where it will cause us to fall off the edge of the world into a terrible void.
For instance, we can begin to imagine a scenario in which inflation continues to run so far out of control that the Federal Reserve cannot arrest its growth. The monetary authorities will be forced to raise interest rates to such an astronomical level that the resulting recession will bring on a global depression, from which the world can never again recover.
As investors, we may have logged on to view our brokerage account on Monday, August 15th (the last high) and been delighted to see that we had a portfolio of $1 million. Now, eight weeks later, it is only worth $840,000. After experiencing a decline like that, it is mathematically true to say that at the current rate, we will be totally wiped out in a little more than a year. Of course, such a statement would also be quite irrational, given the reality of the history of equity markets described by the chart above.
It is not strictly impossible that markets will continue to decline at the current rate forever until all the companies in the S&P 500 are bankrupt and our portfolios go to zero. It is also nowhere close to being probable. Armageddon is always at least a theoretical possibility, but it is no way to make an investment policy.
The more historically probable outcome is that, regardless of how long and painful the current bear market is yet to become, it will eventually hit a bottom and begin to recover. It will regain its all-time high again, and then it will rise further. Just like it has after every other bear market in the history of the U.S. economy. In the words of Nick Murray, “The risk of owning equities now is not that you will get caught in a further decline of, say, 20% or whatever. The risk is that you will get caught out of the next 100% advance, an eventuality which your retirement plan can never survive.”
The Fatal Myth
Genuine panic capable of making any rational investor fall prey to their lizard brain during bear markets always requires that three conditions must be met.
First, we have to be experiencing a global financial trend that no one can understand.
Second, we have to conclude that this crisis is insoluble, that this problem cannot be solved, and that nothing can stop it from incinerating the economy and the stock market.
And third, despite being aware that no financial, fiscal, monetary, economic, or political crisis ever in the history of the world has been capable of inflicting a permanent loss on equity values, this one will. In short, we begin to believe the four most fatal words that an investor can utter:
This time it’s different.
If you have lived to an age where you accumulated enough capital to invest, you’ve already lived through any number of crises in the investing world. And you’ve watched as the economy and the markets dealt with them, muddled through, endured, and then surged to new heights. To panic, you have to conclude that nothing matters, that we have entered a new world so terrible that history and its old laws no longer apply. Typically, you have to believe that this particular crisis is unlike any other that the world has faced before and that we are in entirely new territory.
Inflation, Recession, and A Frantic Bear Market
“The only new thing in the world is the history that you do not know.” – Harry S. Truman
It is almost always true that we are so surprised by the current crisis the economy and markets face, not because this particular crisis has never happened before, but because it has never happened to us.
For example, almost no current investor in America had the capital to be an investor in 1970, so almost nobody in the financial markets today has any recollection of a time when the world faced conditions such as we face today. For most of us, we are actually in new territory. However, that certainly doesn’t mean that this set of circumstances has never happened in the world before. For evidence of this, we offer an image of the front page of Life magazine from June 5, 1970.
As it turns out, in 1970, the U.S. entered a period during which inflation began to accelerate and then run completely out of control. Interestingly, that particular inflationary episode was also at least partially brought on by an energy crisis and skyrocketing oil prices. At that time, the monetary authorities in the U.S. didn’t have the political will to address this inflation by raising interest rates. Our nation suffered a dozen years of cancerous inflation, which peaked at an astounding 13% in 1980.
The Federal Reserve in the 1970s took much longer to tackle inflation than today’s Fed, which seems quite serious about addressing this problem by raising interest rates. However, eventually, Paul Volcker took the reins of monetary policy and engineered the mother of all economic hard landings. He hiked interest rates to such a point where the prime lending rate went to 20%, and unemployment peaked at 10%. Of course, these conditions seem outrageously impossible to us today, but they actually occurred. Can you imagine a 20% mortgage rate on your home? It really happened.
Mr. Volcker successfully drove a stake through the heart of inflation, which eventually set off one of the greatest bull markets of all time. The S&P 500 doubled in a year and tripled in five years. It may also be worth noting that on the date of this magazine cover, Monday, June 5, 1970, the S&P 500 closed at a level of 76, so it has now risen by just about 47 times over the intervening 52 years.
Empowered vs. Victimized
Before we leave the topic of bear markets, our standard advice for what to do in a bear market is worth repeating. As always, we encourage you to use market declines as opportunities to remain confident while everyone else around us is screaming in terror and uncertainty.
We believe that enduring volatility is why 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.
In the fullness of time, each scary episode shown on our bear market chart above can now be regarded as an exceptional buying opportunity for patient, long-term investors. Far from an opportunity to sell or reduce your equity exposure, at Concentus, we regard the recent volatility as a buying opportunity. While equity prices may very well be lower in a month, in six months, or in a year, we are confident that investors with a reasonable time horizon of 5 years or longer can feel very comfortable using this current volatility as a great opportunity to buy equities while they are “on sale.”
For our clients and friends who are already fully invested in equities, we advise that you stay that way. For those who are funding periodic savings plans such as a 401k plan, we suggest you temporarily accelerate your pace of investment if you can afford to. And for those lucky enough to be sitting on a more meaningful stash of cash or bonds…opportunity is knocking.
As always, we welcome your inquiries about this issue. In the meantime, we think the most helpful—and certainly most heartfelt—investment advice we can offer would be that you turn off the television set.