A long term client recently posed a fascinating question to me. He was dejected about seeing his portfolio decline this year, so I said to him, “Greg (his name is not really Greg), I know this year has been tough. But remember that you and I have been through a lot of bad markets. There was COVID in 2020 when the stock market fell over 40%. The 22% market decline in the summer of 2011 when the U.S. government threatened to default on its debt. The 2008 Global Financial Crisis when the market fell 54%. The three year recession from January of 2000 until October of 2002 when the stock market fell over 50%. There was 1990—1992 when the Savings and Loan industry collapsed and an entire industry disappeared from existence. And don’t forget, you and I were together on October 19, 1987 when the stock market crashed. I guess what I am saying Greg, is that we went through all of these debacles and your portfolio not only recovered, but went on to new heights in value.”
Greg thought about that for a moment and then responded, “I know you’re right, Joe. But, why does it hurt so much more this time?” And that, ladies and gentleman, is what we used to call the $64,000 question. It is something that I believe all investors are wondering. And so, I hope to answer that question. . .at least for my clients. So let’s give it a try!
I’ll begin by re-explaining my investment management philosophy. Because I do not believe it is feasible to make every possible dollar during good times nor do I believe it is possible to completely miss all of the decline during bad times, I do not attempt to do either. Rather, our long term clients know that historically, our out-performance has providing reasonable returns in good times. My strategy being, if we can lose less money than the overall market loses during declines, we will begin each market recovery at a higher level than the overall market. Let me ex-plain. If you had $100,000 in the S&P 500 when it dropped 20%, you would then have $80,000. To get back to even you need to make $20,000 (in other words you need to make 25% during the recovery). But, if you only lost 10% during the decline, you would have $90,000 and therefore only need to make $10,000 back during the recovery (meaning you only need to earn 11% to get back to even). At this point it is important to say that, while our long term clients can attest that we have been able to do that over the years, there is no guarantee that we will be able to do this in the future. Sounds easy, but how do we do this?
A stock is simply an ownership interest in a business. Over time, the market value of a business follows earnings. If earnings go up, the value goes up. If the earnings go down, the value goes down. It honestly is that simple. But in the short term (less than a year), the price of a company’s stock has nothing to do with the company’s profit. If people get enthusiastic, they buy and the price goes up. If they get pessimistic, they sell and the price goes down.
A bond is simply a loan. It doesn’t matter if the company’s profit goes up or down, or even if the company loses money. As long as they are solvent, you get interest paid to you and at maturity date, you get back your principal. People who are more interested in growth and are a bit more aggressive tend to buy stocks while people who are more conservative tend to buy bonds.
When Will It Stop Hurting So Bad ?
When people get pessimistic, they become conservative investors and sell their stocks, resulting in the stock market going down. Being that they are now conservative investors with money, they subsequently buy bonds, causing the bond market to go up. The result being, our clients have tended to experience much lower portfolio declines because when their stocks are declining in value, their bonds are rising. Alternatively, when people become more optimistic they become aggressive investors. They sell their bonds and buy stocks. This causes the bond market to decline but the stock market to rise. And now, their stocks rising offsets the declines in their bonds.
Both bonds and stocks make money for investors over the long term. But their short term divergence in price offset each other and bring ballast and stability to portfolios. UNTIL THIS YEAR (UGH!).
As of June 30th, the SPY (an ETF that mimics the S&P 500) is down ~ 21% this year. Simultaneously, this year the LQD (an ETF that mimics the bond market) is down ~ 17%. In the history of the United States of America (since 1788), do you know how many times the stock market and bond market have been down over 15% at the same time? The answer is NEVER! Wars, earthquakes, presidential assassinations, plagues, riots, whatever. In 234 years, it has never happened.
Therefore Greg, the reason why it hurts so much more this time is because everything we own to smooth out portfolio volatility is considerably down in value. Of course, this is all illogical because both sides can’t be right, but it is the world we live in to-day. Why is it happening now? Who knows? My guess is that this is the first time in history that we have had so many news outlets telling people that whatever they fear the most, will happen. “A recession is coming so sell your stocks!” “No, the economy is overheating so sell your bonds!”
But, I’m paid to invest money, not to be a media critic. So what’s my point? It’s that pretty much no matter what people own, it’s losing money. But there is some good news:
When people sell across the board regardless of quality, or value, or price, that is when opportunity abounds. Companies with record levels of cash and whose earnings are projected to grow at double-digit rates, have seen their share price this year decline 10%, 20%, 30% and even more. Mortgage rates are up over 3 1/2%, but the Fed has only raised interest rates 3/4%. This means the bond market has already discounted much of the future interest rate hikes.
In late 2020 when forecasters were warning of impending recession, I wrote that the economy would boom in 2021. At that time I said inflation would sore in the first half of 2022. Both of my forecasts proved to be correct. I also forecasted that inflation would decline in the back half of 2022, probably sometime after summer. If that forecast also comes to pass, we should expect a complete turnaround in sentiment.
In my 45 years of watching the financial markets, every single market bottom has occurred when no one believed it could happen. I believe there is a good chance that the Dow Jones Industrial Average bottomed on June 17th when it hit roughly 29,600. Regardless of whether that turns out to be the absolute low, I am convinced that in future years my clients biggest complaint about me will not be why I wasn’t more conservative in the 2nd and 3rd quarter of 2022. Rather the complaint will be, “Why weren’t you more aggressive with my portfolio?”
It is so hard to call the exact bottom in any financial market. And I may well indeed be wrong about June 17th being that market bottom. Fortunately, I don’t try to be that exact. I am convinced that much of the future pain that may come to our economy over the next few months has already been priced into stock and bond prices (i.e., the prices went down before any problem). And so I believe the downside risk has been mostly priced in. Maybe there is a bit more downside to go, maybe not. I don’t know for sure. My good acquaintance and legendary investor, Ron Barron, recently told CNBC’s Becky Quick, “Somebody has to tell people out there that this is the buying opportunity of a generation.” Who knows if he is right? But I do believe after this year’s severe de-cline, the risk now lies more in missing the current opportunity, even if that means living through whatever downside is left.
