The market sell-off that began in late February has continued through mid-March. For all of us, this is arguably the least important aspect of the crisis, with the health and safety of our loved ones and fellow citizens the most important. But since we are entrusted with the stewardship of our clients’ financial lives, we will focus this communication on the market reaction to the crisis.
While the reason for the sell-off is new and unprecedented – a forced halt of economic activity due to a virus – the nature of the panic itself is not new. Extreme selling begets more selling leading investors to all rush for the exits at the same time.
Some of this selling is entirely warranted. If you need to shore up your personal finances to get through a period of unemployment, or you are leveraged and need to raise cash to cover a margin call, then selling stocks may be your only option.
But selling financial assets like stocks and bonds in an effort to “manage risk” and “avoid” more downside, while comforting, may paradoxically increase your long-term risk. Before joining the herd selling mentality consider the following risks:
One of the obvious risks of selling stocks after a crash or during a panic is timing. If you sell now, when will you know the best time to re-enter the market? Chances are good that at the bottom, wherever and whenever we reach it, no one will want to buy. Oddly, Wall Street is the only market place in the world where nobody shows up when the merchandise goes on sale.
The majority of investors will wait until it feels safe to get back in. By then, most likely, prices will be higher than where you sold. We saw this dynamic play out in real time during the financial crisis. The market offered up “once in a century bargains” with only a few astute takers. Some investors who sold waited years and years to re-enter. Finally feeling good about stocks at higher prices.
The two charts below from Michael Batnick at The Irrelevant Investor provide some interesting perspective on market selloffs and recoveries. The first shows the average return of the S&P 500 following various levels of decline. Note that declines are generally followed by positive returns and that the relationship between declines and returns is inverse. The greater the decline the higher the future return.
The second chart is even more interesting as it highlights not the average return, but the worst return achieved following various levels of decline. The bad news is that the worst return over a 3 and six month period is typically not very good, though it improves as the decline steepens. The good news is that returns following steep declines improve markedly over the 1 and 3 year time horizons. Yes, markets can and likely will go lower. But if you are not a forced seller, then trying to time your entry and exits over a short period of time will likely lead to frustration.
Isn’t cash a safe harbor in the storm? Consider what the Federal Reserve has committed to doing. Our central bank is adding trillions of new dollars to the money supply while at the same time dropping interest rates to zero. Under this scenario, it’s a good bet that the value of cash (i.e. purchasing power) falls. This kind of dilution in the money supply should have the effect of a soup kitchen that waters down the stalk. There is more supply and less nutritional value in a watered-down bowl of soup. If you’re in cash, prepare to be diluted.
For savers, this adds the additional problem of generating a reasonable or fair rate of return on your money. The chart below shows the income generated by savings and cash investment accounts vs. inflation over the last 25 years. 2018 finally saw cash returns recover to nearly match inflation following an eleven year hiatus. Recent Fed actions have pushed cash returns back towards zero. An astute observer might ask, where will all of this cash go to find a return?
Lessons of History
Regardless of the above rationale, we recognize that market panics are as much about investor behavior and psychology as anything else. Sellers today are not asking what the asset they are selling is worth. They are simply asking to get off the rollercoaster.
This is why one of our firm’s five core principles is: “volatility is not risk”. Real risk is the likelihood of permanent capital impairment. What are the odds that an investment that we purchased will permanently go down and never come back, or even worse, go bankrupt? We focus most of our risk management efforts on trying to answer this question before a crisis so that we can ride through the volatility of the crisis and come out the other end.
We quote our principles often in quarterly letters and in a normal functioning market of rational buyers and sellers they are easy to ignore. But these principles were forged through our experience navigating several crises in the early part of the century including the tech bubble, 9/11 and the financial crisis. Now we are facing a new crisis. And we will rely on our principles to see us through.
During the 2008 crisis, the Federal Reserve and other central banks reflated the system with cheap money. The best hedge against monetary inflation was a broadly diversified portfolio of high quality stocks. In 2007 at the market’s peak, the Dow Jones Averages traded above 13,000 before falling 50 percent. Even after the “great recession of 2008,” the Dow is sharply higher today than it was at its prior high. The Dow peaked around 10,000 just before the “tech-wreck” of 2000, followed by the 9/11 attacks on U.S. soil. This was unprecedented, yet markets are sharply higher today. And, just before the dramatic stock market crash of 1987, the Dow was approximately 2200. Today, values have increased almost ten-fold.
Where will financial market indexes trade in five or ten years is anyone’s guess, but odds are very high that prices will inflate. Our system demands it. For this and other reasons, we believe it is prudent for our clients to hedge against money supply dilution as a way to protect their purchasing power.
Our primary objective is to manage your account with a steady hand and level head. We remain confident that over time, our clients will benefit from a properly diversified portfolio of stocks, fixed income, and alternative investments.