Since Saturday, I’ve been attending the annual Financial Planning Association Conference here in Boston. As always, I’ve learned lots of great new things, but that is for another time.
Yesterday, the stock markets around the world had another very rocky day, with the Dow Jones Industrial Average dropping as much as 800 points before clawing back to a close of -358 points. As has been the case for several weeks now, investors around the world have been pouring money into US Treasury bills. So much so that the yield on the 1-month T-bill has dropped to 0.08%. That’s per year, folks. The 3-month T-bill yield is a little higher at 0.52% per year.
The level of fear has risen to highs not seen in at least 21 years, as measured by a widely followed Wall Street fear indicator. The so-called “VIX” (Index Symbol VXO.VXO) hit 66.42 yesterday, a level unsurpassed in its history except during the Crash of 1987, when it went as high as 150.19 (source: Reuters).
So what do we make of all this fear, panic and pessimism? I would like to share a few of the lessons I have learned over my career in the investment advisory business, which includes 23 years in the trenches plus another 3 years studying for my MBA in Financial Planning.
This marks the fifth stock market panic of my career. The first was the Black Monday Crash of ’87. My time also spans three recessions, four asset bubbles, inflation, deflation, and more financial disasters than I care to remember. I’ve also studied market manias leading back to the Tulip Mania of 1637 and of course the Great Depression.
I don’t mean to present what I’ve learned from all these experiences as facts, because I can’t predict the future, nor do we need to. Instead, these are truisms that I have learned to rely on, both by studying the lives of the world’s most successful investors, and through the first-hand lessons I have learned in my career. These have taught me what I believe I need to know to successfully navigate the financial markets, through the very best of times as well as the worst of the worst— times like now. Here goes:
- The Herd is almost always wrong. This means that to be truly successful at investing, you have to train yourself, and be bold enough, to go against the crowd, as difficult as that usually is.Think about it: one axiom of successful investing that we all know is, “buy low and sell high.” Yet that is impossible unless you are willing to be a seller when everyone around you is buying with wild abandon. Buying low is even more difficult. You have to be willing to buy when everyone else is selling. The Michael Phelpses of successful investors are able to, and actually aspire to be buyers when the herd is selling into an outright panic, like yesterday.Let’s run through some of the recent moves the Herd has made, to test the validity of lesson #1. During the Dot.com bubble, investors threw billions and billions into tech stocks and IPOs of internet companies that had no chance of survival. The higher these stocks soared, the more people dumped money into them, convincing themselves that “things were different” this time. In 2000, an investor survey taken by the Securities Industry Association showed that the average investor expected to earn a 33% return over the next year. This was exactly when the S&P 500 Index was preparing to plunge 50% and just before the NASDAQ dropped 75%.
About the time the Dot.com crash bottomed in October, 2002, and despite the fact that stocks went on to double in value over the next five years, the Herd didn’t want stocks any longer. They had moved on to houses. They became obsessed with buying and “flipping” homes and condos. And over the next several years, home prices skyrocketed. They would routinely receive multiple bids for tens and sometimes hundreds of thousands of dollars over the asking price, sometimes before the house was even listed. This activity went on until prices reached levels that could no longer be supported and the result was yet another crash. But because this time the assets had been purchased with leverage (mortgages), when the bubble burst, it led to the failure of many mortgage lenders and the unanticipated problems we have seen unfold in the wider credit markets in recent weeks.
By the way, when you are looking for someone to blame for the current crisis, don’t forget to include the foolish investors that borrowed unprecedented amounts of money to purchase houses at insanely high prices. Greed on Wall Street and in the banks, plus poor regulation of the mortgage industry are all partially to blame for the current crisis. But none of this would have happened without the willing participation and, yes greed, of those who bought all those homes in the first place.
Today, of course, the Herd is foaming at the mouth to get into US Treasuries. Imagine those college pranks during the 1920s where they tried to see how many students they could cram into a phone booth. That is basically what is happening worldwide with the Treasury market. Everyone is competing to buy assets that are essentially yielding nothing! Can you imagine anything more ridiculous than that?
- Emotions have no place in Investing. This is a corollary to #1 above. Of course, the reason the Herd does what it does is because they are not thinking rationally, but rather are being controlled completely by their emotions. Greed and fear are deadly to investment success. This explains why so many today are desperate to earn nothing on their T-bill investments.
- The recent past is not an accurate predictor of the future. An all-too common mistake I see clients repeatedly make is taking recent investment performance and extrapolating it forward into the future. For example, in a hot market, people become absolutely convinced that the recent outperformance will continue indefinitely into the future.Likewise, in a brutal bear market, they mistakenly believe that recent losses are somehow a predictor of the future. They commonly say something like, “If this continues, I will be completely broke in X years.” They also mistakenly believe that they could, “lose everything” in stocks, but the reality is, if they are adequately diversified, the only way they could lose everything would be if every company they are invested in worldwide went out of business.In Jason Zweig’s recent book, Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, the author explains the studies Neuroscientists have done to see what convinces people that they actually have the ability to predict what is going to happen with stocks, when in reality they are completely unpredictable. Turns out our brains, which evolved more than 200,000 years ago to react quickly to patterns and minuet changes in our environment, are not equipped to handle the randomness of the stock market; but nevertheless we attempt to create meaningful patterns where there are none and base our investment decisions on our erroneous assumptions. So our brains lead us to believe we understand and actually have the ability to predict which way stocks are going to move in the future. This is flat out false. Successful investors understand this and do not attempt to play that game. Using hunches and recent patterns of stock movement to predict the future is a sure way to go broke.
Today, in a recession, we tend to think that more bad news coming out will only drive stock prices down further. But this is not necessarily true. At this very moment, stock prices already fully reflect every known fact about the state of the economy. This means that expectations of most of the bad news that will likely come out in the coming months are already priced into the current market valuation. What will affect them going forward are changes to the consensus expectations. A more shallow recession will drive prices higher, while a deeper recession than currently expected would likely drive prices lower.
- Stocks do incredibly well during the later months of modern-day recessions. This will really mess with your primitive man brain. A study of the nine most recent recessions (starting in 1960) performed by LPL Financial Services, determined that the stock market hits bottom and starts rising, on average, six months before the recession actually ends. And, here’s the most interesting, and potentially profitable statistic from the study. By the time the recession ends, the stock market has already, on average, risen by 25%!!The lesson here is that we cannot just get out of stocks and wait until the economy looks better before getting back into them. By the time the economy starts to turn the corner–and we feel better about things– the market is usually already up—WAY up.
- Crises are scary but also provide great opportunities. The two Chinese characters at the top of this message represent Crisis. One character represents danger. We instinctively connect with that because we are scared. The other represents opportunity. But the average person never senses this, and completely loses out on the tremendous chance to profit.Today, stock prices are lower than they have been in many years. Share prices world-wide now trade for an average of about 1.5 times book or net asset value, the lowest level since 1985. They’re less than 0.8 times annual sales, their lowest levels since 1992. The dividend yield — if you trust it, of course – is nearly at a quarter-century high. According to FactSet, a market data monitor, share prices world-wide average less than 10 times forward earnings, also the lowest levels since the bargain-basement era of the early 1980s (source: Wall Street Journal).There are so many other tantalizing opportunities available today as well. I feel like a kid in a candy store. Here are some examples: stocks in China are off by more than 70%, emerging markets are down more than 40%, and European stocks are also down 40%. Investment grade corporate bonds are yielding several percentage points higher yield than Treasuries, and high-yield corporate bonds are yielding a whopping 12% above Treasuries. Opportunities to make money abound, almost everywhere you look.
Okay, so what now? History has demonstrated that if you had to follow just one rule in investing, it would be to do the opposite of what the Herd is doing. You don’t always get it right, but most of the time you do.
Today, the Herd is cramming into the phone booth of US Treasuries for shelter from the storm, and are willing to earn essentially nothing in return. If you weren’t feeling frightened at the moment, would you ever consider doing such a dumb thing?
We also know from history that buying stocks during severe bear markets has produced outsized returns over the next several years for patient investors. So if you don’t sell the stocks you currently have, the odds are in your favor that you could earn outsized returns in the years ahead also.
Most of our clients who are retired have low withdrawal rates and enough cash and fixed income (bond) investments to allow them to continue taking retirement withdrawals for 8-10 years without having to sell a single stock fund in their portfolios. Do you think 8-10 years is sufficient time for the markets to right themselves and get back to earning returns for investors? If so, then you should be able to survive the current market situation in good shape. If you don’t think 8-10 years is long enough for stocks to get back to doing well, then we should adjust your asset allocation.
For those clients not making portfolio withdrawals and not anticipating doing so, if you can sleep at night, then you shouldn’t need to change your asset allocation either. If you can’t sleep, let’s talk.
I don’t know when the current volatility will end, and I don’t know which direction the next 1000 point move will be. But I do know which direction the next 10,000 point move will be and it isn’t down.
We are going to be rebalancing in your account soon to take advantage of the current market conditions. If, after reading my remarks, you would like us to increase your exposure to stocks to slightly higher than the percentage we agreed upon when we began working together, in order to take advantage of the currently depressed stock prices, please send me an email or give a call.
Try to look for the opportunities that exist in the current situation. It really helps to look at things that way. For every terrified, despondent seller in the stock market yesterday when the market was down 800 points, there was a clear-headed buyer fully expecting to earn a great return on his purchase. And looking ahead, the odds overwhelmingly favor that buyer.
Finally, remember that we’re all going to get through this period. People are still going to buy groceries, go out to dinner, take vacations, take prescriptions, and spend money in Starbucks. And there are companies providing those products and services to them. The world is not coming to an end, despite what everyone in the phone booth thinks.
Call me if you want to talk. I’ll be home from Boston tonight.
Richard Del Monte