4 Learnings (so far) During the Latest Bear Market
Markus Muhs - Apr 02, 2020
Partway through this current bear market, I decided to start documenting some learnings.
I figure, best to do this during the market crash than afterward; sort of like writing a diary. We’re obviously not through this yet, but what have we learned along the way so far? We have a lot of market history to look back on and a lot to learn via textbooks and such, but nothing beats actual experiential learning. I consider myself to be ten times wiser having started my career in early 2008 than I would have been if I had started a year or two later. That time period is but a memory now; one that’s still fairly sharp in my mind, but I wish I had written a diary at that time.
Clients are often put through a risk questionnaire before they start investing that poses all sorts of questions pertaining to how they would react to risk. The one question that’s pretty standard is the one that shows either through words or graphically, potential upside returns versus downside. For example, over a one year period are you comfortable in a portfolio that can potentially go down 30%, if it potentially could have gone up 35%? Or can you only tolerate 10% downside in exchange for 13% upside? Or somewhere in between? Such questions are easy to answer during calmer times: if you’re investing for the long term you logically know that you can recover from down markets and that the higher long-term return of the riskiest portfolio is to your advantage. But then it actually happens…
You just invested money in 2019. It’s for your retirement 30 years from now. It’s your life savings. It’s down 30%, or more importantly (from your perspective, because this is a lot of money for you), it’s down tens of thousands of dollars, maybe a hundred thousand, and there's no hope for the future. A question on a risk questionnaire pales in comparison to the actual emotions and fear now overwhelming you.
This brings me to my first major learning, or rather re-learning from the recent market turmoil:
1. Market crashes can happen at ANY TIME and for ANY REASON
What we’ve just experienced is just about the black swanniest of black swans. The definition of “black swan” in the investment world being an event that comes out of nowhere, completely unpredicted, and demolishes the markets. This is quite different than what we went through in 2008 and 2000, where markets crashed upon mass exuberance.
On February 19th, the Coronavirus was an Asia problem and the markets traded at all-time highs. The U.S. economy was in great shape, with some metrics rebounding after a softer 2019. Companies were again reporting record earnings, with profit growth validating the somewhat elevated price/earnings multiple the market was rewarding U.S. stocks with at that time. Globally, things were picking up a little too, and actually some of the good news around that time was that China was getting a hold of their Coronavirus problem. The world has had health scares before (SARS-2003, MERS, bird flu, swine flu, ebola) and we got through them okay, so maybe this one will pass soon too.
Then the markets started their descent into chaos. No need to reminisce, especially since it’s still an ongoing global pandemic as I write this.
The bottom line being, anything can happen at any time for any reason, and because stock prices are constantly reflecting this, they can become very very volatile and negative. There are no “calm markets” to be investing in; if markets are calm when you’re investing, they will become un-calm at some point in the future. A saying I once heard, years ago, was that there are only two types of stocks: stocks with problems, and stocks that are going to have problems.
You set your course navigation on calm seas, and when you hit a storm, you power through it, as it’s much harder to course-correct during a storm (I assume you're more preoccupied at that time battening down the hatches, or whatever; I'm not a sailor). If you can’t handle storms in the high seas, you need to make the decision on calmer waters to maybe stay closer to land.
As the above chart shows, markets were extremely calm going into this (you can tell this by how little the green and red bars were compared to more recently). Black swans can appear at any time and for any reason, when they're the least expected. You either ride them out for your longer-term goals, or you need to have had the proper asset allocation ahead of time, to protect yourself from their impact.
2. Market Timing Doesn’t work
This is so often repeated, and rightfully it will continue to be repeated ad nauseam till the end of time. If it ever does on occasion work, it’s entirely because of luck, and for it to truly work in your favor it requires two improbably lucky decisions. If, for example, you were lucky enough to time your exit from the markets in the second half of February, when do you time your re-entrance?
At time of writing, with the S&P500 at just under 2500, if you exited at over 3000, you can pat yourself on the back and re-enter the markets at more than 20% cheaper; but will you? Will you opportunistically wait for 2000... or lower? What if we don’t get that low and you miss the bottom? If we do hit 2000, will you wait for lower lows? If you miss it, when will you start chasing the markets higher?
Did you get out of the markets out of fear, or do you want to? If you exit or exited the markets at 2500, will you get in at lower levels which inevitably are accompanied by even more fear-inducing news headlines and general hopelessness than the day you exited? Or will you wait for things to calm down? More on this in the next section.
Like I said, as I write this the S&P500 is at 2500 give or take (mostly take), so by the time someone reads this, things can look very different. You’ll know how things pan out. I don’t. I do remember 2008/2009 though.
I had one prospective client who out of sheer luck cashed out all their investments in early 2008, when Canadian stocks were still near highs and U.S. stocks were within 10% of highs (S&P500 around 1300-1400). They came to see me in 2013 and they’d been in cash that whole time (S&P500 had already broken through 1600). They insisted on staying in cash and never became clients.
Like all advisors, I had a few clients who cashed out everything out of sheer terror, when the S&P500 was around the 700 point in March 2009. I also had clients who held back cash from their new RRSP and TFSA contributions in early 2009, which is also a form of market timing. Things definitely weren’t “calm” at that time, but if you had an investment strategy that saw you investing cash into equities when the S&P500 was as high as 1500 in prior years, why on Earth would you avoid investing when it’s at below 1000?
Even professionals aren’t immune to the dangers of market-timing. I remember a star fund manager with one of the Canadian mutual fund shops back in 2009. A really bright lady, whom I met in person years later. She ran a tactical balanced fund, in which she brilliantly cashed out all her global equity positions in 2008 (or before that), running only cash, bonds, gold, and some Canadian equities for a while. It was a top-performing 5-star fund, because while most other balanced funds were down 20-30% by early March 2009, hers was actually a little positive. I remember looking at her fund and wishing that in hindsight I put all my clients into that. When the markets and economy rebounded, she stayed invested the way she was, insisting that stocks would have another leg down or that there'd be the fabled "double-dip recession". She had good well thought out reasons why. A year passed, then another, then another. The markets left her behind in the dust. The fund company left her behind in the dust too; she got fired.
On the other side of the spectrum, according to this blog post, Warren Buffett talked about how excited he was about stock prices and how he was buying. This was in October 2008 and markets dropped another 30% from that point onward. Was he wrong? Was he not, at various times in the decade that followed, among the 3-5 richest people in the world?
3. The Markets Often Make No Sense
The guys at Ritholtz Wealth put it best in this blog post and video discussing the strong market rally after the U.S. announced record-smashing job losses.
To make some sense of how markets act, remember that the prices at which stocks trade at any given time generally reflect all the public information that is known and aggregate expectations for those stocks, the markets, or the economy. In today’s world, where information flows instantly, generally such pricing is very efficient. That thing happening in the future is going to have less of an effect on prices when it happens than it already has, as it's already baked in. As was the case with the jobs report, perhaps the markets were expecting worse, or in any case, the big declines in the prior week probably already took huge job losses into account.
Easiest explanation from recent years is when looking at Canadian cannabis stocks. We all knew recreational use would be legalized in October 2018. We all anticipated companies being able to sell weed and anticipated a little too much their profitability, size of market, and how well things would be executed under an unpredictable regulatory regime. So, as an investor, you made money if you got in years before and sold just prior to actual legalization. You made a lot of money getting in before Trudeau's first surprise election wing, before which legalization wasn't even on the radar. You didn’t make much money buying in 2018 and continuing to hold your cannabis stocks in anticipation of profits rolling in post-October; that was already baked into the price (and because it didn’t happen as expected, prices plummeted).
Today, you’re reading this and looking at the markets and the S&P500 could either be well below 2500, if market expectations got a lot worse than when I wrote this, or above if there’s more hope on the horizon for less economic carnage. If forecasts look bad, this is likely already baked into prices and things can turn up. If things look optimistic, there’s still the possibility for things to get worse. This is how the markets work.
This is why, as mentioned in the previous section, waiting for markets to calm down means waiting for markets to go up a lot. You either buy when the streets are running red in blood, or stay invested—hoping for the bleeding to stop—or you sell and then buy back in at higher prices, when things calm down. Things calmed down in the final week of March and the markets bounced up over 17%. There was nothing positive in the news; there was just less negative.
4. Always Have an Emergency Fund
Lastly, I cannot stress this enough; this was my core learning in 2008, just as I'm being reminded now. I won’t invest a penny of your money for you unless I know you have a reasonable amount of cash reserves as outlined in your financial plan, either at your bank or in some kind of high-interest savings product through me.
The amount to have in an emergency fund can vary by household, but a time like now is really putting it to the test. We always think of either having enough to cover a large unexpected expense, or having enough to cover 3 or 6 months of expenses in the event of job loss. We never thought of having enough to cover a completely indeterminate number of months of cash flow needs while you’re shut in and prevented from working during a global pandemic.
If you determine, either on your own or with the help of a financial planner, that the right amount of emergency fund to have is $30,000, as an example:
- If you don’t have $30K, then every penny that you save should go into a savings account until you have $30K. You're not allowed to invest, yet.
- If all you have is $30K, then every penny of that should go into a savings account and only additional money you're able to save may be invested toward your longer-term goals.
- If you have $100K, then $30K should stay in your savings account and only $70K be under consideration for long-term investing toward your long-term goals.
Don’t put yourself in a position where you invested all of your savings in stocks and now you need access to that money (after job loss and a 30% market drop, which often come at the same time). Long-term investing rewards you in… the long-term. Don’t confuse your investments with short-term accessible capital.
So anyway, that's what I've come up with so far. As we continue through this bear market, which very well could be the next few months, I might document some more learnings. Stay tuned!