I’ve always said that one of my favorite things about living in southwest Virginia is the four distinct seasons we enjoy. Just as we’ve had enough of summer heat, September delivers crisp, starry nights and the excitement that accompanies the kickoff of a new football season. On the flip side, as the long nights and cold days of winter drag on, dreary and gray give way to bright and green as buds blossom and flowers bloom. While we all know winters come and go, February invariably begets comments of ‘I’m ready for this winter to be over.’ I’ve always felt that if our fleeting, twelve weeks or so of Virginia winter is the price we pay for nine months of hiking, biking, and family cookouts, sign me up!
It's also interesting that, though we typically see at least a couple of snowfalls every year, at the first hint of winter weather, otherwise rational people frantically rush to the grocery store to resupply just in case they find themselves snowbound—somehow forgetting that roads are clear and life is generally back to normal by the following afternoon. The emotional response to market corrections reminds me of many people’s reaction to a forecast of 4-6” of snow.
When it comes to the market, investors tend to have short memories as they struggle with what’s known as recency bias wherein more weight is put on recent events to the point of overshadowing the preponderance of historical evidence to the contrary. For example, just two years ago, investors were lamenting that the world was ending, and it would take years to recover the pandemic-induced losses sustained in the 33-day market freefall of March ’20. By August, the market had regained its pre-pandemic high, and some investors claimed the recovery ‘wasn’t real’ or was unsustainable since there was no end to the pandemic in sight. The S&P 500 proceeded to finish 2020 up 16% and only gathered steam through 2021 to culminate what was possibly the best three-year stretch of market growth in our investing lifetime. Even fewer remember that the market was down 20% in December ’18 prior to the commencement of the aforementioned bull run. The market slump that occurs every 2-3 years is the investing equivalent of Old Man Winter, and, likewise, is a small price we pay for the market’s otherwise relentless climb upward.
The 2022 tax season was challenging for many due to larger than usual capital gains and related taxes. We at SageCreek kept our ‘finger in the dike’ to delay recognition of 3-years’ worth of gains as long as possible, but eventually, had to ‘pay the piper’ by taking profits and reallocating to reduce portfolio risk—hence, the tax reckoning that occurred in 2021. No one likes paying taxes, but when it comes to capital gains tax, oddly, the more you pay, the better. I would want nothing more than for all my clients to pay $100k in capital gains tax, because that would mean they each made half a million dollars! One thing we will do differently the next time we face such a large capital gains event is better prepare clients in advance, so at least it’s not such a shock come tax time. Apologies to those presented with a pleasant/unpleasant surprise this spring.
Beyond taxes, the other price of three great years in a red-hot market is a cooling-off period in the form of a correction or even bear market. [NOTE: a correction is a 10% decline in the market from a previous high, while a bear market is a 20% decline.] Neither is any more unusual nor worrisome than the occasional snowstorm. And, while we don’t have to like it, it’s important to recognize the market needs a breather now and then to avoid bubbles like we experienced in 2000 on the heels of the internet/dotcom/Y2K technology explosion of the late ‘90s. Corrections/bear markets are an opportunity to reset inflated stock valuations and investor expectations. The market never has and never will go straight up—it’s more of a two steps forward, one step back march upward, and we’re currently experiencing a much-needed step back.
What I love about these steps back is the feeling that we’re slowly drawing back a bowstring in anticipation of launching an arrow toward a distant target. In the dreary days of late February, we know it’s just a matter of time before the pink and yellow of redbuds and forsythia signal the imminent arrival of spring. Likewise, as the current market drawdown descends further and lasts longer, we know it’s just a matter of time before the string releases and the arrow flies—we just don’t know when, and that’s okay.
If you are a SageCreek client, any money earmarked for near-term goals, has already been set aside to shelter it from the volatility and uncertainty of the equity markets. The fluctuations reflected on your statements come not from your ‘safe’ money but from ‘back burner’ money that we don’t anticipate you needing for at least five years and has already been factored into our long-term plan for achieving your financial goals.
One thing I’ve learned through my decades of working with individuals and families is that behavior is the dominant element of success—however we choose to measure it—and, seemingly, the primary function of financial media is to terrify us out of ever reaching our goals by shrieking about market volatility and recession.
For long-term investors, giving-in to that fear by fleeing equities after they’ve gone down has generally proven to be a tragedy from which their retirement plans may never recover. Our investment philosophy is founded in acceptance of the idea that the only way to be reasonably assured of capturing equities’ premium returns is by riding out their occasional declines. Plan your work, work your plan, and have the discipline to stay the course when emotions, and the media, try to derail you.
DALBAR, a financial services research firm, has made sense of how emotions impact investment decisions by studying the timing of mutual fund flows. Based on that fund flow analysis, DALBAR approximates the return achieved by the “average investor” over a 20-year period. Its conclusion? Most investors are bad at market timing but try to do it anyway. Despite strong index returns over time, the “average investor” has underperformed a basic, indexed 60/40 portfolio by 3.5% annualized. On a $100,000 initial investment from the start of 2001 through the end of 2020, that adds up to nearly $170,000 of missed gains!
“But, it seems different this time!” you may say, as many have said many times throughout history. Or, even more naïve, “The world has never been in such bad shape,” to which we could argue that it’s never been better with regard to the worldwide standard of living, civil rights, and military conflicts. It’s hard not to have an emotional response to the crises de jour trumpeted by the media whether it’s a once in a century global pandemic, one of the ugliest, most contentious Presidential elections ever (although they say Adams vs Jefferson was pretty nasty), or, most recently, high inflation, rising rates, and Ukraine—oh, my! And, all of that is just the past 24 months!
Every market decline of this magnitude has its own unique precipitating causes. I think it’s fair to say that the current episode is a response to two issues: severe inflation, and the extent to which the economy might be driven into recession by the Federal Reserve’s efforts to root that inflation out. (Russia’s war on Ukraine, supply chain issues and the like are surely contributing factors, but recession vs. inflation is the main event, in my judgment.)
The conflict in Ukraine will end one way or another as the multitude of preceding conflicts throughout history have, and its impact on you and your lifestyle has likely already been priced into the market. The most immediate threat to our pocketbooks and standard of living is the blight of inflation, and, unfortunately, the most effective tool we have at our disposal to fight it is interest rates. And, while the risk of raising rates is a stalled economy (aka: recession), if that’s what it takes to break the back of inflation, the cure is not worse than the disease.
We need to accept the fact that we don't know how this situation is going to be resolved. No one does. Thus, what's called for here is that most elusive of human qualities: rationality under uncertainty. If we can't look into the future—since there are no facts about it—we're forced to ask: what other terribly shocking events have we lived through, and what do they teach us about their effect on the long-term values of America's most successful companies?
There have been four genuinely cataclysmic “Black Swan” events in the last third of a century or so, that seemed to come out of nowhere and shake the very financial foundations of this country and the world. None of these is perfectly analogous to Russia/Ukraine—indeed, none is exactly like the others, but I think it might be useful to see where the S&P 500 was as each of these tsunamis hit, relative to where it is now.
The four earth-shattering events I'm thinking of are (in chronological order) the 1987 Crash, 9/11, the Lehman Brothers bankruptcy, and the onset of the COVID-19 pandemic.
- The 1987 Crash—the largest one-day decline in stock prices ever (approximately 23% in one day!)—took place on Monday, October 19, 1987. The S&P 500 closed the previous Friday at 283.
- On the night before the atrocities of September 11, 2001, the Index closed at 1,093.
- The S&P 500 closed at 1,252 on the Friday before the Lehman Brothers bankruptcy filing in September 2008 set off the Global Financial Crisis.
- Finally, the Index closed at 3,386 on February 19, 2020, just as the world was shutting down amid the pandemic.
As I write, the S&P 500 stands at just under 4,100—a little less than 15% off its all-time high in early January.
The stock market, or more specifically the S&P 500, is a showcase of 500 of the greatest, most innovative businesses in the world. It’s an all-star team of the winners in a constant battle of survival of the fittest where Blockbusters give way to Netflix and Disney+, and Amazon takes the reigns from weary Sears and Kmart. Once you understand that equity (stock) investing is not a speculation in some virtual commodity (ie: cryptocurrency), but ownership in the largest, most profitable companies in the world, you realize that, as long as Capitalism prevails (the converse of which would render the value of our portfolios largely irrelevant), the market literally has to go up over time. That being the case, periodic, temporary declines in its value are a small price to pay for its inevitable, permanent advance.
My mission continues, not to insulate you from short- to intermediate-term volatility, but to minimize your long-term regret – the regret that has always followed a fear-driven exit when equities resume their long-term advance. As they always have. Embrace these lulls, as I do, as a normal, healthy part of the market cycle, knowing that, like pruning shrubs in February, we are setting the stage for new, more sustainable growth. Even the longest, coldest winters eventually end, and the sun comes out again. Time rewards the patient investor.
Considering that no competent planner would construct a lifetime financial plan without consideration to ongoing, periodic market and economic disruptions, as your planner/advisor, we see no reason to abandon your well-constructed long-term plan in the midst of the storm, and it may come as no surprise that our continued counsel is to stay the course. We are always here to talk this through if/when you need a pep talk. Thank you for placing your trust in us. It is a privilege to serve you.