E-piphany

I really enjoy listening to financial media outlets on days like this. Six days removed from all-time highs, the equity guys – especially the strategists, who make their money on the way up – talk about “capitulation,” and how “nothing has changed,” and how people need to “invest for the long-term.” If equities have entered a bear market, they will say this all the way down.

It helps to have seen a few cycles. Consider the early-2000s bear market. In 2000, the Nasdaq crested in March. After a stomach-churning setback, it rallied back into August (the S&P actually had its highest monthly close for that cycle in August). The market then dropped again, bounced, dropped again, bounced, and so on. Every bounce on the way down, the stock market shills shrieked ‘capitulation’ and called it a buying opportunity. Eventually it was, of course. But if there is a bear market, there will be plenty of time to buy later. This was also true in ’09, which was much more of a ‘spike’ bottom but let’s face it, you had months and months to get in…except that no one wanted to get in at the time.

If it is not a bear market, then sure – it’s a buying opportunity. But what I know from watching this drama play out several times is that you cannot tell at the time whether it’s a buying opportunity, or a dead-cat bounce. It does not help at all to say “but the economy is okay.” Recalling that the Nasdaq’s peak was in March 2000: the Fed was still hiking rates in May of that year, and didn’t cut rates until 2001.  In late July 2000, GDP printed 5.2% following 4.8% in Q1. In October 2000, GDP for Q3 was reported to still be at 2.2%. Waiting for the economy to tell you that all was not well was very costly. By the time the Fed was alarmed enough to ease, in a surprise move on January 3, 2001, the S&P was down 16%. But fortunately, that ended it as stocks jumped 5% on the Fed’s move. Buy the dip!

By mid-2002, stocks were down about 50% from the high. Buying the dip was in that case precisely wrong.

Then there is the bear market of a decade ago. The October 2007 market high happened when the economy was still strong, although there were clearly underlying stresses in mortgages and mortgage banking and the Fed was already easing. Yet, on January 10, 2008, Fed Chairman Bernanke said “the Federal Reserve is not currently forecasting a recession.” On January 18, he said the economy “has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.” In June 2008, he said “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Stocks were already down 19%. It got somewhat worse…and it didn’t take long.

So the thing to remember is this: equities do not wait for earnings to suffer, or for forecasts of earnings to suffer, or for everyone to figure out that growth is flagging, or for someone to ring a bell. By the time we know why stocks are going down, it is too late. This is why using some discipline is important – crossing the 200-day moving average, or value metrics, or whatever. Or, decide you’ll hold through the -50% moves and ignore all the volatility. Good luck…but then why are you reading market commentary?

I don’t know that stocks are going to enter a bear market. I don’t know if they’ll go down tomorrow or next week or next month. I have a pretty strong opinion about expected real returns over the next 10 years. And for that opinion to be realized, there will have to be a bear market (or two) in there somewhere. So it will not surprise me at any time if a bear market begins, especially from lofty valuation levels. But my point in this article is just to provide some historical context. And my general advice, which is not specific to any particular person reading this, is that if anyone tells you that price moves like this are ‘capitulation’ to be followed by ‘v-shaped recoveries,’ then don’t just walk away but run away. They haven’t any idea, and that advice might make you a few percent or lose you 50%.

To be sure, don’t panic and abandon whatever plan you had, simply because other people are nervous. As Frank Herbert wrote, “fear is the mind-killer. Fear is the little-death that brings total obliteration.” This is why having a plan is so important! And I also think that plans should focus on the long term, and on your personal goals, and matching your long-term investments to those goals. Rebalancing and compounding are powerful tools, as is a value ethic of buying securities that have a margin of safety.

And, of course, diversification. Bonds today did what they’re supposed to do when ‘risky assets’ take a tumble: they rallied. As I noted on Friday: “I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities.” The problem with nominal bonds at this point, though, is that they’re too expensive. At these yields, there is a limit to the diversification they can provide, especially if what is going to drive the bear market in stocks is rising inflation. Bonds will diversify against the sharp selloff, but not against the inflation spiral. (I’ve said it before and I will say it again. If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. “What happened to inflation? And What happens if it comes back?”)

Which brings us to commodities. If the factor driving an equity bear market turns out to be inflation, then commodities should remain uncoupled from equities. For the last few days, commodity indices have declined along with equities – not nearly as much, of course, but the same sign. But if the problem is a fear of inflation then commodities should be taking the baton from stocks.

So there you go. If the problem is rising interest rates, then that is a slow-moving problem that’s self-limiting because central banks will bring rates back down if stocks decline too far. If the problem is rising inflation, then commodities + inflation bonds should beat equities+nominal bonds. Given that commodities and inflation bonds are both relatively cheaper than their counterparts, I’d rather bet that way and have some protection in both circumstances.