By Larry Swedroe
As the director of research for Buckingham Strategic Wealth and The BAM Alliance, whenever markets head south for an extended period, the number of calls I get from clients and other advisors jumps. This time is no different.
With that in mind, I thought it important to share how investors should be thinking about the recent drop. To begin, there is always a reason for investors to worry about the stock market, be it valuations at historically high levels, the economy, the risk of inflation or geopolitical risk. That is why there is an equity risk premium, and why historically it has been large enough to be called the “equity premium puzzle.” It’s also why it’s often said that “bull markets climb a wall of worry.”
While the news on the economic front has been just about as good as it gets, there are always things to worry about. To make sure you have a balanced view of things and are not just obsessing about potential risks, let’s first look at some of the economic news:
- Economic growth is strong. The Philadelphia Federal Reserve’s Fourth Quarter 2018 Survey of Professional Forecasters projects real GDP growth for 2019 of 2.7%, down just slightly from the forecast of 2.9% for 2018.
- Unemployment is at 3.7%, the lowest rate in 50 years.
- Inflation is moderate. The Philly Fed’s latest 2019 forecast is for an increase in the CPI of 2.3%, down slightly from their forecast for 2018 of 2.4%.
- Consumer sentiment (a leading indicator) is strong. The December University of Michigan Consumer Sentiment Survey came in at 97.5, remaining near the highest levels we have seen over the past 18 years (despite the recent weakness in stocks). The last time the Consumer Sentiment Index was consistently above 90.0 for at least as long was 1997 through 2000, when it recorded a four-year average of 105.3.
- The November ISM (Institute of Supply Management) Non-Manufacturing Purchasing Managers’ Index came in at 60.7%, a 0.4 percentage point higher than the October reading of 60.3%—representing continued growth in the nonmanufacturing sector and at a slightly faster rate. The six-month moving average of the index is at about the highest level in more than 20 years. And the Non-Manufacturing Business Activity Index increased to 65.2% in November, 2.7 percentage points higher than the October reading of 62.5%, reflecting growth for the 112th-consecutive month, at a faster rate.
The bottom line is there is nothing in the economic data to indicate we’re headed into a recession that could lead to a bear market (with the stock market being a leading indicator). While the economic expansion is now 10 years old, expansions don’t die of old age. They die either because geopolitical risks show up or because the Fed tightens monetary policy, driving real rates to high levels to fight inflation.
Today the real rate on one-month Treasury bills is about zero. Even if the Fed were to raise rates three more times over the 12 months (the market currently expects a hike in December and one more next year), the real rate would still only be around 1%, which is about the historical average, and certainly not indicative of a tight monetary policy. That said, there are always things to worry about.
While we will take a look at some of the concerns investors are dealing with, the list is not meant to scare you into action. Most importantly, you need to understand that all these risks are well known by the sophisticated institutional investors who do as much as 95% of the trading, and thus are setting prices (the risks are already embedded in prices). The only way you can exploit them is to outguess the collective wisdom of the market—something very few professional investors have been able to do.
Consider that, over the 10 calendar years from 2008 through 2017, the HFRX Hedge Fund Index lost 0.4%, a period in which all major equity and bond indexes produced positive returns. For example, the S&P 500 Index returned 8.5% and five-year Treasuries returned 3.2%. Here’s the list:
- Equity valuations are high, with the CAPE 10 still almost 30.
- Historically, the nominal yield on intermediate-term Treasury notes has been about equal to the nominal growth in GNP. With nominal growth in 2019 expected to be about 5%, and the current yield on five- and 10-year Treasuries about 2.7% and 2.9%, respectively, we’re now well below what we would expect. Higher yields would create more competition for equities by reducing the equity risk premium. If the low interest rates around the globe suppress U.S. rates, even a 4% intermediate-term Treasury rate could create pressures on stock prices.
- We now have a very slight yield curve inversion on one point of the curve—on Dec. 7, the yield on the two-year Treasury note (2.73%) is 1 basis point above the yield on the three-year note (2.72%). A yield curve inversion (typically defined as a higher yield on a two-year note than a 10-year note), currently 2.88%, has forecasted each of the last nine recessions since 1955. But does that provide actionable information? In an August 2018 article, “What Does a Yield Curve Inversion Mean for Investors?”, Dimensional Fund Advisors examined the returns to stocks following inversions for five major developed nations, including the U.S., since 1985. The article stated: “Equity returns (as measured by MSCI local currency indices) were a mixed bag in the three years following an inversion, with US index returns higher 66% of the time at the 12-month mark and only 33% of the time 36 months later. When all countries are included, returns of the indices were higher 86% of the time 12 months later and 71% of the time 36 months later.” Dimensional concluded: “It is difficult to predict the timing and direction of equity market moves following a yield curve inversion.” I would add that, historically, inverted curves are a result of very tight monetary policy, which is certainly not the case today, with the real rate on Treasury bills at about zero. Thus, an inverted yield curve without tight monetary policy might not have the same explanatory power.
- The Fed began to unwind its $4.5 trillion balance sheet in October 2017, the growth of which was a result of its quantitative easing policy (buying Treasury bonds to suppress both longer-term and shorter-term rates). At that time, the yield on the 10-year note was about 2.3%. One year later the yield was about 0.9% higher. It has since fallen to about 2.9%, as the stock market’s drop led to a flight to safety/quality. The unwinding of the Fed’s balance sheet is a great experiment, one we have never tried before. Hence the uncertainty.
- Uncertainty over tariffs is negatively impacting business investment.
- The potential for a full-scale trade war with China, with negotiations complicated by the arrest of Meng Wanzhou, chief financial officer of Chinese tech giant Huawei. With a Democrat-controlled U.S. House, there’s uncertainty about passing the new trade agreements with Mexico and Canada, which are meant to replace the existing North American Free Trade Agreement (NAFTA) (and President Trump’s threat to cancel NAFTA if the new agreements are not passed).
- Massive federal budget deficits continue. We have never had such large deficits while having strong economic growth. The current forecast is a deficit of more than $1 trillion in 2019, a figure that pushes the deficit to more than 5% of GNP. Such large deficits have the potential to crowd out private investment, slowing economic growth.
- The low rate of unemployment could lead to wage increases, which, while good for the economy, could squeeze corporate profit margins, negatively impacting earnings. Margins are at record levels and have, historically, shown a strong tendency to mean revert, falling when unemployment is low.
- The election of a Democrat-controlled House has created the potential for a shutdown of the government as early as later this month.
- There is uncertainty over the 2020 presidential election and concerns about the possibility of the unwinding of the recent tax cuts (which would hit corporate profits hard).
- Geopolitical risks created by Russian aggression and the death of journalist Jamal Khashoggi are complicating relations with Saudi Arabia.
Unfortunately, investors who are worried about these issues and are tempted to sell are likely subject to the all-too-human trait known as “confirmation bias”—interpreting new evidence as confirmation of one’s beliefs. Goldman Sachs likely added to their concerns, perhaps pushing them over the tipping point, with their Nov. 21 warning that “cash will be king.”
Yet Another Concern
To this list of concerns, I would add the following. To rescue the economy from the financial crisis of 2008-2009, the Fed implemented policies to lower interest rates and then to keep them down.
That led many who take a cash flow approach to investing to chase yield, taking on more risk to meet their spending requirements. That led them to abandon the safety of Treasury and CD investments and to the purchase of risky assets, such as high-dividend yielding stocks, real estate investment trusts, master limited partnerships, high-yield bonds, convertible bonds and preferred stocks. The result is that investors took on more risk than they had the ability, willingness or need to take (otherwise they would have had those higher exposures to risky assets to begin with).
Such strategies work until the risks show up—and then panic selling typically occurs. With the rise in rates to more normal levels, and the recent downward volatility of the market, those same investors may now decide to flee those riskier assets. While a stock paying a 3% dividend is attractive when a CD is yielding 1%, it might not seem so when the dividend yield is 3% and the CD yield is 3.5%.
Cash flow investors bailing out of risky assets could put even more pressure on their prices than we have seen in the past few months. There is also the possibility that tax-loss harvesting could put further pressure on prices.
Risk Transforms Into Uncertainty
For many, the perception about equity investing shifts from risk (where we can calculate the odds) to uncertainty (where the odds cannot be calculated) during bear markets. We often hear commentators use phrases like “there is a lack of clarity or visibility.”
Because we prefer risky bets to uncertain bets, when we see markets as uncertain, the risk premium demand rises. It is the rise in the risk premium that causes severe markets. Note: Equity investing is always about uncertainty. It’s just that overconfidence during bull markets causes us to think about it more in terms of risk (which we tend to underestimate).
The historical evidence is clear that dramatic falls in prices lead to panic selling, as investors eventually reach their “GMO” (get me out) point. The stomach screams, “Do Not Just Sit There. Do Something. Get Me Out!”
Investors have demonstrated the unfortunate tendency to sell well after market declines have already occurred and buy well after rallies have long begun. That is why it’s so important to understand investing is always about uncertainty, and you should never choose an asset allocation that exceeds your risk tolerance (which a cash flow approach to investing can lead you to do). Avoiding that mistake provides the greatest chance of letting our heads, not our stomachs, make investment decisions. Stomachs rarely make good decisions.
Possibility Of Dual Bear Markets
I’ve also been getting questions about whether we could see a bear market in stocks accompanied by a bear market in bonds. Unlike in 2008, when safe bonds provided strong gains to help offset huge losses in equities, investors have asked whether we might have a dual bear market.
The answer is yes—it definitely can happen. However, it’s been so long since it happened that many of today’s investors either were not alive or were too young to experience the pain.
According to data from Dimensional, the last year of negative returns to both stocks and bonds occurred in 1969. In that year, the S&P 500 Index lost 8.5% and long-term government bonds lost 5.1% (five-year Treasuries lost just 0.7%).
While those losses are not dramatic, consider that, as 1969 began, the Shiller CAPE 10 was about 22. It’s now about 30. Thus, valuations could fall a lot further if risks increase and investors demand a larger risk premium.
Also, Federal Reserve Bank of St. Louis data shows the yield on the long-term Treasury bond in 1969 was about 6%. Today, yields are a lot lower. The result is not only that yields could rise much more but also that the same change in interest rates causes a larger drop in bond prices, because the duration of a bond with a lower yield is longer (the same change in yields leads to a larger change in price). Thus, it’s important to not be lulled by the relatively small losses that occurred in 1969.
The lack of a recent event (or even one investors have ever experienced) could lead many to conclude a dual bear market is so unlikely to occur again, they don’t have to consider the risks and plan for it.
Unfortunately, treating the unlikely as impossible can lead investors to take too much risk. And when the unlikely occurs, their plans can fail, or they might engage in panic selling (which is often difficult to recover from because there is never a green flag that lets you know it’s once again safe to invest).
How Bear Markets Happen
Bear markets typically occur because something unexpected happens. Other times they occur because bubbles burst (as one did in March 2000). When bear markets occur, they can happen with great speed, as risk premiums rise quickly in the face of uncertainty, and earnings often fall at the same time. That is what usually begins the process. Unfortunately, a bear market can gain momentum as progressively more investors reach their GMO point.
Each round of selling brings in a new cohort of panicked sellers whose risk tolerance was only slightly greater. And each round brings more margin calls, accompanied by forced sales. Then momentum traders jump on the bandwagon, selling into already weak markets that often have little liquidity, leading to large daily drops. And of course, sellers harvest losses and don’t reinvest immediately (until they see markets recovering).
Investing in stocks is always risky. As the following analysis of data from Ken French’s website shows, for the period 1927 through 2017, the stock premium was negative in 27 of the 91 years (30% of the years). There were 17 years (19% of the years) when the premium was worse than -10%, 12 years (13% of the years) when it was worse than ‑15%, and seven years (8% of the years) when it was worse than -20%.
As another indicator of the volatility of the stock premium, we see that the gap between the best and worst years was 102.2%, more than 12 times the size of the premium itself. The worst year was 1931, when the premium was -45.11%.
Given a premium of 8.5% and a standard deviation of 20.41%, this was more than a 2.5 standard deviation event. The best year was 1933, when the premium was 57.05%, also more than two standard deviations from the mean. In fact, we had six such two-standard-deviation events. We would have had just four if the returns had been normally distributed.
Such risks create the temptation to try to time the market. However, the record of active managers able to successfully do so is horrific, which led Warren Buffett to conclude: “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”
As a “timely” (I assure you my crystal ball is always cloudy) column from October 2018 pointed out, smart investors are always prepared for bear markets. Knowing they cannot predict (nor can anyone else) when they will arrive, how deep they will be or how long they will last, they simply build them into their plans.
Being prepared includes not taking more risk than you have the ability, willingness or need to take so that your stomach never takes over the decision-making. Being prepared also increases the odds you can act like legendary investor Warren Buffett, keeping your head and buying when others are panic-selling, through the act of rebalancing your portfolio.
Remember, once you sell, it’s difficult or impossible to recover, because you not only have to be right when you sell, you have to be right when you eventually buy back (since most investors cannot reach their goals invested in the safest bond investments).
Unfortunately, as noted in the beginning, investing in stocks is always risky—there’s always a laundry list of concerns. Thus, there’s never a green light letting you know when it’s safe to get back into equities. It’s my experience that once you panic and sell, you’re almost doomed to fail. Which is why it’s so important to have that well-thought-out plan in place.
Finally, before you abandon one strategy in favor of another, make sure you ask yourself if there is any peer-reviewed, published evidence that the new strategy (such as market timing or hiring an active manager) is a superior strategy. If there is not, why do you think you’ll be more successful? Forewarned is forearmed.
For those interested in learning how to reduce the risk of a severe bear market by diversifying across unique sources of risk and expected return, I recommend you read my book, co-authored with Kevin Grogan, “Reducing the Risk of Black Swans” (2018 edition).
This commentary originally appeared December 19 on ETF.com
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