Beyond The Headlines
Not The Wrong Question, Yet, But The Promise Of A Right Answer
On January 14th, I published this article which predicted that one of these days, after a spectacular decade of progress, the stock market would encounter a serious air pocket. Investors would then ask the perennial question, “What caused the market collapse yesterday?” But this is not a helpful question. The more discerning inquiry would really be, “Why did the market rise so much before yesterday’s crash?”
Since then, we have not seen a sudden crash. The investing crowd, exhibiting more fast-changing opinions than longer-term convictions, has been busy worrying alternately about inflation and recession while generally looking to the Federal Reserve for answers. Meanwhile, financial markets have done what they do. Since January 14th, the S&P 500 index has lost about 22%, and the more “tech-heavy” NASDAQ 33% (Source: Bloomberg).
In the original article, I referred to Hyman Minsky, an economist who was widely overlooked until the Great Recession of 2007-2008. That disruption vindicated his hypothesis that “stability breeds instability.” In other words, when markets or economies are stable (or on a seemingly predictable uptrend), businesses and investors tend to accept ever more risk. For Minsky, this primarily meant taking on more debt, but “risk” should be understood more broadly as getting involved in all sorts of speculative activities. We have had a long, uneven period of recovery from the Great Recession of 2007-2008, but high inflation and threats of recession persist. So where does this leave us, looking forward?
I have been investing long enough to remember first-hand the 1973-1974 bear market. It followed a long investor infatuation with theoretically recession-resistant “Nifty Fifty” growth companies, which climbed to stratospheric valuations for the period. From its early 1973 level, the Dow Jones Industrial Average lost 44% of its value in about two years and took eight years to return to its previous high.
Importantly, those statistics still understate the damage that was done to one-time market favorites. For instance, McDonald’s declined 73% and Coca-Cola 69%. Disney, which had reached a price/earnings ratio (P/E) of 70 at the peak of the bubble, wound up selling at 13 times earnings, while beauty giant Avon declined 85% as its P/E collapsed from 63 to 9. (Source: Wikipedia)
This flashback merely reminds us that even significant market corrections, such as the one we are currently experiencing, seldom reflect the full capitulation and re-evaluation when real bear markets end, especially among previous favorites. Obviously, some re-evaluation of this kind is already occurring. Former super-favorites such as the FANG stocks (Facebook, Amazon, Netflix, and Google) have already lost more than $2 trillion of combined market value.
The more speculative areas of the investment universe have evolved away from early “TINA” stocks — short for “There Is No Alternative” — to so-called “ABTE” (“Anything But Traditional Equities”). Since realizing that bonds were doomed after the long spell of near-zero interest rates, and since stocks seemed endangered as well, investors have engaged in a frantic search for presumably “uncorrelated” investment vehicles such as private equity. The field was initially known as “venture capital” before it began to involve the purchase of companies with overwhelming financial leverage (debt). More recently, investment vehicles have extended to art, wine, bitcoin, and crypto innovations (NFTs), among others. These involve some new areas of speculation that have been enthusiastically adopted among less-knowledgeable “investors” encouraged by recent excess liquidity.
Some stocks where volatility and speculation have been most visible have reached valuation ratios (price/earnings and other, more exotic creations) that seem stratospheric even when compared to the Nifty Fifty or Dot.com follies. I would argue that a downward adjustment is not complete for those securities. For others, however, it is possible that declines of more than 50%, 60% or more, which are already numerous, may have brought us closer to the ultimate lows. My advice to my younger partners is to “get our feet wet” in the stocks of likely survivors (good businesses with essential, proven products and services reflected by strong balance sheets).
I recently retrieved a January 15th, 2018, mention of John Neff by Jason Zweig in his blog Articles & Advice. This iconic investor, who retired from the Vanguard Windsor fund in 1995, beat the market by more than 3 percentage points annually for 31 years. But he reminded people that he lost 25% in 1973 and 16.8% more in 1974 before regaining 54.5% in 1975 and another 46.4% in 1976. He also pointed out that “a noticeable portion of [his] cumulative performance came from these two years alone.”
I am also convinced that it is possible to beat the market over long periods covering several cycles, but recoveries from severe bear markets are when meaningful outperformance is achieved. To achieve this, however, it is advisable always to keep very liquid reserves (like cash) while things are less compelling. Also, since catching the ultimate bottom of a market is hard to time, we tend to invest progressively into new names. In a portfolio of about 30 stocks, for example, an initial purchase may amount to 1% of the portfolio value, followed by subsequent purchases of 1% or 2%, as market conditions allow or dictate.
Good luck getting your feet wet!
François Sicart – November 17, 2022
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