Gut-Wrenching Volatility
January 20, 2022
“Everyone has a plan until they get punched in the face.” - Mike Tyson
I am burdened by the knowledge that bear markets follow bull markets, like the ebb and flow of the tide. I expressed the opinion in August (copied below) that the next bear market, when it finally occurs, will likely be shocking in its intensity, and that folks would be well-advised to take a fresh look at their finances and consider how they might fare if things were to get really ugly.
I have found in my travels that the negligible returns offered by the bond market have compelled many investors to ramp up their allocations to stocks over “normal” levels. And I have a seat-of-the-pants feeling that many investors who are active in the market today have never experienced the terror of gut-wrenching volatility.
As a benchmark, let’s consider as noteworthy a day when the S&P drops 2% or more. It doesn’t happen that often. In 2021, there were only 5 down-2% days. In 12 of the last 21 years, there were less than seven, and in a nearly three-year stretch 2004-2006 there were none at all.
And occasional down-2% days are no big deal anyway, because they get interspersed with some up-2% days, and it’s all good again, right? Which leaves us with all the brave talk about “buying the dips”. Smart guys never panic; they buy on weakness and sell on strength. Or never sell, because in the long run the market always goes up… Right?
But here’s the thing: when you get concentrations of bad days, it’s a different story. Take, for example, August 4, 2008 to March 5, 2009, when the S&P dropped 45%:
Looking at these numbers reminds me of the time I went body surfing on Lumahai Beach on the north shore of Kauai. After I dove under the first 5 or 6 waves, I realized how strong, close together, and relentless they were. By about wave 8, I realized I was in trouble. I remember thinking that I should have paid more attention to the warning sign on the beach, but by then it was too late. Drowning had become a distinct possibility.
Please take a moment to reconsider the opinions of the very smart people I referenced in August. Because the time to ensure your ability to survive sustained adversity is before the market goes into a freefall, not once it starts. The big mistake – the greatest destroyer of wealth – is having to sell stocks when the market is down, thus missing the inevitable rebound.
If you are very rigorous in defining your essential priorities and you fund them in a manner that is impervious to market, inflation, and interest rate risk, you will be prepared to weather market downdrafts, and you can then be intentional and deliberate in estate planning, philanthropic activities, lifestyle choices, and the consideration of more speculative investments.
Preparing for the Opportunity of a Lifetime
Posted August 15, 2021
I think it’s critical to consider the disproportionate potential of the markets today. We have today:
· The most overpriced US Equity market in history, according to Jeremy Grantham, reasonably priced only relative to bonds
· The most overpriced bond market in 4,000 years, according to Jim Grant of Grant’s Interest Rate Observer
· The housing market priced at the same multiple to median family income as it was at the peak of the housing bubble in 2006
· The commodity market recently matching the historical peak of 2011, as measured by the Goldman Sachs Index of non-energy commodities
· Speculative fervor that rivals or exceeds 1929 and 2000 (see Robinhood below)
· Current inflation that greatly exceeds the Fed’s stated 2-3% target.
Regarding the speculative fervor of today’s market, consider the disclosures from the Robinhood IPO. As many as 50% of all new retail accounts opened in the U.S. since 2016 have been on the Robinhood platform, 47% of Robinhood’s users access the site daily and look at it an average of seven times a day, 47% of Robinhood’s transaction-based revenues in 2020 came from options, and, straight from the Robinhood S-1: “A substantial portion of recent growth in our net revenues earned from cryptocurrency transactions is attributable to transactions in Dogecoin.” Robinhood also noted that clients held approximately $12 billion in crypto assets, yet in the first quarter of 2021, $88 billion of crypto were traded on the platform. By conventional standards, that’s serious portfolio turnover. I’m making the assumption that most of Robinhood’s clients haven’t enjoyed the experience of a bear market. A cynic would suggest that this won’t end well.
(Note: Robinhood's IPO was priced at $38 on July 28, 2021. It traded at $85 on August 4 and closed January 18 at $14.50.)
A 5% real (inflation-adjusted) return has long been the accepted target for institutional investors. From January 1926 through June 2021, a 60/40 portfolio (S&P 500/5-year Treasuries) had an annualized inflation-adjusted return of 5.65%. But there have been at least four 10+ year periods in which the 60/40 has failed to meet the 5% real return hurdle:
6/1929-6/1938 4.08% (Helped by cumulative deflation of 2%)
1937-1947 -0.03%
1969-1982 -0.05%
2000-2012 1.37%
Furthermore, in each of the periods above, either the stock component or the bond component was, according to GMO’s research, reasonably priced at the beginning of the period. Today by contrast, both components are substantially over-priced. (This is the subject of the Chiappinelli link below). I fear we will be adding the next decade to the list above, and this has practical implications for people in retirement, expecting to pull the “safe withdrawal” of 4-5% from their portfolio each year.
You may be able to make a little more money in the stock market as (if) the rally continues, but I doubt that it will be incrementally life-changing for you and your family. On the other hand, if Stanley Druckenmiller, Jeremy Grantham, Ray Dalio and Larry Summers, and Peter Chiappiarelli are right, are right, not having the proper financial structure in place could have a disastrous impact on your equanimity and financial health, and leave you on the sidelines for one of the greatest opportunities in stock market history.
The bear market is inevitable; only the timing is in question. I believe it is essential to prepare for it, and the time to do it is when you have the wherewithal to do it thoughtfully, not in the throes of a market freefall. Better to be early on this!
Postscript to Preparing for the Opportunity of a Lifetime
As 2021 wore on, the market continued to make new highs, at least as measured by the S&P 500 index, which hit an all-time high of $4,786 on Jan 3, 2022. But a deeper look, especially at the more speculative parts of the market, tells a different story:
These numbers make an eloquent case for deep diversification. But even more conventional stocks, many of them stalwarts of the bull market, are well off their 12-month highs:
This may be a huge buying opportunity -- or not. No one can consistently predict where the market is going. My advice is to respect the power of the ocean.
