Note from the CIO: What Should We Do Now?
Despite the stock market roller coaster ride, I hope everyone had an enjoyable summer. As of my last quarterly CIO Note, the S&P 500 index had reached its lowest point for the year on June 16, down 24% from its all-time high on January 3. At that time, I shared my best interpretation of the drop which was that the market was pricing in the likelihood of a recession resulting from the Federal Reserve’s effort to bring down inflation by raising interest rates and slowing down the economy.
At the start of the summer, we experienced two months of mostly positive economic news and recession concerns appeared to ease somewhat, causing stocks to gain 17% by August 16. Yet before there was a chance to celebrate a market recovery, the final six weeks of the third quarter showed signs of a slowing economy but without any meaningful reduction in inflation. This caused the market to erase all the gains from earlier in the summer. The S&P 500 index closed at a new low on September 30, down 25% from the high, and more or less right back to where we were last quarter, with the market pricing in a high likelihood of a recession.
So, now what?
First, let’s not be reactive to short-term market moves. In my opinion, the direction of each significant market move - up or down - this year has made sense, as it showed the efficiency of the market processing all available information nearly instantaneously. But the magnitude of these moves can only be described as, technically speaking, bananas. In fact, during periods of twelve months or less, the market appears to overreact to the point that seems irrational. As I have covered in the past, the S&P 500 index since WWII (the modern era of the index), has seen 12-month gains as high as 61% back in 1982 (more on this one later!) and 12-month declines as sharp as -43% during the Global Financial Crisis. And yet its long-run annualized performance has consistently averaged around 10%.
What does this tell us?
Let’s continue acting on our financial plans, which means focusing on the things that are in our control rather than fretting over things that are uncontrollable like market returns, the economy, and the news. The key to all successful investing is having a plan that maps out how you are going to get to your goals from where you are now, with concrete steps that are in your control. Unless your goals materially change, or your circumstances shift (employment status, marriage, divorce, inheritance, etc.), your financial plan, which includes your investment plan, should stand the test of time. A drop in portfolio value this year by say 20% should not meaningfully change a long-term plan any more than a rise of 20% should have changed the plan in 2021. A financial plan accounts for and anticipates years like this (that is why it is called a “plan”). The likelihood of needing to make a course correction in the future, either by reducing spending, working longer, etc., for sure goes up somewhat after a 25% drop in the market, but our research shows that the likelihood at this point of needing to make a course correction in our clients’ financial plans has not risen above our acceptable tolerance range.
How does this all work?
Some of the concrete features within our control and common across all of the financial plans we implement include keeping costs low, tax reduction and tax efficient investing, estate structuring, and reducing risk through asset allocation and diversification across thousands of companies within many countries. But the key feature within our control that distinguishes and drives every financial plan is the savings and withdrawal schedule over the life of the plan.
Some of our clients have expressed concern about continuing their planned withdrawal from their portfolio for the year given the drop in portfolio values. It is important to know that a planned withdrawal amount for 2022 is not dependent on what the markets do because the plans we create already account for years like this. Think about years like 2021 when we did not increase the withdrawal amounts just because the market was up. Essentially the withdrawal amount is a sustainable average that works in strong markets and down markets. And of course, the best time to sell, and the only time to sell, is when you need the cash.
Clients who are still adding to their portfolios should strive to stick to their savings targets this year. It is only human to feel some hesitancy to invest new money with so much uncertainty, but the best time to invest cash is when you have it. That is especially true right now. The odds of the stock market being positive in any 12-month period have historically been around 75% in your favor. But what do the odds look like after a 25% drop such as we recently experienced this year?
The following table looks at all the market declines since WWII that experienced drops of at least 25%. It shows the 12-month return (including dividends) starting from the point when the drop reached 25%. We see that every subsequent 12-month period saw positive returns except for the Global Financial Crisis (which saw a single-digit negative return but saw positive returns over the next 3-, 5- and 10-year periods). The average of all those 12-month returns was a positive 22%. There are not enough 25% declines for this average to be statistically significant, but I am not going to deny that it gives me much comfort.
History of Market Crises
| Years | Crisis | Total Drop | 12-month Return After Drop Hit 25% |
|---|---|---|---|
| 1961-1962 | Cuban Missile Crisis | -28% | 31% |
| 1968-1970 | End of Post-War Expansion | -36% | 32% |
| 1973-1974 | Oil Embargo | -48% | 1% |
| 1980-1982 | Inflation Strikes Back, Return of the Fed | -27% | 44% |
| 1987 | Black Monday | -34% | 15% |
| 2000-2002 | Dot Com | -49% | 0% |
| 2007-2009 | Global Financial Crisis | -57% | -7% |
| 2020 | COVID-19 Pandemic | -34% | 56% |
| Average | -39% | 22% |
Going beyond planned savings targets, the data suggests that the risk of holding cash is particularly high right now. Here are two scenarios for an investor to weigh:
Be invested and the market continues to decline. Since every market decline historically has been temporary, I expect that this scenario will at worst lead to short-term or medium-term regret.
Not be invested. Regardless of when the market bottom occurs (September 30 or some date in the future), the chance of an investor timing it well is slim to none. People are much more likely to freeze up and miss critical portions of the recovery. In fact, some of the biggest portions of market recoveries happen in single days, and I expect that this scenario will lead to regret that lasts for a lifetime. By far the most powerful emotion in investing is long-term regret.
As any competent financial advisor can demonstrate, the steeper the historical trajectory downward during a stock market decline, the steeper the subsequent trajectory upward during its recovery, and that the greatest single-day advances have clustered in the immediate aftermath of market bottoms. That is why the goal-focused, plan-driven, lifetime investor need not be interested in how deep the current bear market will go, which depends imponderably on factors out of our control: the energy market, labor market, inflation, interest rates, recession, the war in Ukraine, and many more. In other words, the risk is not that you get caught in a further decline of say 20%, but that you get caught out of the next 60% advance which most financial plans never catch up with.
The market does not turn when we see light at the end of the tunnel, it turns well before that point when things are still dark. Before the last bout with inflation 40 years ago was even settled, the stock market began a legendary recovery in July 1982, gaining 61% over the next 12 months and tripling in value in five years. Anyone holding cash at the start of this recovery likely never made up for it and experienced regret that lasted a lifetime.
That does not mean we will see returns like that again, but in a very real sense, we have seen this movie before. Take a look at the cover of Time Magazine in 1970! That could easily be a cover page today. As President Harry Truman famously said, “The only thing new in the world is the history you don’t already know.”
Life Magazine, June 1970
So, what is Quantum doing differently right now?
We are continuing to be vigilant about what we sell for withdrawal purposes. In most cases, when withdrawals are needed, it still makes sense to sell investments that are down from their high on January 3. Our financial plans assume markets will have significant downturns from time to time, and in many cases, those investments are still positive compared to when they were originally purchased. In other cases, we are selling only certain bond funds to the extent this does not push us out of the investment policy asset allocation range that was agreed to with you, our client. We continue to tax-loss harvest where possible, and importantly we are on the lookout for rebalancing opportunities to take advantage of the drop in prices.
What do all economic and market crises have in common? They end. Economic growth rebounds. Stock prices resume their upward trend. And in time, that is all that matters. If you are not clear on what your plan is, then I encourage you to reach out to your advisor for a chat – it could be one of the most important conversations you have this year.
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