This is always tough, as no one knows when we will hit bottom, just as no one knew when exactly we were at the top. Furthermore, both bad markets and good markets can last longer than expected. While average length of a bull market has been about 4.5 years, and average bear market is about 9 months, we just came off an 11 year bull run and we’ve experienced extended bear markets like we the first 20 years of the 20th century, or the 1930s or the 1970s.
The more important question for an opportunistic investor is, “have we gone through the steps of a distress cycle for opportunities to become abundant, where we can avoid catching falling knives?” The typical distress cycle must reach the fourth of the phases below for opportunities to become abundant.
- Market prices collapse and credit quality deteriorates
- Covenants are violated and cash flow pressures appear
- Payment defaults, broken deals, and insolvencies emerge
Forced liquidations, distressed sales, and bankruptcies are commonplace
Aside from bringing the perfect storm of coronavirus fears, collapse in energy, historic debt levels and reversion from the longest bull market in history, we are witnessing a unique combination of both an economic and financial crisis. A financial crisis is characterized by the collapse of financial assets, liquidity shortages, and general upheaval in the financial system – as we saw in 2008. An economic crisis is characterized by supply and demand challenges, such as low production levels, unemployment, falling GDP growth, and inflation. Financial crisis can be dampened by government stimulus and central bank intervention (and they are certainly doing all they can on this front), but economic crisis requires businesses reopening and people getting back to work. In most recessions, irrespective of how many markets may have fallen, GDP doesn’t fall by more than single digits. In the current shut down of several economies, however temporary it may be, may result in considerable drops in GDP. This is unique because even during the Great Depression, where markets fell almost 90% from their highs, GDP fell roughly by 26%. Having a wholesale economic shut-down is somewhat unprecedented. That said, as soon as the impact of the virus can be handicapped, we will shift towards recovery with extraordinary opportunities to follow.
Markets operate with some measure of efficiency. At some point, one of the three things below will happen, likely in order of increasing probability.
- We find a vaccine or cure for the virus. There are many efforts underway, and rumors of early success stories. Should they prove to be true, regulators will do everything in their power to expedite the approval process. And even before widespread distribution, markets will price in the progress and work will resume.
- It goes away on its own – due to seasonality and weakening of the virus’s potency or due to our methods of containment. Either way, people will return to work and the economic engine will restart.
- We learn to live with it. At some point, the cost of shutting down the economy exceeds the benefit of some percentage of the population getting sick. If one must choose between feeding their children or catching the virus, our instincts will prioritize the former over the latter – irrespective of how contagious it may be. That will result in businesses reopening and markets recovering.
In any of these situations, markets return to their usually sentimental selves and the economy rebounds.
Staying calm and focusing on the long-term. Managing liquidity and waiting patiently for obvious opportunities. Remaining, and helping others remain, thoughtfully optimistic. Anxiety and stress can have a far worse impact on our mental and physical health than the financial impact of the portfolio and/or the probability of being hit with COVID-19. Right now, the focus should be on making sure you and your family are safe. A properly diversified portfolio will prove to be just fine. Though, the quickest way we can compromise that portfolio is by looking at it every day – even during a crisis – as it will compel us to react in ways we will later regret and have an adverse impact on our health.
Countless studies have shown that timing the markets is neither productive nor possible. If there were unmistakable signals of market tops and market bottoms, everyone would know them, utilize them and they would then become ineffective. Not only that, but people who get out in order to come back in are also trying to perform an even greater feat of timing the market twice – when it is best to exit and when best to re-enter. The statistical probability of that is shockingly low.
The primary function of diversification is to reduce risk, NOT to enhance or increase returns. Though, quite ironically, a properly diversified portfolio is one that’s exposed to as many different risks as possible, ensuring that none of them can unilaterally have a meaningful adverse effect. The optimal expression of this is best-practice asset allocation. An optimal asset allocation includes three elements:
- Broader asset class exposure, including both traditional asset classes (stocks and bonds), and non-traditional asset classes (real assets, private equity, credit, etc.)
- Diverse managers and strategies, ensuring that positions are differentiated and the sizes of those positions are large enough to move the needle on performance but small enough that if things went horribly wrong it would not jeopardize one’s lifestyle.
- Targeting isolated risks, ensuring that each dollar has a proverbial job description. In other words, some allocations would be to protect against inflation, others against rising rates, others against falling equity markets, others for liquidity, etc.
The reason central bankers lower interest rates is to stimulate economic growth. In theory, cheaper financing costs encourage borrowing and investing. For example, those with variable mortgage rates now pay less, and those with fixed-rate mortgages may refinance for cheaper. Similarly, those with other forms of debt that are tied to a floating rate, suddenly find themselves with more money in their pocket, which they can now use for consumption or investing.
From an investor’s point of view, it has both a positive and negative effect of higher prices. The positive is driven by the fact that saving is essentially being dis-incentivized by lower rates, driving more money into risk assets and raising prices. The negative is that this increases efficiency and reduces what one gets paid for taking on risk, thereby reducing return expectations on new investments.
It’s statistically likely that you are more anxious or stressed than you need to be. Panic is a deeply imbedded survival instinct. If we didn’t have it, we wouldn’t have escaped approaching predators in the wild. In the realm of markets, however, it is more likely to cause harm than offer any real protection. Furthermore, given the dynamics of loss aversion – i.e. the pain of loss is twice as painful as the pleasure from gain – we will tend to react far more intensely to falling prices than we ought to if we were being perfectly rational humans. Stress and uncertainty will inevitably shrink our field of vision and make it considerably difficult to think long-term.
All this isn’t to mitigate the seriousness of the COVID-19. It is quite serious, all the protective measures we are taking are vital. Furthermore, we are not recommending blind, rose-colored optimism. Though, one can both acknowledge the seriousness of the situation and the reality that we will overcome this.
- Public Health Agency of Canada Government of Canada’s national updates including travel, preparedness, symptoms & treatment, and prevention.
- Canadian Travel Advisories Updated travel notices, domestic and international.
- Canadian Mental Health Association Feeling anxious and need to talk? CMHA has resources to assist with managing anxiety and getting help.
- World Health Organization for global updates.
On March 12th, for the first time in recorded financial history, ALL asset classes declined on the very same day. It didn’t matter if you were in stocks, bonds, treasuries, gold, real estate, developed or emerging markets, everything dropped. Margin calls were flying, leveraged parties were selling anything that was nailed down and people were stockpiling cash in anticipation of a State of Emergency. As asset prices were collapsing, some panicked investors called us asking, “Why is my asset allocation not working? What am I doing wrong?”
This question is perfectly legitimate. Though, there are only two answers to that question. Either your asset allocation is problematic or your expectations from your asset allocation are out of whack, as there are three common misconceptions about asset allocation.
The first misconception about asset allocation is that it could deliver a precise outcome. Finance is not physics – nor, for that matter, any science. It does not have rigid immutable laws, which lead to perfectly repeatable and predictable outcomes. In financial markets, sometimes wonderful assets get pummeled, and inferior assets experience meteoric rises. Sometimes stocks and bonds are uncorrelated and sometimes they are correlated. Sometimes real estate is diversified and sometimes it’s not. As we saw in the last two weeks, markets don’t always replicate their past behaviors. All asset allocation decisions are probabilistic rather than deterministic. Asset allocation doesn’t prevent short-term loss; it just reduces the long-term probability of it. There’s an element of chaos, risk, and randomness in the markets that is impossible to handicap.
The second misconception about asset allocation is that it protects against every scenario. There are some things asset allocation cannot solve for – for+ example: nuclear or regional wars, the complete collapse of the global economy, or environmental devastation and pandemics like we’re experiencing today. Expecting your asset allocation to protect you from these, is akin to expecting an umbrella to protect you from a tsunami. Occasionally, tsunamis come through, and in that very moment, everyone feels the pain; prices collapse, everyone is a seller, and every asset is correlated. Though, once the dust settles, it is usually those with a diversified stream of cash-flows, with exposure to a diversified set of risks, and with a healthy dose of liquidity, who are in the best position to both carry on and take advantage of the abundant opportunities in front of them.
The third misconception about asset allocation is that there’s an ideal asset allocation. Absolutely no such thing. If there was, everyone would utilize it. Thousands of financial products would be built around it. And then, countless others would learn to arbitrage it. Just like no dating app could produce your perfect spouse, no computer program can engineer your perfect asset allocation. Optimal asset allocations don’t just employ good rules-of-thumb and best practices. Asset allocation also accounts for the idiosyncrasies of individual investors – their needs, concerns, constraints, and aspirations – giving them the staying power to make better investment decisions.
So, if you’re questioning your asset allocation, consider whether it’s your allocation or your expectation.
Amidst this crisis, people are wondering why diversification is not offering them the protection they hoped for. [See Mo’s thoughts on whether asset allocation is failing us]. Many may erroneously or naively assume that diversification is a panacea – a protection against the crisis. It is not; at least not in a simplistic, silver bullet form. Diversification does work, but it works overtime – not everytime. Why is that? What kind of risks does it protect us from? And what kind of risks does it not help us with? Answering those questions requires a better understanding of the three types of risks we may be exposed to – systematic, unsystematic and behavioral.
- Systematic risk is the risk of being an active participant in the markets (i.e. an investor). Generally, participants receive a premium for their participation (i.e. returns), but they are also subject to the risk that the entire system may be adversely affected. That may be as a result of entire equity markets collapsing, a growing credit crisis, raging inflation, currency collapse, or history-altering events (wars, pandemics, etc.). Systemic risks are unavoidable and will not be protected by simple diversification strategies, like holding a few dozen stocks. Largely, at times like these all assets fall in tandem. There are various sophisticated ways to protect against systemic shocks (by employing different hedges and the full range of asset classes), but these are out of reach for most retail investors.
- Unsystematic risk is the risk of isolated factors impacting specific companies, industries or geographies. For example, a worker strike or a bankruptcy in a specific company, social unrest or weather conditions in a specific country, technological obsolescence of a specific industry and so on. Whether they are political, legal, economic, caused by natural disaster or anything else, unsystematic risks tend to affect a small group of market participants and are generally manageable through naïve diversification. Simply by having a basket of stocks and bonds that are spread across various industries and geographies one can shield themselves from any significant impact of these isolated factors.
- Behavioral risk is simultaneously the easiest and most difficult risk to manage. It is easiest because it’s not dependent on outside sources and most difficult because it requires us to manage our emotions or the frailties of any human decision-making process. It effects how we think about everything from when to buy, when to sell, at what valuations, who to partner with, how much liquidity do we need, how much risk we can endure, etc. Every investment decision is subject to our behavioral biases, and it is one risk that any form of diversification will have limited benefit from, as its chief culprit is ourselves. It can, however, be managed by the inclusion of an objective, unbiased 3rd party (usually, a trusted investment advisor) and the employment of a disciplined investment process.
We are not experiencing one of the biggest recessions of the last 100 years. We’ve had several of the most severe drawdowns (while also several of the most dramatic comebacks) and everyone is asking, when will this be over? When will this correction start turning around?
It is important to distinguish which market and which correction we are talking about. We talked about the fact that what we’re experiencing is both a financial crisis and an economic crisis – capital markets have been hugely volatile, and the real economy of companies (i.e., factories, restaurants, theatres, etc.) are being decimated. That combination makes this more difficult than ever to understand (as if it was ever possible). Though, a turn-around looks very different in the real economy compared to the capital markets. In the real economy things will only start turning around when we get a grip on the spread of COVID-19. In other words, the question is when will the market be able to handicap and start pricing in this pandemic’s damage to GDP?
Capital markets, on the other hand, will react with alarming efficiency. Even if a single person has yet to return to work, no Starbucks has re-opened or NBA game yet been played, the mere confirmation of a timeline towards restart will send the markets flying.
While we cannot provide an answer to the question above, people should recognize that there is a lag between capital markets and the real economy. Traded markets were affected before the economy initiated a large-scale shutdown, and the pain was felt by investors before employees or entrepreneurs. The inverse is also true. The markets will rally at the first whiff of a recovery, but it may take several months for economies to revert to “normal” – whatever that may look like on the other end of this crisis.
[The response below is a transcription of Mo’s recent video]
With regards to investments, there is rarely a “best” and absolutely no perfect decision. Mostly, our decisions will be reasonably good or ostensibly bad, and there are several reasons why perfect investment decision-making is a myth.
The first challenge to perfect decision-making is the non-linearity of investments. To most people’s chagrin, investing is closer to poker than it is to chess, as it’s a game with incomplete information, is both part art and part science, and involves an element of luck – so risk management is paramount. By considering the number, the size and probability of the bets being taken, both pokers players and investors could produce exceptional results – EVEN while being wrong 40% of the time. In making decisions about the future, we must assess the probability of our desired outcomes, what we are willing to bet on being right and what we are prepared to lose if we’re wrong. That’s how someone who loses 40% of the bets can still end up with 100% of the pot. The challenge is that the average investor cannot ascribe perfect probabilities to specific future outcomes. This makes it difficult to distinguish between that which is possible and that which is probable, which in turn makes it difficult to be certain about what will be profitable.
The second challenge to perfect decision-making is the involvement of luck. The role of luck is perhaps the hardest for most people to digest, as foolish investors could get lucky and savvy investors to get unlucky. That means that good decisions and good outcomes aren’t always aligned.
Some reckless endeavors have a positive outcome, for example playing Russian roulette and surviving. Conversely, some protective endeavors – like putting your savings in a bank that collapsed – have a bad outcome. As such, the quality of a decision cannot be determined solely based on its outcome. But, since outcomes are observable, while the risk is not, the best decision is rarely obvious.
The third challenge to perfect decision-making is the absence of immediate feedback. Researchers have shown that when doctors claimed that the patient had a 90% chance of having pneumonia, they were correct only 15% of the time. Whereas when weather forecasters predicted a 90% chance of rain, they were correct 90% of the time. The difference between a doctor and a weather forecaster is the gap between the prognosis and feedback. We see the weather every minute, allowing meteorologists to adjust and refine their assessment, whereas treatments (and investments) can take weeks, months and years to prove themselves. And investors have one more complication – a subjective time-horizon. One person requires a specific outcome in three years, another in ten. Each will have a different decision-making calculus and feedback needs, compounding the challenge of the decision-making process.
So, no, neither you nor anyone else will make perfect decisions. No one can definitively tell you if you should sell, buy now or wait. There will be no indicators to say, “the coast is clear”. The best we can do is make directionally correct decisions that align with our needs, where the risk of loss is much smaller than the prospect of gain. And even if we are wrong in our assessment, the bets are small enough that we’ll live to remedy it. Perhaps, if we accept the imperfection of all our investment decisions, we’ll become better equipped to make them.
Central banks and governments around the world are now unleashing stimulus programs of unprecedented magnitude. Just the members of the G20 have committed in excess of $5 trillion. That is considerably greater than the 2008 stimulus plan, and the number can yet rise. The question needs to be asked, where are governments getting this money from? And what are the implications of these programs?
Governments do not have trillions sitting in their coffers, and it is quite clear that during this tumultuous period tax revenues are at all time lows. Governments are also not downsizing or reducing spending, as that may exacerbate the crisis. So, the stimulus cash is coming from one of two sources – either the manufacturing of money or debt.
Manufacturing money typically involves either printing physical dollars or central banks issuing dollar credits to other banks, thereby increasing the money supply. Manufacturing debt typically involves the issuance of new government bonds, and then selling those bonds to investors to generate liquidity.
Naturally, there are risks from both tactics. The manufacturing of money has the potential to trigger inflation, as there has never been a time in history when increasing the money supply didn’t also increase inflation. And the manufacturing of debt has the potential to increase the national deficit to unhealthy levels.
While low-interest rates obviously benefit borrowers, as it reduces their debt servicing costs, and there are many reasonable arguments to make for inflation continuing to stay low, stimulus efforts will invariably increase the risk of both concerns, and it behooves investors to begin planning accordingly.
In the first weeks of this crisis, the Dow Jones experienced the largest point drop (and 2nd largest percentage drop) in history. Since the start of this crisis in late February, we’ve already seen eight of the ten largest point drops in the 124-year history of the Dow Jones Industrial Average. Ironically, the same can be said for eight of the ten largest point gains. The level of daily volatility has been unprecedented. And the question is why?
To answer that question, we must recognize some of the fundamental differences in today’s markets that may not have been present in previous bear markets. These three trends are primarily an outgrowth of indexation, regulation, and automation.
Indexation: In September 2019, the market crossed an important milestone, where over 50% of US equities are now being managed in passive strategies – i.e. generally through indices and ETFs (Exchange Traded Funds) – as opposed to active stock pickers. This has been beneficial in reducing the costs and simplicity of accessing diversified pools of stocks. At the same time, it has materially increased both correlations and the volatility of the market. This is due to passive investors now owning or buying securities for structural, as opposed to fundamental reasons. In other words, today over 50% of investors own GM or Coca Cola or Walmart because it’s in the S&P 500, not because it’s a good investment or a great business. And the day either of those fall out of the index, tons of investors will sell it – not necessarily because it’s a bad investment or business, but simply because it’s out of the index. Most passive investments, they tend to disregard fundamental value and margins of safety (most indices are price-driven). That “basket-buying” or “basket-selling” dynamic changes the historic character of the market because when there is a sell-off, you’re not seeing more liquidity going to good, quality companies and less going to worse companies. Since ETFs were a fraction of the market in 2008, this new dynamic is only now reducing the efficiency of the market, limiting price discovery (as a smaller number of investors are picking up on the nuanced differences between companies) and reflecting the natural impulses or psychology of people. All this is in addition to the fact that a smaller number of companies have greater sway over the economy, as five companies like Microsoft, Google, Facebook, etc. are 1% of the companies in the index, but they account for 18% of it’s value.
Regulation: In the aftermath of the 2008 crisis, new regulations such as Basel III forced banks to be less leveraged, with greater capital requirements and generally carry less risk. As a result, banks responded by shedding their bond inventory, which they used to hold for making markets. Leading up to 2008, banks held over $250 billion in inventory and over 10% of all corporate bonds in the US on their balance sheets. Today, banks hold around 1% of corporate bonds and under an even smaller fraction of their previous inventory level. Instead, banks have opted for a “just-in-time” inventory approach, effectively buying bonds and turning them around quickly to make a sale. So, trading velocity has increased, as has peer-to-peer trading. Though, in a liquidity crisis when buyers tend to disappear, there’s nobody who can hold inventory opportunistically to buffer the slowdown. This makes the bond market less liquid, increasing its volatility more than we’ve ever experienced, which we have seen play out in the high yield market recently.
Automation: While in 2008, only 60% of trading volume was conducted by machines, today 90% of trading volume is done by computers. Electronic trading desks run by algorithms, not driven by value, but largely by momentum and other factors. That means that emotional sentiment can swing towards greater volatility and more extreme illiquidity. Automated or computer-generated trading is far quicker than human trading. It doesn’t have inertia or emotional paralysis. There is no loyalty to companies or asset managers. Computers react to the millisecond when the algorithms dictate that a change is necessary. Whether or not this is positive or negative is beside the point, what is obvious is that collective market sentiment will drive much greater swings in volatility.
There has never been a more important (and more challenging) time to be a long-term investor, as the increased volatility tends to translate into increased submission to behavioral biases – which tends to be the greatest eradicator of wealth.