Stages of a market decline
Unless you’ve been hiding under a rock you’re probably aware that the stock markets around the world are falling.
This is what we’ve been expecting for some time.
What we didn’t predict was the reason.
Because we’re no better than anyone else at predicting the future.
What we did know for certain, however, is that expensive stock markets don’t stay expensive forever.
This is the reason why we use market cycles and mean reversion as part of our 8 timeless principles for investing.
The final grain of sand
The reason why markets fall could almost be irrelevant because we know from history that expensive markets deliver lower returns over various time horizons.
But the fundamental laws remain: low valuations lead to higher returns and vice versa.
This is the reason why we believe that an investor seeking strong returns needs to actively manage their portfolio and we want to place these returns in a historical context.
We aim to show you why buy and hold is not a performing strategy for all markets at all times (it also delivers lower returns than is often advertised).
The below statistics are for the US market and as we tell folks, the US is the big one, and when their markets decline the rest tend to follow.
Even as recently as 2018 when the US declined so did other markets (and in 2019 its bounce back was replicated across other markets too).
Here’s how buy and hold can damage your portfolio if you don’t incorporate macro valuations and market cycles into your investment strategy.
Note that we’re not ‘market timers’.
But if you look at recent earnings yields instead of the potential capital growth then you will understand that markets have been too expensive for a while.
The celebrations from last year’s 25% return have vanished in just a few weeks, with the ASX down 31% in 17 trading sessions (so far).
So much for buy and hold in all markets.
‘But there’s no alternative’ we hear the critics cry.
Well, yes, bonds may be awful, and certainly, interest rates are low.
But it’s prudent to hold cash when there’s very little to buy at a reasonable price and most stocks are expensive.
Being fully invested exposes you to a large probability of losing a lot versus a very small probability of making returns of a few per cent.
That’s what you face when the CAPE and other macro valuations are extremely high.
And that’s what history shows us.
The following excerpt is from an excellent book called Bull! by Maggie Mahar (a book we highly recommend you read):
So, your chances of holding on to extremely good returns over a long period are low – especially if you do not utilise market cycles.
Real returns from stock prices growth are lower than people think, and the geometric average return is materially lower.
Australian share prices have increased by a geometric average of around 6% per year over the past 100 years, or by around 2% after accounting for inflation.
The geometric average return is lower the frequently advertised returns because the downturns erase so much of the preceding gains, while inflation takes care of much of the rest.
This is strong evidence for buying equities when they’re cheap, and selling them when they’re not.
Requiem for a bull market
Now on to more recent events.
One could be shocked at the recent extreme volatility in markets, but we can tell you that this is fairly standard when markets are very overpriced.
This time the initial panic set in after a decade-long bull market in US stocks which generated more than 400% of gains.
It’s just plain silly to think these kind of returns will be sustained when the 10-year average returns are far below this level.
Don’t now make the mistake of watching daily moves and trying to time the market to the last cent.
In highly volatile markets it’s difficult to pick the short-term trend, but we know that because the market is expensive it will fall as high volatility happens in declining markets.
Realize that the CAPE remains high and that there’s a probability is of further significant falls once companies announce their earnings or delay their earnings guidance.
Steady, systematic investing while screening out the noise will stand you in good stead over the longer term.
What will certainly fail is jumping at every shadow or move by a market that will be very volatile.
We’ll show why in the next few posts why our 8 timeless principles are, as ever, relevant to current events, and how they can be used to avoid large investment losses.
To find out more about our coaching programs see here.