Reversion to the mean
It’s been what can only be described as a great 10 years for stock market investors.
From 2009 to 2019 the US markets returned approximately 350%.
It was the 4th best decade in terms of returns.
But we know that the good decades are usually followed by below-average decades and we’ve started this decade in a distinctly ominous fashion.
After 10 years of solid returns there are plenty of investors who think the show will just continue and markets will be fine.
Cautious talk of mean reversion and market cycles is dismissed with the wave of a hand.
All the same old reasons are dragged out again.
The market will apparently stay high because of ‘new’ tech like Netflix and Uber, or due to different accounting methods.
Value investing is dead, and the old industries will fade away, they’ll say, and growth will continue forever.
And the creme de la crème:
’Buffett is underperforming because he’s an old fogey and out of touch…’.
You get the picture, it’s the same old story repeated over and over again, with but with different protagonists and new characters….
The recent steep fall and high volatility has provided a wake-up call for many investors: young and old, beginner and experienced.
Suddenly, we’re talking about bear markets again.
But these warnings are countered by the ongoing sales pitches of the finance industry, including the old favourite that now presents a ‘once in a generation’ buying opportunity.
If you ask the finance industry there’s almost never a time to sell, and it’s nearly always a time to buy.
Prices are low? Buy lots!
Prices are high? Buy anyway!
Whatever you do, just buy and hold and you will be fine in the long term, goes the patter.
If you invested funds near the market top of 2000 (as you tend to when you have a superannuation account) then the returns have been less than impressive since we’ve now experienced two periods of steep losses.
Now you can quite rightly argue that it’s all well and good cherry-picking dates.
Point duly taken.
But when do you start buying again?
After all, you can’t sit idly by on the sidelines forever.
Well, no, you can’t, but a read of market history can give us some valuable clues.
History leaves clues
Most bull markets end in a two-phase process as we’ve discussed previously.
That is, an initial steep fall, then followed by a slow and agonising decline (we call it being sandpapered to death).
What you may not know is that secular bear markets can last for a long time.
As in, a very long time.
From early 1966 to the latter half of 1982, for example, the Dow Jones Index in the US went nowhere, and tailed away sharply in real terms.
That’s right, the market meandered across 17 excruciating years.
First and foremost, bear this timeline in mind when the finance industry tells you it must always be a great time to buy.
We believe that it’s still early days, and that there will be plenty of time to buy, rather than feeling the need to rush back in.
Because 2009 rebounded quickly, many folks think this time around will be the same.
But history shows that bear markets usually take longer to stop than we think than they will.
Things may be somewhat different this time because policymakers have learnt that they can’t just sit idly by and wait for free markets to function again.
Governments and central banks were quicker to respond in 2009 than they were in 1929, and they’ll be quicker again this time around.
7 lessons from previous grizzly bears
Can we learn anything useful from previous bear markets?
Given that history doesn’t repeat but it does rhyme, we think we can.
Firstly, bear markets can last for a long time.
OK, you’ve got that one down pat.
Here are 7 other lessons on bear markets:
1. They end on pessimism, not optimism – with many financial folks advising others to rush in and buy stocks, this seems to indicate that we’re not at the bottom yet.
The bear market has more likely ended when you tell your friends that you’re buying stocks and then find yourself blocked from their Facebook or Twitter page!
2. Research shows that equity valuations are mean-reverting and that the bear market may not be finished until some equities trade at a 70% discount to the replacement value of their assets.
Macro valuations indicators such the US CAPE ratio also indicate that, if history is a useful guide, we’re still a considerable way from the cycle low and the start of a new secular bull market.
The long-term CAPE average is roughly 17 and we’re still – even after the declines to date – tracking at around 24.
And if earnings collapse as we expect then there will be no imminent recovery.
3. Sentiment is still somewhat positive in the sense that many folks are still saying everything will be fine in markets within a relatively short period of time (say, 6 months).
The industry is naturally and persistently optimistic in talking up markets, but a more considered and realistic view would tell you that there’s likely to be considerable carnage in the global economy resulting from the Coronavirus.
Bear markets usually end when folks simply refuse to believe positive economic news, having been burned too hard and often previously (a bit like a discrepancy between company performance and share price performance where the company is growing its retained earnings).
We’re not nearly at that point yet.
4. Bear markets usually do not last only one month.
Bear markets tend to go for longer than you expect, and so we don’t think we are there yet given it’s been only one month.
5. The auto industry starts to increase sales due to reduced prices.
We suspect this might be a while away, too, since Aussie households carry considerable debt, while we also recently went through a prolonged boom period for new motor vehicle sales.
Only relatively recently did Aussie consumers start to ease their collective foot off the pedal, so to speak.
6. One leading indicator is that copper prices start to improve, and that commodities more broadly begin to pick up.
This is not happening yet, but it could be argued that at some time in the future oil will bounce and demand will improve in a bid to catch up for lost time.
We also believe that governments will spend up big over the coming years in order to build, repair, and replace our ailing infrastructure assets, which have been allowed to run down due to constrained government budgets.
These projects will also be great job generators thereby increasing demand for a range of products and services.
7. One important flag is the market in general stops falling on negative news.
The idea here being that only bad news becomes the norm and to be expected, and by that point there are few who believe things might be improving (even when they actually are).
It’s only at this point that the stock markets start to awaken.
End of the bear
Here, then, are a few ways to think about how bear markets end, and you can begin to watch yourself for the signals.
Overall, we believe that there’s plenty of time to build a solid portfolio that will perform over the long term.
We think that when the secular bear market ends, a new secular bull market will begin, in part thanks to the global stimulus being delivered.
Perhaps that’s the most important lesson of all from history: nothing stays the same forever.
There’s no need to rush in now, but on the other hand (and it’s always annoying when folks say that) you also can’t simply wait around on the sidelines until the good news is flowing again.
If you want to catch equities somewhere near the bottom, then you need to start buying at some stage.
Remember that if you have a systematic approach with a well-thought-out plan using asset allocation, diversification, and our other timeless investment principles, you will be able to prosper in the coming bull market.
The benefit of having market experience is the ability to understand that trees don’t grow to the sky, and that markets will always cycle and mean revert.
Markets become cheap, and then expensive, and then cheap again.
Often there’s a considerable amount of time between these points, but if you’re prudent and neither too greedy nor too fearful, then you should do just fine.
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