These are troubling times for us all in a variety of ways. We are concerned for our health, the health of our loved ones, a return to our customary lifestyle, and our individual and collective financial well-being. I sincerely believe through hard work and perseverance, sound public policy, and the strength of the American people, we will emerge successfully from this crisis. I recognize the greatest concern for most is the impact the Coronavirus could have on your family’s health. The purpose of this communication, however, is to inform you how we, as your investment advisor, are addressing the economic and financial impact this crisis is having on your investments.
As you know, we are in a bear market. A bear market occurs whenever the stock market, using the S&P 500 equity index as its proxy, declines by 20% or more from its previous high. Here a few key data points regarding bear markets:
- They are quite common. Since World War II, a bear market has occurred on average once every 5 to 6 years. It has been eleven years since the last one.
- They are painful. The average bear market sees a drop in the S&P 500 equity index of approximately 40%. As of this writing the S&P 500 has declined 37% off its high.
- They are typically much shorter than bull markets: 10 months on average for a bear market versus 2.7 years for a bull market.
- They are an inevitable part of the investment process for all assets, publicly traded or private.
“The stock market is a device for transferring money from the impatient to the patient.”
- Warren Buffett
The stock market is moved by investor sentiment. Human beings, as a species, are very social. Consequently, we are very much influenced by others. This characteristic has been critical to our survival. When our ancestors saw a panicked look on the face of another tribe member, they ran. If they had waited to see what came out of the bushes, they wouldn’t be our ancestors.
Panics are almost always a component of a bear market. Sometimes panicked behavior is exhibited throughout the market downturn (which is what we are seeing currently), but is most common toward the end of a bear market. As several clients have said to me in recent days: “This time it’s different.” I couldn’t agree more. But that’s why people are panicking. If pandemics were frequently occurring events, we wouldn’t be so afraid. This is the case for previous panics as well. While the specific catalyst is different in every downturn, in every major market decline there are significant casualties in the investor population: those who capitulate and sell out after asset prices have dropped dramatically.
Why do investors panic? Psychologists Daniel Kahneman and Amos Tversky suggest in their 1973 study there are various biases that affect our thinking and decision making. Confirmation bias is our tendency to interpret information that strengthens our prior personal beliefs. In stressful times we may virtually ignore data that is counter to our mindset. Availability bias is when we assume that if something can be easily recalled, it must be more important than alternatives which are not readily recalled. Therefore, we tend to heavily weight the most recent information, creating new opinions based on the latest news. And lastly, Kahneman and Tversky identified Framing bias. This is when we allow how information is presented affect our interpretation of the information. Let’s face it, the media can impact our thinking.
So, how do we overcome these psychological characteristics that are hard wired into our brains? First, think long term. When Alesco worked with you to determine your target asset allocation, we used stock market data from as far back as 1926. Since then we have had the Great Depression, World War II, the great bear market of 1973 -1974, the dot com bubble bursting in 2000, 9/11, the Great Recession, and numerous other bear markets. And yet the long-term average return for equities from 1926 to the present is attractive. At today’s lower prices, the long-term future return for equities has improved, not declined.
Second, it is important to recognize that one’s wealth is “relative,” not absolute. In addition to stocks and bonds, we are currently seeing a broad-based repricing of most other assets: real estate, commodities, collectibles, private businesses, bank loans, intangible assets, and more. When this ubiquitous repricing occurs your wealth relative to others changes modestly. In effect, the purchasing power of your portfolio, relative to your neighbor and the rest of the world, hasn’t changed much. The ones who get hurt are those who sell their assets at low prices. These investors will lose wealth relative to others when the markets recover.
Staying the Course
It takes great discipline to maintain one’s long term asset allocation in times like this. But it is critical to do so. While past performance is not necessarily indicative of future results, since 1929, according to Fidelity Investments, in the 12 months after a bear market bottom, the S&P 500 has gained 47% on average.
We have recently been making some adjustments to most of our clients’ portfolios. Last week it was rumored we might have a nationwide shut down. Included in this discussion was potentially closing the stock market and the bond market. Consequently, we decided to raise a 5 percent cash position in most portfolios. This will provide adequate liquidity for almost every client scenario for months. We raised this cash by selling investment grade bonds, which have held their value in recent weeks.
The second portfolio move we are making is a partial rebalancing. For clients with a blend of bonds and stocks, we are selling a small portion of the bond position to buy stocks. At present we are reducing the underweighting in equities by one third. If the market continues to weaken, we will rebalance again. This disciplined, systematic rebalancing will allow your portfolio to recover more quickly when the markets ultimately rebound.
The United States and the world are in a recession. Although most economists expect the recession will only last through June, estimates of the magnitude of the downturn and the subsequent economic recovery cover a broad spectrum. Projections for second quarter GDP in the U.S. range from a decline of 10% to a decline of 24%. Most economists expect a global recovery in the second half of the year with full year economic activity being slightly negative. If this thinking is reasonably accurate, the stock market is likely to recover well in advance of the economy. We will work to ensure your portfolio fully participates in that recovery.
This is a very difficult time to maintain one’s investment discipline. Fortunately, we have history as a guide. Psychologists provide insight as to why we may make bad investment decisions during difficult times. With this understanding of the market and ourselves, I am confident Alesco Advisors will effectively navigate your portfolio through this crisis. As always, we are most grateful for the opportunity to work for you. Please contact us at any time if we can be of assistance.
James G. Gould