First published in January 2019 newsletter, before anyone could foresee the COVID-19 outburst, which started only a year later. The article is reprinted exactly as it was initially published. It’s amazing to see how what made sense then, when the markets were trading at much higher prices than today (April 2020), still makes sense today.
The alarm is on. And it is flashing bright red lights, sounding a strong voice:
“Beware! Beware! Danger ahead!”.
Inexperienced investors see the sights and hear the sounds and think:
I could be losing my life savings now! This could be 1929 all over again…or 2008…or worse.
I’m taking my money (what’s left of it) and running away.
But experienced investors, those that had lived through the 2008 crash, and maybe through the 2000 dotcom blow-up – know better.
They hear the same voices and see the same horrible sights but give the situation a different interpretation.
Those experienced investors, the long-term winners, hear the sirens say:
“Beware! You are prone to make decisions driven by your emotions. You are fragile now.
You can easily become a victim of your biases.
You must calm down.
Come back to your senses.
Stick to your SYSTEM.
Stick to your SYSTEM.
Do me a favor, stick to your SYSTEM. If you don’t have a system, take a deep breath, and develop one.
Your system can be as simple as being fully invested, all the time, avoid checking your portfolio on down days, and attend your portfolio only when the time to rebalance has arrived.
Your system may be to keeping some money in cash and increasing your exposure as the market declines a certain amount. Your system may be using market timing signals to sell a portion or ALL your positions’ value when the signals tell you to. You may be using the SPY signal, the UI signal, or the SPY-UI (if you’re not sure what are market timing signals, refer to the November 2018 Newsletter, which is available on the membership dashboard).
The beauty is – Your system need not be perfect. It helps you win in the long-term not because it is so special, but because it is a rational way to deal with uncertainty. It keeps you from making hasty decisions out of fear alone. It thus keeps you from losing.
My personal system, up until November this year (2019), was to be fully invested no matter what. That is how I survived the 2008-2009 crash. If you’ve read my emails, you may remember a story I told about how I had lived through that crash.
My Old System
The 2008-2009 market crash was a formative experience for me.
I had a sincere belief that the world was NOT coming to an end, and eventually, markets will recover.
Deep down inside, I am an optimist.
But seeing my hard-earned money evaporate, day after day, week after week, was tough indeed.
I remember us, my wife Noa, my kid, and myself traveling in Switzerland in August 2008 and watching CNN in our hotel room.
“This may be our last travel abroad for the foreseeable future,” a thought crossed my mind as I saw the bloodbath in the news.
The lower the stock market tanked, the less I wanted to look at my stock portfolio or hear anything about it.
I was still fully invested, and I didn’t sell anything going into the crash.
I simply ignored the market.
I had shut down.
You see, I figured that selling was unwise. It would only make my paper losses become real losses. And I knew deep down that stocks will eventually recover.
The stocks I owned were decent, and I figured that most would survive.
Through the rest of 2008, I totally ignored the stock market. I was fully invested, was not intending to sell, and couldn’t buy more.
But then, at the beginning of 2009, I’ve noticed by chance that Yitzhak Sharon (a.k.a. Yitzhak Tshuva), the Israeli Natural Gas and Real Estate tycoon, was buying shares of his own holding company, DELEK, which I owned some.
Per regulatory requirements, he was required to report his purchases to the Tel-Aviv Stock Exchange.
It was amazing – DELEK was making new lows every day, and the controlling shareholder was piling up stock.
After researching the company some more, I thought – hey, this is a once-in-a-lifetime opportunity.
…The stock was trading at a significant discount to NAV…
…And the controlling shareholder was piling up.
I’ve made a decision.
I borrowed some money and bought a large chunk of the stock myself.
Not that I recommend it to anyone.
Keynes is famous for saying: “The market can be irrational longer than you can stay solvent.”
But I had a steady job, and the opportunity was staring me in the face.
Not sure it was a brilliant decision, but that’s what I did.
Luckily, March 2009 was the bottom, and the market started recovering. My stocks came back and then some, and DELEK went from 30 NIS a share to 100 NIS when I sold it.
Living through the great recession had taught me a valuable lesson. I’ve proven to myself that I can withstand a major crash and not run away and not make hasty sales.
The whole experience gave me a tremendous amount of confidence in my mental strength.
I was thrilled to discover that I had a genuine value investor temperament.
Sure, it was tough, but I’ve lived through it without bailing out.
My new system
In November 2018 edition of the Members’ Newsletter, I published my original research on market timing signals (now available here). I was surprised to find out (in a good way) that the SPY-UI signal, which combines both a technical rule (sell stocks when SPY is below its 200-day moving average) and a macro rule (sell stocks when the unemployment rate rises above its 12-months average) – had a surprisingly good performance. Using that signal cuts the drawdowns and volatility by a significant amount while having an only minor effect on returns. As a reminder, here are the results of the QV and QM portfolios with and without market timing:
In that newsletter edition, I mentioned that market timing signals, and especially SPY-UI, are not guaranteed to work well in the future as they’ve worked in the past. I highlighted that the favorable results are not statistically significant as we would want. While market timing signals had worked well with indices and portfolios, they do not work well with individual stocks. We are yet to fully understand why. Relying on market timing signals requires some leap of faith.
But given all those disclaimers, I decided to modify my SYSTEM for investing. I would now use the SPY-UI signal to sell half of my positions’ value when the signal turns Risk-Off. I will also use the same method in the Lion model portfolio.
We are not there yet. The SPY signal is Risk-Off, but the UI signal is still Risk-On, meaning that the unemployment rate has not risen above its average. We are not in a recession. So as long as one of the signals (UI in this case) shows risk-on, I am still fully invested (published in January 2019, T.D.).
Is This Time Different?
It’s a cruel market as of late. Major indices already lost more than 15%-20% since their October peak. As usual, when it rains, it pours, and all stocks are beaten, both the cheap ones and the expensive ones, both those with high quality and the junk.
Whoever did not experience the 2008 fall or the short period in 2011 when the market fell 20% – has enjoyed many years of a stock market rally, and now need to face a major downturn for the first time. Not an easy feat. Scary, even.
It’s interesting to realize that the market declines this time around are steeper than any other decline in the last 20-30 years. Examine the S&P 500 chart below. See the slope of the declines. The recent decline looks like a free fall. Some “experts” say that the steep decline is an indication that the rebound will be quick and steep as well. Well, I don’t know. I sure hope so.
Also, in contrast to previous crashes, this time – there’s nowhere to hide. All sectors are going down. Energy declines the most, although many energy stocks were not overly expensive going into this downtrend. Financials are suffering pretty badly as well, although U.S. banks are more stable than ever, and interest rates rises are expected to have a positive effect on banks’ profitability for the next several quarters.
Why Is It Happening?
The major economic concerns of this day and age are known for a long period of time, and nothing new has really been discovered during the last quarter.
Here is a shortlist of the major economic concerns:
- Trump is fighting a trade war with the Chinese Government
Trump’s tariff plan has a good cause, allegedly – protecting U.S. companies and U.S. workers. It’s the tariffs’ effectiveness that’s in question. Not many people believed that Trump would go all the way with his agenda and actually engage in a trade war against China. As he seems more determined to do so, investors get edgier.
Recently, U.S. and China agreed on a 90-day “cease-fire” to try to reach a long-term agreement, but Peter Navarro, the White House economic consultant, estimated lately that the U.S. and China would find it hard to establish a long-term agreement in the foreseeable future, raising investors concerns over an economic slowdown burdening both U.S. and Chinese companies.
- Europe’s Weakness amid Quantitative Easing Cessation
These days we are marking ten years of quantitative easing around the world. So far, The Fed alone had purchased $4 Trillion worth of bonds, while the ECB purchased $2.5 trillions worth of bonds. As a result, governments and companies around the world had become addicted to 0% interest. Now, when the party is about to be over, it is hard to break away.
The FED stopped buying bonds two years ago, and the U.S. economy fares pretty well without it, but in Europe, there are signs of a slowdown amid political changes giving rise of extreme right-wing parties. Brexit is going tough, and Italy and Greece are still an economic mess. Some economists question Europe’s ability to function well without additional monetary support.
- The Fed wants to raise interest rates while Trump opposes
The Fed estimates that the U.S. economy is robust enough, and inflation is high enough to justify additional rate hikes. In opposition, Trump and some economists fear that further rate increases will tamper growth and may lead also to a recession. Here’s what Trump really thinks.
- China could get out of control
China has grown double-digit up until two years ago. Since then, China is going through a major shift from an export-laden growth economy to an inward-facing economy focused on the well-being of its citizens. That process is happening in parallel to coping with high corporate debt levels and a large-scale real-estate bubble. In China, there are enormous ghost cities empty of any human beings, as a result of an uncontrolled building.
The transparency of the Chinese government is low as it has always been, so no-one outside of China is fully aware of the accurate economic situation. It is evident, though, that the GDP growth rate of China is on a decline, and there is a weakness in both industrial indicators and retail. The trade war with the U.S. is occurring in the least suitable time for China and may tamper its growth even further.
How Low Can Markets Go?
No one of us has a crystal ball, so everything I write here won’t be more than an educated guess. If we examine the great downturns during the last 50 years, we’ll see that most declines were around 20%, with the last two (2000 and 2008) being exceptionally larger.
We’re already down almost 20% from the peak. Are we close to the bottom of the correction? I hope so.
Another indication is how expansive the market is compared to its valuation history. The composite P/E ratio of the S&P 500 is 19.4x (compared to a mean of 15.7x). It’s high but not as high as it was in 2000 and 2007.
Sometimes, economists refer to Shiller’s PE, Price to earnings ratio, which is based on average inflation-adjusted earnings from the previous ten years. Shiller’s PE is at 28x, compared to the historical average of 16.6x. It seems that further declines are somewhat more likely, but bear in mind that the low-interest environment supports higher multiples than the historical averages.
What To Do Now?
The decision what to do with your portfolio is entirely yours. Only you know your temperament, your abilities, and your investing goals. Nevertheless, keep in mind – history tells us that in times of declines and uncertainty, the best course of action is do nothing, ignore the noise and search for investment opportunities created by recent declines.
It is not easy to keep calm when the media delivers fear, uncertainty, and doubt. It is OK to be concerned. But being concerned doesn’t mean panic. It is OK to reduce positions if it fits your system, your goals, and your state of mind. It is unwise, though, to sell everything and hide entirely in cash.
Warren Buffett says that the best time to buy stocks is when there’s blood in the street. To tell you the truth, I see bruises here and there, but I don’t see blood on the street. Google, Netflix, Facebook, Amazon, and many others are still very expansive. It is nothing like the end of 2008 where everything was cheap. There’s no blood on the street.
On the other hand, I see many bargains out there. Fiat Chrysler (FCAU), ArcelorMittal (MT), Sony Corp (SNE), Micron (MU), Bed Bath and Beyond (BBBY), and many others – all trade at record low valuations.
At this time, the best course of action is being selective.
On the one hand, don’t go and buy everything you see.
On the other hand, don’t hide in cash.
Invest in stocks selected by careful manual analysis, or better, by carefully-crafted quantitative algorithms. It is true today, as it is true every day. When you have a long-term investing mindset, market corrections become a meaningless blip in history for you.
When you have a SYSTEM in place, not only you can even sleep well at night, but even enjoy the ride.