“You better tuck that in. You’re gonna’ get that caught on a tripwire.” – Lieutenant Dan, Forrest Gump

There is a popular game called Jenga in which a tower of rectangular blocks is arranged to form a sturdy tower. The objective of the game is to take turns removing blocks without causing the tower to fall. At first, the task is as easy as the structure is stable. However, as more blocks are removed, the structure weakens. At some point, a key block is pulled, and the tower collapses. Yes, the collapse is a direct cause of the last block being removed, but piece by piece the structure became increasingly unstable. The last block was the catalyst, but the turns played leading up to that point had just as much to do with the collapse. It was bound to happen; the only question was, which block would cause the tower to give way?

A Coronavirus

Pneumonia of unknown cause first detected in Wuhan, China, was reported to the World Health Organization (WHO) on December 31, 2019. The risks of it becoming a global pandemic (formally labeled COVID-19) was apparent by late January. Unfortunately, it went mostly unnoticed in the United States as China was slow to disclose the matter and many Americans were distracted by impeachment proceedings, bullish equity markets, and other geopolitical disruptions.

The S&P 500 peaked on February 19, 2020, at 3393, up over 5% in the first two months of the year. Over the following four weeks, the stock market dropped 30% in one of the most vicious corrections of broad asset prices ever seen. The collapse erased all of the gains achieved during the prior 3+ years of the Trump administration. The economy likely entered a recession in March.

There will be much discussion and debate in the coming months and years about the dynamics of this stunning period. There is one point that must be made clear so that history can properly record it; the COVID-19 virus did not cause the stock and bond market carnage we have seen so far and are likely to see in the coming months. The virus was the passive triggering mechanism, the tripwire, for an economy full of a decade of monetary policy-induced misallocations and excesses leaving assets priced well beyond perfection.

Never-Ending Gains

It is safe to say that the record-long economic expansion, to which no one saw an end, ended in February 2020 at 128 months. To suggest otherwise is preposterous given what we know about national economic shutdowns and the early look at record Initial Jobless Claims that surpassed three million. Between the trough in the S&P 500 from the financial crisis in March 2009 and the recent February peak, 3,999 days passed. The 10-year rally scored a total holding-period return of 528% and annualized returns of 18.3%. Although the longest expansion on record, those may be the most remarkable risk-adjusted performance numbers considering it was also the weakest U.S. economic expansion on record, as shown below.

They say “being early is wrong,” but the 30-day destruction of valuations erasing over three years of gains, argues that you could have been conservative for the past three years, kept a large allocation in cash, and are now sitting on small losses and a pile of opportunity with the market down 30%.

As we have documented time and again, the market for financial assets was a walking dead man, especially heading into 2020. Total corporate profits were stagnant for the last six years, and the optics of magnified earnings-per-share growth, thanks to trillions in share buybacks, provided the lipstick on the pig.

Passive investors indiscriminately and in most cases, unknowingly, bought $1.5 trillion in over-valued stocks and bonds, helping further push the market to irrational levels. Even Goldman Sachs’ assessment of equity market valuations at the end of 2019, showed all of their valuation measures resting in the 90-99th percentile of historical levels.

Blind Bond Markets

The fixed income markets were also swarming with indiscriminate buyers. The corporate bond market was remarkably overvalued with tight spreads and low yields that in no way offered an appropriate return for the risk being incurred. Investment-grade bonds held the highest concentration of BBB credit in history, most of which did not qualify for that rating by the rating agencies’ own guidelines. The junk bond sector was full of companies that did not produce profits, many of whom were zombies by definition, meaning the company did not generate enough operating income to cover their debt servicing costs. The same held for leveraged loans and collateralized loan obligations with low to no covenants imposed. And yet, investors showed up to feed at the trough. After all, one must reach for extra yield even if it means forgoing all discipline and prudence.

To say that no lessons were learned from 2008 is an understatement.

Black Swan

Meanwhile, as the markets priced to ridiculous valuations, corporate executives and financial advisors got paid handsomely, encouraging shareholders and clients to throw caution to the wind and chase the market ever higher. Thanks also to imprudent monetary policies aimed explicitly at propping up indefensible valuations, the market was at risk due to any disruption.

What happened, however, was not a slow leaking of the market as occurred leading into the 2008 crisis, but a doozy of a gut punch in the form of a pandemic. Markets do not correct by 30% in 30 days unless they are extremely overvalued, no matter the cause. We admire the optimism of formerly super-intelligent bulls who bought every dip on the way down. Ask your advisor not just to tell you how he is personally invested at this time, ask him to show you. You may find them to be far more conservative in their investment posture than what they recommend for clients. Why? Because they get paid on your imprudently aggressive posture, and they do not typically “eat their own cooking”. The advisor gets paid more to have you chasing returns as opposed to avoiding large losses.

Summary

We are facing a new world order of DE-globalization. Supply chains will be fractured and re-oriented. Products will cost more as a result. Inflation will rise. Interest rates, therefore, also will increase contingent upon Fed intervention. We have become accustomed to accessing many cheap foreign-made goods, the price for which will now be altered higher or altogether beyond our reach. For most people, these events and outcomes remain inconceivable. The widespread expectation is that at some point in the not too distant future, we will return to the relative stability and tranquility of 2019. That assuredly will not be the case.

Society as a whole does not yet grasp what this will mean, but as we are fond of saying, “you cannot predict, but you can prepare.” That said, we need to be good neighbors and good stewards and alert one another to the rapid changes taking place in our communities, states, and nation. Neither investors nor Americans, in general, can afford to be intellectually lazy.

The COVID-19 virus triggered these changes, and they will have an enormous and lasting impact on our lives much as 9-11 did. Over time, as we experience these changes, our brains will think differently, and our decision-making will change. Given a world where resources are scarce and our proclivity to – since it is made in China and “cheap” – be wasteful, this will probably be a good change. Instead of scoffing at the frugality of our grandparents, we just might begin to see their wisdom. As a nation, we may start to understand what it means to “save for a rainy day.”

Save, remember that forgotten word.

As those things transpire – maybe slowly, maybe rapidly – people will also begin to see the folly in the expedience of monetary and fiscal policy of the past 40 years. Expedience such as the Greenspan Put, quantitative easing, and expanding deficits with an economy at full employment. Doing “what works” in the short term often times conflicts with doing what is best for the most people over the long term.

“The process by which money is created is so simple that the mind is repelled.” – JK Galbraith

By formally announcing quantitative easing (QE) infinity on March 23, 2020, the Federal Reserve (Fed) is using its entire arsenal of monetary stimulus. Unlimited purchases of Treasury securities and mortgage-backed securities for an indefinite period is far more dramatic than anything they did in 2008. The Fed also revived other financial crisis programs like the Term Asset-Backed Securities Loan Facility (TALF) and created a new special purpose vehicle (SPV), allowing them to buy investment-grade corporate bonds and related ETF’s. The purpose of these unprecedented actions is to unfreeze the credit markets, stem financial market losses, and provide some ballast to the economy.

Most investors seem unable to grasp why the Fed’s actions have been, thus far, ineffective. In this article, we explain why today is different from the past. The Fed’s current predicament is unique as they have never been totally up against the wall of zero-bound interest rates heading into a crisis. Their remaining tools become more controversial and more limited with the Fed Funds rate at zero. Our objective is to assess when the monetary medicine might begin to work and share our thoughts about what is currently impeding it.

All Money is Lent in Existence.

That sentence may be the most crucial concept to understand if you are to make sense of the Fed’s actions and assess their effectiveness.

Under the traditional fractional reserve banking system run by the U.S. and most other countries, money is “created” via loans. Here is a simple example:

• John deposits a thousand dollars into his bank
• The bank is allowed to lend 90% of their deposits (keeping 10% in “reserves”)
• Anne borrows $900 from the same bank and buys a widget from Tommy
• Tommy then deposits $900 into his checking account at the same bank
• The bank then lends to someone who needs $810 and they spend that money, etc…

After Tommy’s deposit, there is still only $1,000 of reserves in the banking system, but the two depositors believe they have a total of $1,900 in their bank accounts.  The bank’s accountants would confirm that. To make the bank’s accounting balance, Anne owes the bank $900. The money supply, in this case, is $1,900 despite the amount of real money only being $1,000.

That process continually feeds off the original $1,000 deposit with more loans and more deposits. Taken to its logical conclusion, it eventually creates $9,000 in “new” money through the process from the original $1,000 deposit.

To summarize, we have $1,000 in deposited funds, $10,000 in various bank accounts and $9,000 in new debt. While it may seem “repulsive” and risky, this system is the standard operating procedure for banks and a very effective and powerful tool for generating profits and supporting economic growth. However, if everyone wanted to take their money out at the same time, the bank would not have it to give. They only have the original $1,000 of reserves.

How The Fed Operates

Manipulating the money supply through QE and Fed Funds targeting are the primary tools the Fed uses to conduct monetary policy. As an aside, QE is arguably a controversial blend of monetary and fiscal policy.

When the Fed provides banks with reserves, their intent is to increase the amount of debt and therefore the money supply. As such, more money should result in lower interest rates. Conversely, when they take away reserves, the money supply should decline and interest rates rise. It is important to understand, the Fed does not set the Fed Funds rate by decree, but rather by the aforementioned monetary actions to incentivize banks to increase or reduce the money supply.

The following graph compares the amount of domestic debt outstanding versus the monetary base.

Data Courtesy: St. Louis Federal Reserve

Why is QE not working?

So with an understanding of how money is created through fractional reserve banking and the role the Fed plays in manipulating the money supply, let’s explore why QE helped boost asset prices in the past but is not yet potent this time around.

In our simple banking example, if Anne defaults on her loan, the money supply would decline from $1,900 to $1,000. With a reduced money supply, interest rates would rise as the supply of money is more limited today than yesterday. In this isolated example, the Fed might purchase bonds and, in doing so, conjure reserves onto bank balance sheets through the magic of the digital printing press. Typically the banks would then create money and offset the amount of Anne’s default.  The problem the Fed has today is that Anne is defaulting on some of her debt and, at the same time, John and Tommy need and want to withdraw some of their money.

The money supply is declining due to defaults and falling asset prices, and at the same time, there is a greater demand for cash. This is not just a domestic issue, but a global one, as the U.S. dollar is the world’s reserve currency.

For the Fed to effectively stimulate financial markets and the economy, they first have to replace the money which has been destroyed due to defaults and lower asset prices. Think of this as a hole the Fed is trying to fill. Until the hole is filled, the new money will not be effective in stimulating the broad economy, but instead will only help limit the erosion of the financial system and yes, it is a stealth form of bailout. Again, from our example, if the banks created new money, it would only replace Anne’s default and would not be stimulative.

During the latter part of QE 1, when mortgage defaults slowed, and for all of the QE 2 and QE 3 periods, the Fed was not “filling a hole.” You can think of their actions as piling dirt on top of a filled hole.

These monetary operations enabled banks to create more money, of which a good amount went mainly towards speculative means and resulted in inflated financial asset prices. It certainly could have been lent toward productive endeavors, but banks have been conservative and much more heavily regulated since the crisis and prefer the liquid collateral supplied with market-oriented loans.

QE 4 (Treasury bills) and the new repo facilities introduced in the fall of 2019 also stimulated speculative investing as the Fed once again piled up dirt on top of a filled hold.  The situation changed drastically on February 19, 2020, as the virus started impacting perspectives around supply chains, economic growth, and unemployment in the global economy. Now QE 4, Fed-sponsored Repo, QE infinity, and a smorgasbord of other Fed programs are required measures to fill the hole.

However, there is one critical caveat to the situation.

As stated earlier, the Fed conducts policy by incentivizing the banking system to alter the supply of money. If the banks are concerned with their financial situation or that of others, they will be reluctant to lend and therefore impede the Fed’s efforts. This is clearly occurring, making the hole progressively more challenging to fill. The same thing happened in 2008 as banks became increasingly suspect in terms of potential losses due to their exorbitant leverage. That problem was solved by changing the rules around how banks were required to report mark-to-market losses by the Federal Accounting Standards Board (FASB). Despite the multitude of monetary and fiscal policy stimulus failures over the previous 18 months, that simple re-writing of an accounting rule caused the market to turn on a dime in March 2009. The hole was suddenly over-filled by what amounted to an accounting gimmick.

Summary

Are Fed actions making headway on filling the hole, or is the hole growing faster than the Fed can shovel as a result of a tsunami of liquidity problems? A declining dollar and stability in the short-term credit markets are essential gauges to assess the Fed’s progress.

The Fed will eventually fill the hole, and if the past is repeated, they will heap a lot of extra dirt on top of the hole and leave it there for a long time. The problem with that excess dirt is the consequences of excessive monetary policy. Those same excesses created after the financial crisis led to an unstable financial situation with which we are now dealing.

While we must stay heavily focused on the here and now, we must also consider the future consequences of their actions. We will undoubtedly share more on this in upcoming articles.

A recent article on MarketWatch by Sanjib Saha caught my attention:

“After taking the Series 65 exam last February, I set a goal for 2019: Help 10 friends and family members with their finances. Instead of giving specific investment advice, I wanted to educate them on money matters. I knew that they would benefit from one-on-one discussions, well-regarded books, educational videos and credible websites.”

Think about that for a moment. Here is a young man, who grew up during the longest bull market in history, just took his exam last year, has no real investment experience to speak of, and is now giving advice to people with no investment knowledge.

What could possibly go wrong?

While the majority of the article is grossly misinformed and a regurgitation of the “bullish mantras,” there was one paragraph that jumped out with respect to investment success and failure over time. To wit:

“Many years ago, Aisha, received a windfall that she needed to invest. She interviewed a few financial advisers and went with someone who had an impressive job title, a long list of designations and a friendly demeanor. She regularly reviewed her portfolio with the adviser, but never considered there might be performance problems. After all, a paid professional ought to do better than the market, not worse—or so she thought.

As it turned out, her portfolio had more than doubled over 16½ years.Aisha was impressed, until she backtested an identical asset allocation—one with half U.S. stocks and half corporate bonds. A 50-50 allocation consisting of just two broadly diversified index funds would have quadrupled her money over the same holding period. She stared at the results in disbelief. The opportunity cost was huge.”

The Comparison Trap

This is one of the biggest tools used by financial advisors to get clients to switch their accounts over to a “better” program. Let me explain.

Comparison is the cause of more unhappiness in the world than anything else. Perhaps it is inevitable that human beings as social animals have an urge to compare themselves with one another. Maybe it is just because we are all terminally insecure in some cosmic sense. Social comparison comes in many different guises. “Keeping up with the Joneses,” is one well-known way.

Think about it this way.

If your boss gave you a Mercedes as a yearly bonus, you would be thrilled, right? However, what if you found out shortly afterward that everyone else in the office got two cars.

WTF? Now, you are ticked.

But really, are you deprived of getting a Mercedes? Shouldn’t that enough?

Comparison-created unhappiness and insecurity is pervasive, judging from the amount of spam touting everything from weight-loss to plastic surgery. The basic principle seems to be that whatever we have is enough, until we see someone else who has more. Whatever the reason, comparison in financial markets can lead to remarkably bad decisions.

It is this ongoing measurement against some random benchmark index which remains the key reason why investors have trouble patiently sitting on their hands, letting whatever process they are comfortable with, work for them. They get waylaid by some comparison along the way and lose their focus.

If you tell a client that they made 12% on their account, they are very pleased. If you subsequently inform them that “everyone else” made 14%, you’ve now made them upset. The whole financial services industry, as it is constructed now, is predicated on making people upset so they will move their money around in a frenzy.

Therein lies the dirty little secret. Money in motion creates revenue. The creation of more and more benchmarks, indexes, and style boxes is nothing more than the creation of more things to COMPARE to, allowing clients to stay in a perpetual state of outrage.

Aisha, for example, was completely happy with doubling her money over the last 16-years, until our young, inexperienced, newly minted financial advisor showed her “what she could have had.” Now she will make decisions which will potentially increase the amount of risk she is taking in the second most expensive bull market in history.

Our Worst Enemy

I have written about the psychological issues which impede investors returns over longer-term time frames in the past. The two biggest factors, according to Dalbar Research, which lead to chronic investor underperformance over time are:

• Lack of capital to invest, and;

• Psychological behaviors

Psychological factors account for fully 50% of investor shortfalls in the investing process. Of course, not having the capital to invest is equally important.

These factors, as shown by data from Dalbar, lead to the lag in performance between investors and the markets over all time periods.

Behavioral biases are an issue which remains little understood and accounted for when individuals begin their investing journey. There are (9) nine of these behavioral biases specifically which impact investors the most.

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as “panic selling.”
• Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
• Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
• Mental Accounting – Separating performance of investments mentally to justify success and failure.
• Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
• Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
• Regret – Not performing a necessary action due to the regret of a previous failure.
• Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
• Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

These cognitive biases impair our ability to remain emotionally disconnected from our money. As a consequence, we are continually lured into making decisions which are inherently bad for our long-term outcomes.

The Advisor’s Role

These psychological and behavioral issues are exceedingly difficult to control and lead us regularly to making poor investment decisions over time. But this is where the role of an “experienced advisor” should be truly defined and valued.

While the performance chase, a by-product of the very behavioral issues we wish to control, leads everyone to seek out last years “hottest” performing manager or advisor, this is not really the advisor’s main role. The role of an advisor is NOT beating some random benchmark index or to promote a “buy and hold” strategy. (There is no sense in paying for a model you can do yourself.)

Jason Zweig summed it well:

“The only legitimate response of the investment advisory firm, in the face of these facts, is to ensure that it gets no blood on its hands. Asset managers must take a public stand when market valuations go to extremes — warning their clients against excessive enthusiasm at the top and patiently encouraging clients at the bottom.”

Given that individuals are emotional and subject to emotional swings caused by market volatility, the advisors role is not only to be a portfolio manager, but also a psychologist. Dalbar suggested four successful practices to reduce harmful behaviors:

1. Set Expectations Below Market Indices: Change the threshold at which the fear of failure causes investors to abandon an investment strategy. Set reasonable expectations and do not permit expectations to be inferred from historical records, market indexes, personal experiences or media coverage. The average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices.
2. Control Exposure to Risk: Include some form of portfolio protection that limits losses during market stresses. Explicit, reasonable expectations are best set by agreeing on a goal that consists of a predetermined level of risk and expected return. Keeping the focus on the goal and the probability of its success will divert attention away from frequent fluctuations that lead to imprudent actions
3. Monitor Risk Tolerance: Periodically reevaluate investor’s tolerance for risk, recognizing that the tolerance depends on the prevailing circumstances and that these circumstances are subject to change. Even when presented as alternatives, investors intuitively seek both capital preservation and capital appreciation. Risk tolerance is the proper alignment of an investor’s need for preservation and desire for capital appreciation. Determination of risk tolerance is highly complex and is not rational, homogenous nor stable.
4. Present Forecasts In Terms Of Probabilities: Simply stating that past performance is not predictive creates a reluctance to embark on an investment program. Provide credible information by specifying probabilities, or ranges, that create the necessary sense of caution without negative effects. Measuring progress based on a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.

The challenge, of course, it understanding that the next major impact event, and market reversion, will NOT HAVE the identical characteristics of the previous events. This is why comparing today’s market to that of 2000 or 2007 is pointless. Only the outcome will be the same.

One thing that all the negative behaviors have in common is that they can lead investors to deviate from a sound investment strategy which was narrowly tailored towards their goals, risk tolerance, and time horizon.

The best way to ward off the aforementioned negative behaviors is to employ a strategy that focuses on one’s goals and is not reactive to short-term market conditions. The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer more disciplined investors. The data also shows that when investors react, they generally make the wrong decision.

The reality is that the majority of advisors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high.

When the impact event occurs, advisors who are prepared to handle responses, provide clear messaging, and an action plan for both conserving investment capital and eventual recovery will find success in obtaining new clients.

The “do-it-yourself” crowd will also come to learn the value of experience. When the impact event occurs, the losses in passive investments, “yield-chase” investments, and ETF’s will be substantially larger than individuals currently imagine. Those losses will permanently impair individuals ability to obtain their financial goals.

If you don’t believe me, then explain why, with 30 of the last 40 years in major bull market trends, is a large majority of the population woefully underfunded for retirement?

The reason is that investing is not simple. If it was, everyone would be rich. The reality is that whatever gains investors have garnered over the last decade will be largely wiped away by the next impact event.

Of course, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”

You can do better.

The bull market turned in an impressive gain of over 30% (on a total return basis) in 2019. While not a rarity in market history, it certainly falls into the “outlier” category. Not surprisingly, the media has been quick to jump on the story suggesting that if 2019 was strong, just wait until 2020. To wit:

“BTIG’s Julian Emanuel believes 2020 will be a milestone year. With the major indexes kicking off Christmas week at fresh all-time highs, he’s not ruling out a 22% surge in the S&P 500. 

The reason: Most investors don’t trust the record rally.”

I am not sure such is the case judging by both our “Smart/Dumb Money” and “Investor Positioning Fear/Greed” indices.

One of the primary tenants of investing, other than “buy low and sell high,” is always analyzing BOTH sides of every argument to avoid confirmation bias. Therefore, while many are making the case for being invested in the market, we should at least question the possibility of what could go wrong?

With the S&P 500’s stellar gain for 2019, the case for raising some cash is comprised of three primary issues:

1. 1. The impact of reversions,
   2. Historical length of economic recoveries, and;
   3. Historical returns following years of 30% market returns.

The Impact Of Reversions

There have been numerous studies and discussions on the historical impact to returns due to “reversions to the mean.” However, the impact of reversions remains lost on most individuals as the emotion of “greed” overtakes rationality during strong market advances.

One of the biggest mistakes that individuals make when investing is “not doing the math.” Let’s assume that the S&P 500 is trading at 3000 (nice round number for easy math purposes). If the market advances 30% it would then be trading at 3900 (3000 x 1.3).

However, the “risk,” and inherently the reality for the majority of investors, is that individuals would not “sell out” of their portfolios at the next market peak and would suffer the next 20% decline.

“So what, I am still up 10%.”

That is where the flaw in “the math” comes in. A 20% decline, following a 30% advance, does not leave you holding a 10% gain. In reality, the 30% gain is reduced to just 4%, as the market reverts back to 2600.

In other words, if a 20% correction occurs at any point in the next year, your previous gain would be almost entirely wiped out, not to mention the emotional strain of the decline.

The impact of reversions are devastating to long term portfolio returns, particularly when individuals, as opposed to financial markets, have a finite period within which to save and invest before needing those savings for retirement.

Economic Recoveries & Subsequent Market Returns

However, the real issue is the market is unlikely to correct “just 20%.” The next major market correction will very likely coincide with the next economic recession. (Of course, by simply writing the “R” word, this article will be summarily dismissed by the ‘financial illuminati’ who continue to marvel at the day to day levitation of the market with the inherent belief ‘trees can grow to the sky'”). However, all economic recoveries will eventually contract. The chart below shows every post-recession economic recovery from 1879 to the present.

The statistics are quite interesting:

• Number of economic recoveries = 29
• Average number of months per recovery = 42
• Current economic recovery = 126 months
• Number of economic recoveries that lasted longer than current = 0
• Percentage of economic recoveries lasting 60 months or longer = 20.6%

Think about this for a moment. We are currently experiencing the longest economic recovery in history, with most analysts and economists giving no consideration for a recession in the near future.  This is important because, as stated above, major market corrections occur during economic recessions, and those “reversions” tend to be much larger than 20%. The chart shows each of the past economic recoveries and the subsequent market correction during the inevitable contraction.

The statistics are equally interesting:

• Average number of months of contraction: 14
• Average market declines during all contractions: -29.13%
• Average market decline following top seven economic recoveries: -36%

With these statistics, it is somewhat easy to assess the risk/reward of remaining invested in the markets currently in hopes of further advances. If we assume that the markets reach our target of 3300 before the onset of the next economic contraction, the resulting decline, using the historical average of -36%, would push the markets back down to 2100ish.

In other words, all your gains since 2015 would be wiped away.

30% Gains And Sideways Markets

The following chart shows the annual real returns (capital appreciation only) using monthly data for the S&P 500. The purple bars are years of gains 29% or greater. I then showed the subsequent years following that 30% gain and the P/E cycle (expansion or contraction) they were contained in.

Here are the statistics:

• Number of years the market gained 29% or more:  19
• Average return of 19 markets:  35.65%
• Number of total subsequent years measured: 53
• Average return in subsequent years following a 30% year:  1.48%

What you should notice is that 29%+ return years tended to mark the beginning of a period of both declining rates of annualized returns and typically sideways markets. It is also essential to notice that some of the biggest negative annual returns eventually followed 30% up years.

While it is entirely possible that the markets could “melt up” another 20% from current levels due to the ongoing monetary interventions; history suggests that forward returns not only decline, but bad things have eventually happened.

Go To Cash Now?

I want to be clear that I am not advocating that anyone should go to cash today. The problem with this analysis, unfortunately, is while individuals are unlikely to sell at the top of the market; they are just as unlikely to buy at the bottom. History is replete with market booms and busts and the devastation of individuals along the way.

This is why chasing an all equity benchmark is inherently flawed. Benchmark indexes are riddled with issues that you can not replicate in your portfolio which I discussed in detail in “Active vs. Passive & The Simple Reasons You Can’t Beat An Index:”

The reason that individuals are plagued by these emotional behaviors is due to well-meaning articles espousing stock ownership at cyclical valuation peaks.

Sure, it is entirely possible the current cyclical bull market is not over yet.

Momentum driven markets are hard to kill in the latter stages, particularly as exuberance builds. However, they do eventually end. That is unless the Fed has truly figured out a way to repeal economic and business cycles altogether. As we enter into the next decade, we are likely closer to the next contraction than not. This is particularly the case as the Federal Reserve continues to build a bigger economic void in the future by pulling forward consumption through its monetary policies.

Will the market likely be higher in another decade from now? Maybe. However, if interest rates or inflation rise sharply, the economy moves through a normal recessionary cycle, or if Jack Bogle is right – then things could be much more disappointing. As Seth Klarman from Baupost Capital once stated:

“Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

We saw much of the same mainstream analysis at the peak of the markets in 1999, and again in 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same.