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The current market environment is showing to be tough for many investors. Market drawdowns are hard for everyone, both experienced and inexperienced investors. No matter how long you have been in the market, you always prefer seeing prices go up, especially if you are fully invested.
It’s very easy to say that, when prices drop, you’ll be willing to buy more, but it’s much more difficult actually doing it once they come down. When everything keeps going lower and lower every day, many investors end up waiting for better prices and fall into the trap of timing the market. We’ll help you see why the market is unpredictable, and you shouldn’t fall for this.
First things first, let’s go over the current market environment.
Every week, we share weekly recaps with our subscribers. As you might have imagined, the current state of the market has been a common topic in these recaps throughout the last editions. The conclusion has almost always been the same in recent weeks: “There’s no denying that the stock market has seen better times.”
There are plenty of things going on simultaneously, all of which have created a multiple re-rate, especially in tech growth. The indexes saw a strong rebound yesterday (9th of March), but the Nasdaq (NASDAQ:QQQ) is more than 17% off ATH (all-time highs), while the S&P 500 (NYSEARCA:SPY) is more than 10% off ATH. Both are in correction territory, with the Nasdaq closer to what could be considered a bear market:
YCharts
Now, there’s no denying that what happened in 2020 and 2021 was not healthy either. After suffering a complete shutdown of the economy, indexes bottomed in March 2020 and rallied triple digits in under two years:
YCharts
Fundamentals of many tech companies improved during the period, but probably not enough to justify these rallies. Of course, this is already the past, but it should help us learn some lessons.
This said, let’s go back to the current market environment. Now, the indexes are approaching a similar drop to what they suffered at the end of 2018, although under a very different context, of course.
Inflation was already a concern for the market before Russia invaded Ukraine. During COVID, the Federal Reserve injected around $9 trillion into the economy and lowered rates to almost 0 to stimulate it. Just to give a little bit of context on the magnitude of the stimulus, during the 2008 recession, the Federal Reserve injected around $800 billion into the economy.
In 2008, the economy eventually recovered with stimulus, but it did so in a gradual manner:
US Bureau of Economic Analysis
Notice how the recessionary period in 2008 was much longer than in 2020 when it recovered in a V-shape. This is great to see, of course, because long-lasting financial crises can have very adverse effects on society. However, not everything is positive. If you stimulate the economy through monetary (the Federal Reserve) and fiscal (the government) policy, the economy recovers fast, and you don’t stop the stimulus – you have a perfect cocktail for a heating-up economy.
If you add supply chain disruptions caused by the pandemic to the already heated economy, you get high inflation. Unfortunately, this is precisely what we have seen during the past months.
US Bureau of Labor Statistics
If you add a war between two net exporters of essential commodities such as oil, gas, or wheat to already high inflation, then you have the potential scenario for hyper inflation. Of course, we still have to see what inflation will bring in the next months, but everything indicates it will be higher.
Inflation is really dangerous because it erodes purchasing power very quickly, making the population poorer. So there’s no doubt that the Federal Reserve needs to raise rates to combat surging prices.
However, after the recent invasion of Ukraine, there are fears of stagflation. Stagflation is when we get a stagnant economy combined with high inflation. If this coincides with low rates and in the middle of the Fed’s balance sheet runoff, there’s no way to stop both the recession and inflation simultaneously. If we get to this situation under the current environment, the Federal Reserve will most likely have to choose between one of those variables. Now, we’re not saying that this will indeed happen. We’re just saying that the market might be selling off because it fears that scenario.
War is always worrying, not because our portfolio falls, because innocent people are killed simply because others who don’t suffer the consequences have a big ego. It’s pretty surprising that something like this happens in 2022, but humans haven’t really changed much despite all the lessons that history has taught us. It’s as if humans sometimes have a natural tendency to destroy themselves. This said, let’s go back to war in the context of investing.
A couple of weeks ago, we shared the following table on our weekly recaps arguing that war periods have not turned out to be bad periods to invest:
Investopedia
Of course, the past should never be used as a perfect proxy of the future, but it’s always a decent guide. Every period in history is different, but you should really understand that the market is forward looking.
This means that it tries to price events before they happen, which is why we get a scenario where stocks perform well after the event itself. The same happens with interest rates. Markets typically perform well after rate hikes because the market had already discounted the hikes, so once it’s done, uncertainty settles, and the market goes higher. Same can be happening with the war in Ukraine and the surge in oil prices. Knowing what the market has or hasn’t priced in is almost impossible, as the market is just a consensus opinion of millions of players.
We are no geopolitical expert by any means. Still, we think that a war in Ukraine should not have much of an impact on the businesses we hold. Yes, inflation will be high in the coming months, but we’re also well protected in that regard because we mainly hold software businesses which are mainly affected by wage inflation, which we saw last week that is cooling down a bit.
The question that many investors are making themselves is:
What about the potential risk of a nuclear war?
Well, let me tell you that if Russia decides to invade a NATO territory, we could go to WWIII, and it has the potential to be nuclear. This said, our gut (which should not be taken that seriously) tells us that Russia won’t do this. One of the reasons why Russia invaded Ukraine is because it doesn’t belong to NATO, and they want it to stay this way forever. Vladimir Putin has threatened the West with escalation, which would be disastrous, of course. But we honestly believe that this won’t happen. And if it does, your portfolio should be the least of your worries.
The only thing we can control is what depends on us. In this case, buying strong businesses that have little exposure to geographies where the legal and freedom framework is weak and that are reasonably protected against volatility. We focus on resilient businesses under any scenario, so we also take these things into account, of course. As much as we would like to control Putin’s actions, we can’t.
Inflation has not been a problem in the developed world for more than a decade. In fact, what was looming in the background was deflation. We have been with loose monetary policy (low interest rates and asset purchases by Central Banks) for a long time now, and inflation has never hinted at going out of control. This has been possible thanks to two deflationary forces: Globalization and technology. We’ll talk about globalization here.
Thanks to globalization, developed countries have taken advantage of cheaper labor abroad, significantly reducing the cost of everyday goods. For example, wheat imported from Ukraine is much cheaper than US wheat because the cost to produce wheat in the US is much higher. This applies to millions of products.
With the recent sanctions of west economies to Russia, many people think we are witnessing globalization’s end. However, we take the opposite stance. We believe that this conflict has further evidenced how dependent economies are. So, can this be the end of globalization? Maybe, but we think that governments will realize they need each other to prosper. Nobody is better off under regionalization.
Up to now, we have seen that the current market and geopolitical environment are far from ideal. We have an explosive cocktail coming all at once and the market is flooded with negativity. Many investors are scared, and it’s normal because every selloff feels like the end of the world.
Remember that you can find a reason to sell for almost any stock, and you’ll most likely find many during negative sentiment periods. There are a ton of bear cases coming out now with price declines, but these are mainly momentum investors. Companies have not changed much over the last month. Why didn’t they publish these bear cases when prices rose? And mostly, if they did, they had been doing it for years and years, which has made them miss the big run as well, as most of the great stocks are still up substantially over the last three years and even more over the last five years, even if they have fallen so much. See how everything works, right? Price drives sentiment.
However, unfortunately for permabears, this is probably not the end of the stock market.
If we look at some stock market history, we have had much scarier times than the one we are living today. Take, for example, the 2008 Global Financial Crisis, where both indexes dropped more than 50%:
YCharts
And those were the indexes! A lot of stocks were down much more. That must have been scarier, right? Imagine seeing your investments cut by 90% in the middle of a steep recession. Yikes. Of course, the media just makes it worse, trying to expand fear across market participants. The media know that fear sells more than prudence. Here are some examples of headlines during that time.
“Lehman Collapse Sends Shockwaves Around the World,” The Times, September 16, 2008
“Mounting Fears Shake World Markets as Banking Giants Rush to Raise Capital,” WSJ, September 18, 2008
“Panic Grips Credit Markets,” Financial Times, September 18, 2008
“Worst Crisis Since ‘30s, with No End Yet in Sight,” Wall Street Journal, September 18, 2008
“A New Phase in Finance Crisis as Investors Run to Safety,” New York Times, September 18, 2008
Source
Note how several of those articles use expressions such as “new phase” and “no end yet in sight,” more or less claiming that this time is different and the stock market might be under more trouble than ever before.
However, after bottoming around December 2008, the indexes recovered quicker than many expected. In a bit more than two years, the Nasdaq had recovered, after a 100% run:
YCharts
We can find something similar if we look at the 2018 selloff. During this period, both the Nasdaq and the S&P 500 were down 23% and 20%, respectively:
YCharts
As you can see in the graph, the drop was quite violent towards year-end. Stock market crashes tend to unravel quite fast.
If we look at some of the headlines during that time, we can see that fear and panic was the media’s main topic:
Stock market slide in 2018 leaves investors bruised and wary. – Financial Times, December 31, 2018
Global trade spats, rising interest rates and Brexit uncertainty have helped most stock indices to their worst year in a decade. Recession fears for 2019 could mean more significant drops, especially for tech stocks. – DW
Again, the market recovered very fast. By exactly the same date the next year, the Nasdaq had rallied 47% and the S&P 500 had rallied 37%:
YCharts
Where are we going with this? Stock market crashes always feel like the end of the world, but this has never been the case despite the world going through much tougher times. The media, the price, and your emotions are all acting against you simultaneously, making you think that it does feel like the end this time. There’s almost always a reason for the market to come down, but it always comes out stronger over the long term.
There are cycles in the economy, and there are cycles in the stock market. It’s just the way it is, and we have to learn to live through these moments. They are simply part of the game.
Schwab
OK, so we know they (market drawdowns) are coming, and they are inevitable. Can we avoid them? Most likely not, as they tend to happen when nobody expects them to. Can we protect ourselves against them? We surely can.
It should be pretty clear by now that market crashes are unavoidable for any investor. Some investors have been correct in guessing tops and bottoms, but we still have to get to know someone that has done this consistently with a small margin of error. For example. Michael Burry nailed the 2008 top and made a ton of money, but he has been calling a bubble for pretty much the past decade. This is what the indexes have done since 2011:
YCharts
That’s a lot of missed gains, and it always comes back to Peter Lynch’s famous quote:
Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.
We consider ourselves a “buy and hold until the thesis changes investors,” which is a synonym of “buy and verify.” We aim to hold quality companies for a long time in which we have high conviction. We don’t plan to jump in and out of positions because we are bad at timing the market, and we think you can be a great long-term investor without needing to time it. This means that we will almost surely hold through every market selloff, and we must be psychologically prepared for these periods. Here’s what we do.
The most important thing is having a plan. If you improvise, you’ll most likely fail, and you’ll make this “game” much more complicated than it really is. Our plan is to dollar-cost average a predetermined amount of money every two weeks. This way, we build my positions slowly, avoiding timing the market. Of course, if we see evident opportunities (for example an undeserved drop around earnings), we can improvise a bit and add outside of the regular schedule. This, however, should not be the norm, as you’ll start falling into the trap of market timing.
Of course, the key resides in what you DCA (dollar-cost average) into. We must DCA into high-quality companies, because DCAing in bad businesses is a great way to lose money over the long term. This is precisely why we do such deep research and keep our quality standards very high. Finding quality companies at reasonable valuations is obviously the tricky part, which is precisely what we try to facilitate for our subscribers.
Once you have found an outstanding company, you simply have to follow the company closely and continue adding periodically to your position if the thesis is unchanged.
This is how we do it, but everyone should tailor this plan to their own needs. Our situation may be very different from yours, so blindly following our strategy might not make sense. However, following a plan is vital because it mitigates the most dangerous part of investing: The emotional aspect. Every two weeks, we buy, regardless of whether the stock is up 3% or down 10% the past week. Of course, if I see a broad market selloff, we can temporarily increase our allocations to gain more exposure, which is what we have been doing over the past weeks, and what we expect to be doing during the coming weeks too.
Having a plan is great, but it’s useless unless you know what game you are playing.
Besides having a strategy, knowing the game you’re playing is also very important. Many people feel stupid if the stock falls after they buy and feel smart if it goes higher just after they buy. It’s as if they were looking for a confirmation that they were right. Up, right. Down, wrong. As much as this might be true for day traders, it’s really stupid to think this way if you invest long term.
Where a stock trades one day, one month, or even one year after you buy is irrelevant if your holding period is more than five years. What counts is where the stock is trading when you decide to sell. If you’re not thinking about selling, don’t beat yourself too much and monitor the company. Price will eventually follow fundamentals if you have bought a quality business and have not vastly overpaid. Take the example of Warren Buffett. The Oracle of Omaha bought Wells Fargo (WFC) in 1990, but he didn’t get the timing quite right. This is what the stock did after he bought:
YCharts
Did he sell? Nope, he held for 31 years. Of course, this is cherry picking, but I honestly can find thousands of great buying spots (in hindsight) for great companies that were preceded by a selloff. So don’t beat yourself up too much if you are in the red. Instead, keep allocating and be long-term oriented. Quality companies will perform in due time.
Know the game you are playing, and don’t behave like someone you aren’t. If you are not a day trader, you should not care about daily performance. We have made several purchases that have kept doing down. We don’t care because we are not trying to catch bottoms. We will keep allocating periodically because we believe we hold quality companies. And very importantly, don’t waste your time arguing with people that are playing a different game. We feel that almost 100% of market discussions between investors come from the fact that they are playing completely different games and have vastly different investment horizons.
There are many ways to make money in the market, and we think that holding quality companies long-term is the most rewarding and safest one. Of course, we could be wrong, but we have history on our side. We don’t think it will be different this time.
If you’re still unsure about the macro environment, just look at what some of the greatest long-term investors of all time have said about this matter:
We have usually made our best purchased when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist. – Warren Buffett
If you spend 13 minutes a year on economics, you’ve wasted 10 minutes. – Peter Lynch
Macro worries are like sports talk radio. Everyone has a good opinion which probably means that none of them are good. – Seth Klarman
I spend little time worrying about the macro trends and even less time trying to apply predictions about them in order to manage our portfolios. – Terry Smith
See what we mean? Why were these investors able to disregard macro but still beat the market comfortably? Because they focus on the business and acknowledge that they’ll go through many different macro environments if they remain invested during long periods. Strong companies come out stronger from any of these events, and these are the companies that we are trying to find at Best Anchor Stocks.
There’s no denying that we are in a challenging market environment. Everything keeps going south, and it could perfectly go much lower. We don’t know what the market will do tomorrow, next month, or even next year. The only thing we know is that it will fluctuate.
Time is limited, and we think this time has a higher ROI (return on investment) when allocated to a thorough understanding of businesses rather than unpredictable macro events. This said, we must be prudent and build our positions slowly. I’m sure that over the long run we won’t regret it.
Stay calm, buy high-quality companies slowly and sleep well. The market has recovered 100% of the time during the past. Is it different this time? Could be, but statistics are on our side.
In the meantime, keep growing!
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This article was written by
Disclosure: I/we have a beneficial long position in the shares of SPY, QQQ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
