“The market is like a large movie theater with a small door.”
— Nassim Nicholas Taleb, Skin in the Game
There is an old saying that experiencing a bull market is similar to riding up an escalator while living through a bear market is more like riding down in an elevator. At times, the elevator may appear to be in a free-fall. Bull markets, born in an environment of maximum pessimism, are initially met with skepticism and build in strength as confidence grows over time. Howard Marks compared the market cycle to the movement of a pendulum in Mastering the Market Cycle. At the inflection points, when the pendulum reaches maximum optimism or maximum pessimism, it momentarily stalls out and then reverses course. When markets expect perfection, one chink in the armor can be the catalyst causing the reversal. When multiple hits occur nearly simultaneously, the reversal can be shockingly rapid.
At the time of this writing, on the morning of Monday, March 9, 2020, the Standard & Poor’s 500 is not yet in “bear market” territory, as defined as 20 percent drop from its record high, but conditions do resemble a free-falling elevator. Exchange “circuit breakers” were triggered almost immediately when trading began due to the S&P 500 falling 7 percent. The fifteen minute halt in trading was followed by a modest rally and the index now trades at 2,785, about 17.8 percent below its February 19, 2020 record high of 3,386.15.
To add further gloom to market sentiment, a price war in crude oil broke out over the weekend between Russia and Saudi Arabia sending the oil price down to the low $30 range this morning. Concerns regarding an impending recession have sent the ten year treasury note to a record low yield below 0.5 percent. Of course, all of these numbers are sure to be obsolete by the time you read this article. All of these developments are being attributed to stress related to the Coronavirus pandemic which has only become more severe since I posted some thoughts about it last week.
Same Movie, Different Circumstances
Almost exactly eleven years ago, on March 6, 2009, I published Coping with Market Meltdowns which proved to coincide almost exactly with the end of the financial crisis bear market and the start of the bull market that still lives today, albeit ailing in the intensive care unit on life-support.1 Of course, the big story at that time was a “pandemic” of a different sort, one that shook confidence in the underlying pillars of the worldwide financial system. By the time the financial crisis bear market was over, stocks had fallen well in excess of fifty percent. We are nowhere near such a decline today but some of the lessons from that bear market still apply today.
Let’s take a brief look at the five principles outlined in Coping With Market Meltdowns to see if they still apply today.
- Know Your Temperament. “Successful investors need to have a temperament that permits independent thinking and analysis and does not allow the opinions or actions of others to dictate their own actions.” Having a calm and rational temperament is a perennial requirement for operating successfully in financial markets. There is no doubt that arming yourself with the right principles helps. Having a strong sense of what Warren Buffett calls an “inner scorecard” is necessary — a bear market is no time to seek external validation. You need to have confidence in your positions and the temperament to avoid rash actions when under stress.
- Know Your Investments. “Successful investors know their investments. They do not make investments based on talking heads on television, by reading newsletters, or by taking “hot tips” from their neighbor. The problem is that knowing your investments takes significant time and effort.” There’s a significant learning curve when it comes to understanding a business well enough to make a meaningful financial commitment but maintaining the knowledge does not necessarily require a massive amount of time. For example, it might take months of effort to understand Berkshire Hathaway well enough to invest in it but maintaining that investment might require only a few days per year.2 If you cannot invest the time needed to understand a company, you are better off buying an index fund.
- The Market Is Your Servant, NOT Your Boss. “Mr. Market is a manic-depressive who serves up all kinds of quotations for what you own on different days. On some days, he is giddy with optimism and offers you a high price and you can choose to buy or sell. On other days, he is depressed and marks everything down.” This always has been true and always will be true … not allowing Mr. Market’s emotions to influence your own behavior is absolutely required.
- Understand Intrinsic Value. “What keeps me out of trouble is that I never listen to Mr. Market’s opinion on the value of my holdings. I really don’t care what the market thinks. Instead, I keep a spreadsheet of the intrinsic value of my holdings based on my estimates.” This advice still holds true today. Having an independent assessment of intrinsic value allows us to anchor our sense of value to a number that is independent of market quotes. One very important caveat is that intrinsic value estimates can and will change over time. If you owned a cruise ship operator and made an estimate of its intrinsic value as of January 1, you would be delusional to not update your intrinsic value assessment in light of the severe business impacts that have accompanied the coronavirus situation. One should never be emotional but should strive to be realistic at all times and to then anchor to realistic assessments of intrinsic value, not market quotes.
- Don’t Invest the Rent Check! “No one can make intelligent decisions if they do not know where their next rent or mortgage payment is coming from. The stress would make it impossible. It makes no sense to put yourself in a situation where you must liquidate long term holdings for short term consumption needs.” Stocks represent pieces of real businesses and are inherently long term investments. Stocks are no place to put any money that is needed in the near term.
Then and Now
The market crash of 2008-09 represented extremely trying times. As I wrote in a brief personal history a couple of years ago, the crash of 2008-09 vaporized a significant percentage of my net worth at a time when I least expected it and I had a limited margin of safety. Although I had lived through the dot com crash of the early 2000s as an investor with skin in the game, a combination of luck and skill (but mostly luck) spared me from any significant harm during that debacle. So, the 2008-09 crash represented my first real “trial by fire” in which I lost a significant amount of money.
The nature of an eleven year bull market means that millions of individual investors and thousands of professional investors have never lived through a period in which 20 percent or more of their net worth is vaporized. These individuals are untested and cannot completely know how they will react until the losses appear on paper. No amount of “paper trading” or simulations can prepare an investor for losing a big chunk of their net worth for real. Even reading every word that Benjamin Graham and Warren Buffett ever wrote cannot provide full immunity from acting foolishly during bear markets.
In truth, even experience in prior bear markets provides no immunity from foolishness, although knowing how you reacted in the past can provide a decent indicator of how you might react today. Of the factors discussed eleven years ago, perhaps the most important one is to not have funds invested in stocks that will be needed in the near term. There is no way to act with equanimity when you are under financial duress. When your baseline financial safety is threatened, you fall all the way down to the bottom of Maslow’s hierarchy of needs which is a recipe for panic. As Charlie Munger says, in a reference to the Monopoly board game, no one wants to “go back to go”, meaning having to start over from scratch. The prospect of such a disaster is not conducive to rational thought.
Buying (Partial) Immunity
Making yourself financially bullet proof is the only way to buy partial immunity from panic during market crashes. The problem is that buying this immunity comes at a high cost during bull markets. It starts with avoiding leverage that can be called in response to a decline in security prices – in other words, avoiding direct leverage on your positions via margin. Avoiding personal leverage of other types provides further mental peace of mind. For investors relying on their portfolio for cash flow needs, maintaining either cash or a bond ladder representing several years of cash adds more peace of mind, but at the cost of abysmal negative real returns on that cash.
Investors who are regularly accumulating financial assets through savings from employment or a business face different challenges. These investors need to focus on the fact that market declines present opportunities to purchase assets at lower prices which should enhance their long term returns. The main concern for investors in the accumulation phase should be to maintain their earnings power through their employment.
What if an investor is relying on his or her portfolio for current cash flow but has invested everything in stocks or other risky assets? Such an investor will end up being a forced seller, but must still avoid panic! Here the key factor is to have a low withdrawal rate as a percentage of the portfolio. By limiting withdrawals to a modest level, ideally below 3 percent, the damage can be contained by only liquidating a small amount of the portfolio at depressed prices. Too many investors in this situation will instead panic and liquidate everything — this is a mistake in all scenarios other than a multi-year bear market followed by stagnation, in other words another Great Depression scenario.
More Things Can Happen Than Will Happen
It is tempting at the moment to fall victim to hindsight bias — wasn’t it “obvious” that the market would trade sharply lower due to coronavirus? It is true that the prospect of a pandemic occurring at some point is always a risk, but this is a risk that is impossible to time or predict.
Consider the headlines over the past weekend that led to today’s sharp decline. Coronavirus cases have increased and many dire predictions have been made regarding potential spread and economic impact. Then, the news regarding oil prices added to the gloom and markets went into a freefall.
Returning to Howard Marks, consider this tweet from 2018:
What would the markets be doing this morning if the Israeli researchers who have been searching for a Coronavirus vaccine had announced a breakthrough over the weekend? Or if researchers at the Galveston National Laboratory had announced a breakthrough?
These alternate histories did not occur last weekend, but if they had, what we would be experiencing today would probably be the opposite of what is actually taking place. Extrapolating the current state of affairs into the future is fraught with risk.
Many of the pundits who now claim credit for predicting the current decline are “perma-bears” who have been predicting doom and gloom for years. Even broken (analog) clocks are correct twice a day. The world does not stand still and humanity’s quest for answers is constant.
The fact is that no one knows whether the stock market will soon enter a bear market, how long that bear market will last, and the catalyst that will eventually cause the pendulum to reach its nadir and reverse course. Coping with market meltdowns successfully requires a calm temperament, confidence, knowledge, and financial resources built up during calmer times.
- Readers may also find Using Checklists to Control Emotions During Market Meltdowns, published in 2010, to be useful in the current market environment. [↩]
- I spend a couple of days analyzing Berkshire’s annual report (some thoughts on the 2019 report were sent to newsletter subscribers last month) and around half a day analyzing each quarterly report. [↩]