April 8, 2020
Wow, we made it through the first quarter of 2020. Seemed like an eternity! Remember January 2020? Suleimani Drone strike and an almost-war with Iran? Australian Wildfires? February? The Super Bowl, the impeachment trial? Even early March: Super Tuesday (March 3). It all feels like years ago! All those daily 100-point S&P 500 and 1,000-point Dow Jones moves took a toll. They make you age in dog years, I guess!
Time to look back and reflect. Let’s take a look at a few lessons I learned…
1: Under the circumstances, the stock market held up surprisingly well!
I don’t want to sound too cocky here but considering the potentially extensive damage to the economy, we got off relatively easy (so far). From its 2/19 peak, the S&P 500 Total Return Index was down 23% as of 3/31 and 21% as of yesterday, April 7.
Estimates float around that indicate we could have a drop in economic activity significantly worse than in the Global Financial Crisis. Just to put this in perspective: the drop in GDP top to bottom was 4% between 2007 and 2009. Not 4% every quarter, but 4% total, spread over 1.5 years. In 2020 we might potentially get a worse drop but all in one single quarter! And as I mentioned previously, a 4% drop quarter-over-quarter will be reported as a (compounded) 15% drop. A 10% drop quarter-over-quarter will be reported as a -35% growth rate annualized (0.9^4-1=-0.3439=-34.39%). The worst economic decline ever – Bummer!
How about unemployment? The unemployment rate jumped to 4.4% in March from 3.5% in February. That 4.4% figure doesn’t sound so bad, but under the surface, it looks really scary:
- The survey was performed throughout the month of March. The impact will be much larger in April when we have a full month worth of job losses!
- The number of unemployed rose by 1,353,000, see the table below which caused the rise in the unemployment rate by 0.9 percentage points. But the number of employed dropped by almost 3 million. The reason we didn’t see a rise by roughly 2 percentage points in the unemployment rate is that the labor force participation rate also went down significantly. Thus, 1.6 million people left the ranks of the unemployed not because they found a job but because they gave even looking for one.
So, the employment picture is really, really, really grim and will get much worse as time goes on. An unemployment rate of 10%+ is almost guaranteed. I’ve heard estimates of 20+%! Just for comparison, during the financial crisis, unemployment peaked at 10% and the U.S. broad stock indices dropped by over 55%.
In other words, we shouldn’t feel so bad about the stock market drop in the first quarter. The reason we’re not down as much as during the Great Recession or even the Great Depression (80% drop peak to bottom!) is that financial markets still heed the expectation that this whole mess is a short-term affair and the economy will “reboot” later in the summer.
Let’s look at how this (hopefully) short shutdown and reboot would work their way through the GDP calculation. I constructed the following thought experiment, see the table below: Start with an economy that grows at an annual 2% trend rate. In March 2020 we shut down 10% of the economy but only for the second half of the month (i.e., 5% average for that month). In April we suffer a 15% loss of economic activity. Then we slowly restart the economy and shrink the shutdown percentage gradually to 5% in September. Furthermore, let’s assume that this 5% is also the permanent damage to the economy and we’ll not recover that anytime soon (at least not in 2020).
Quarterly growth rates at an annualized rate (as they will be reported by the BEA) will be -4.6% and -35.5% in the first two quarters of the year. That sounds a bit more awful than it is because the peak to trough GDP drop is “only” 11.46%. Still really bad because that’s almost 3-times the magnitude of the GDP drop in the Global Financial Crisis and half the drop during the Great Depression. But also notice that Q3 and Q4 will look really good with, +33% and +8%, despite the still severely depressed economic conditions.
Update 4/29/2020: The GDP numbers came out. -4.80% according to the BEA Advance Estimate (again, this is Q/Q at an annual rate, so Q/Q dropped by “only” about 1.2%). So, I was pretty close with my -4.64% guesstimate. 🙂
So, as long as we can keep the shutdown short enough and cross our fingers that enough of the damaged businesses survive we should be OK! That’s why the stock market is down by “only” 20% and not 80%!
Will the shutdown be that short? I certainly hope so! Because a longer shutdown will raise those “cure worse than the disease” issues again. There seems to be a decline in new infections in Europe over the last few days, which could imply a loosening of the shutdown there. Schools will open again in Denmark next week. Austria will cautiously open businesses again next week and more businesses, including shopping malls on May 1. Hopefully, we’ll see the bend point in the U.S. soon. It certainly looks like the new cases peaked over the weekend, though the fatalities are still increasing.
2: I slept well through this episode because I prepared well
If you’re retired and you did your homework you’d make sure to stick to two simple rules:
- Retire with a diversified portfolio, with no more than 75% equities and the rest in Treasury bonds and other safe assets to diversify.
- Pick a low enough initial withdrawal rate so that even with the recent drop you’ll still have a safe and sustainable withdrawal rate going forward from here. See my Safe Withdrawal Rate Series and especially Part 28 for a free tool to customize your own personalized safe withdrawal rate. If the withdrawal rate would have been safe during the Great Depression and we cross our fingers that the current bear market will be shorter than that we should be OK.
And I certainly slept better than I would have if I’d still had my corporate job!
But what about folks who are not retired yet? That brings me to the next lesson, which is not exactly a lesson from the current bear market, but I’m willing to go out on the limb here and forecast that this bear will work out the same way as every other bear market in U.S. history …
3: There’s never a bad time to start investing
OK, so maybe you’re not retired but just starting to get your financial house in order. You want to start investing, but is now a good time to start? That’s a question I’ve gotten a few times from neighbors and friends over the last few weeks.
True, there are better times and not so good times to retire. But I always emphasize that there’s never a bad time to start investing. I always share my own personal experience: I got two major pay raises in my life: getting my first job after the Ph.D. program in 2000 and moving from my government job to Corporate America in 2008. In both situations I faced the question “is now a good time to put that extra money into the stock market.” And in both cases, we were at the stock market peak, right before a nasty bear market. Sure, some of the first contributions got hammered, but sticking with the plan I was able to dollar-cost-average my way through each bear market. And retire very comfortably as a multi-millionaire in 2018.
So, even if you had started investing in equities at the February peak, ask yourself, how much have you really lost? Stick with the plan and you will likely do well if you don’t lose your nerve.
Talking about new investors, the #1 question I get from newbies: Do I have to be an expert to pick the “right” stocks and ETFs? My advice is always: “Keep it Simple” and just go with passive index funds. Ignore the mumbo-jumbo with bells and whistles, which brings us to the next lesson…
4: Keep it Simple; two popular “smart” investing styles vastly underperformed the simple 60/40 portfolio in the first quarter
Because I used to work in finance (in asset management of all places!) a lot of people always think that I had some “special sauce” that allowed me to beat the market to reach FIRE. Not true! For the most part of my personal investing career, I’ve relied on simple passive index investing, mostly S&P 500 and U.S. Total Stock Index funds from Fidelity.
But there’s always the siren song of doing something different. Something smarter, better, sexier, right? Proponents of those smarter investing styles can always point to some past periods where they outperformed the totally passive investors. But it’s also good to look at the episodes that the proponents like to hide. Let’s go through two stock investing styles I’ve come across that didn’t do so well:
- Small-Cap Stocks, Value Stocks and Small-Cap Value Stocks Best-in-Class Portfolios, as popularized by Paul Merriman and a lot of other financial advisers. They had Paul on the show on ChooseFI (episode 130) to talk about this investing style with the potential to beat the boring old broad equity index by a 2% annual “alpha” (his words, not mine). I was always a skeptic, especially about the consistency and the magnitude of that alpha and wrote a post about “My thoughts on Small-Cap and Value Stocks” last year.
- The “Yield Shield”, i.e., start with a 60% Stock, 40% Bond portfolio and then jack up the ETF dividend yield to get close to 4% or whatever your withdrawal rate may be. I think I did a pretty thorough job debunking that strategy in the Safe Withdrawal Rate Series, see Part 29, 30 and 31.
In order to compare apples-to-apples, I contrast the good-old 60% S&P 500 plus 40% U.S. intermediate Treasuries portfolio (i.e., the two major asset classes I utilize in my safe withdrawal simulations) simulated as 60% in IVV (iShares index ETF) and 40% IEF (iShares Intermediate Treasury) with the Merriman Moderate portfolio (60% equities, 40% fixed-income) and the Yield Shield (also 60/40).
Note: In the basic 60/40 portfolio you can also replace the IVV with the VTI (Vanguard Total U.S. Stock Market ETF) and you’ll get very similar results. I have nothing personally against the VTI. But the S&P 500 index did perform slightly better than the total stock market index, simply because small-cap stocks got beaten up so badly recently.
The results are in the chart below. The plain 60/40 portfolio held up pretty well in Q1. Down only 8.2%, while both exotic styles were down by 17%. Also, I included the returns during the previous 2 calendar years: the mildly bad year 2018 and the 2019 blockbuster year. Both fancy ETF portfolios underperformed the simple 60/40 in each time window. So, it’s not just that the exotic portfolios are merely giving back some of their excess returns from previous years. They both underperformed consistently. Simplicity Rules, everybody!!!
Why did these fancy styles underperform so badly?
- U.S. REITs underperformed. Notice this is not guaranteed in every bear market. REITs held up very well in 2000-2002, but were pulverized in 2008/9. I haven’t looked into the details (yet) but I suspect shopping mall REITs, hotel REITs, and mortgage REITs are especially badly hit now. Not sure what’s happening in the residential real estate yet. Maybe readers know more about that and want to leave a comment…
- International stocks were down more than the U.S. in Q1. This is a world-wide problem and other countries are even worse off than the U.S.!
- Jacking up the yields in your fixed-income portfolio? While some of the other yield-maximizing stuff is not necessarily bad in every single recession (REITs, international stocks have also worked in your favor in other historical recessions), it’s unequivocally bad in the fixed-income space. This happens in every single recession/bear market because you are introducing back-door equity exposure into the asset class you hold for diversification.
- Small-cap stocks: When times get tough large corporations tend to have an easier time relative to smaller ones: getting financing, getting politicians to pull strings on their behalf, etc.
- Value Stocks: Shouldn’t value stocks perform better when times get tough? Not really: in this bear market (as well as 2008/9) the non-value stocks (i.e., growth stocks) performed better. It sounds counter-intuitive that growth stocks do better when (macroeconomic) growth is weak. But that’s the whole point: growth stocks can generate their own growth even if the economy is hurting by a) generating new markets (Google, Amazon, etc.) and b) taking business away from existing players (Google, Amazon, etc.).
- U.S. dividend stocks underperformed. Only by a few percentage points, though. Again, ask yourself who the generous dividend payers are: the more established businesses that are hurting the most in this crisis: oil companies, REITs, etc. But dividend stocks are not a total disaster either. Think of Procter & Gamble and Johnson & Johnson, who are some of the really popular stable dividend payers and their respective industries are holding up pretty well.
But I should also note that there is a way I would become more interested in the Small-Cap and Value styles again. It looks like we’re now going into exactly the scenario I described in my post last year “My thoughts on Small-Cap and Value Stocks”
“You want the value premium to work again? Careful what you wish for!
You know what it would take to bring doubters like me on board again? During the next (!) recession and bear market, value stocks get totally clobbered! Just as Paul Merriman said on the podcast: More risk implies more return. Value stocks are more exposed to macroeconomic shocks. But do you see the irony in that? In order for value to be considered a bona fide risk premium again, we’d have to see a big drawdown” (Big ERN, June 12, 2019)
So, what I tried to convey in the post from last year is that small-cap and value stocks should outperform when they are more exposed to downturns and thus require an additional expected return to compensate for that. After getting hammered in the current recession and bear market, they should also do well in the subsequent recovery.
5: Complicated beats Simple: Three “exotic” equity investing styles that actually worked pretty well in Q1
I outsourced that point into a new post, see here: Three Equity Investing Styles that did OK in 2020
6: Jack Bogle’s Revenge
Jack Bogle, Vanguard founder and index fund pioneer, passed away a while ago. One of the last interviews he gave was in March 2017 when he shared his personal equity expected return for the next 10 years: only +4%. He was ridiculed back then. But who looks ridiculous now? Since 2017 the S&P 500 hasn’t returned much more than 4% p.a.!
In the chart below I looked at how his forecast and my own market outlook made in August 2017 performed since then relative to the actual S&P 500. Well, the market (+20%) did a little bit better than Bogle’s projection (+13%). It’s currently about halfway between my own baseline forecast (+5.75% p.a. = 23% up to 2020) and my “pessimistic” scenario (+3.5% p.a. = 16% up to 2020). Notice that I start my projection at the time when I wrote my blog post when the S&P was at the slightly higher August 2017 level.
Of course, the ten-year window isn’t over until it’s over. A lot can happen over the next seven years. But the lesson here is that the market has been very richly valued with CAPE-ratios in the high-20s even above 30 only a few months ago and it was only a question of time until valuations normalize again. This market crash was overdue! Of course, I still hope that I will be wrong and we now get a faster recovery than 5.75% p.a. going forward! But my retirement will still be totally fine even at that measly return!
What are your stock market lessons for the year so far? Please share your thoughts in the comments section!
Title Picture Source: Pixabay.com