Weekend reading: Hello bear market, my old friend

Good reads from around the Web.

This week saw North America finally bite down on the stock market rout that has roiled most of the rest of the world for the past year or so:

• The UK’s FTSE 100 index is now down nearly 18% from its peak on 27 April 2015.

• The German Dax index is down 23% since 13 April.

• Emerging markets such as Brazil are down far more again since their peaks a few years ago.

These are bear market declines – or near as damn it in the case of London.

Armed with these numbers, it is somewhat amusing to hear U.S. commentators explain why a bear market in the US isn’t possible due to the state of the global economy or low interest rates across the developed world.

If it’s clearly already happened elsewhere, why not there?

Indeed in reality most of the US market is already in bear market territory, in terms of peak-to-trough declines.

In the past year only a handful of stocks such as Facebook and Amazon held up the US indices. Now they’ve rolled over and the indices have come down.

That’s the bad news.

But there are plenty of reasons why it’s not really so bad.

It is happening again

First and foremost is that if you’re a sensible passive investor, you know this sort of thing is going to happen and you’ve built your portfolio around it.

For example, our Slow & Steady model portfolio will keep trucking on, despite having plenty of exposure to global equities.

Sure, if this continues then 2016 isn’t likely to be a banner year for passive portfolios.

So what? It happens.

One of the most amusing things I’ve heard in the past few days is otherwise sensible investors such as the veteran Leon Cooperman of Omega Advisers blame some of the US volatility on the post-financial crisis regulatory landscape that has restricted the ability (or incentive) of intermediaries such as investment banks and dealer-brokers to hold inventory1 and so reduce volatility.

These old-timers usually also point at robot traders for good measure.

Now, I happen to agree liquidity has been reduced by financial regulation, and I don’t doubt momentum-based traders are influencing the markets.

But crashes have happened pretty regularly ever since we’ve had markets, and long before quant funds or the shrinking of bank trading desks.

Indeed recent years have been marked by relatively low volatility in America – despite the prevalence of these factors.

You can hardly have it both ways!

Therefore, we can safely bin these theories as poppycock.

Things fall apart

Of course people always want explanations.

My best one is that the US market has looked expensive for years, and traders finally found some excuses – the US rate rise before Christmas, the otherwise irrelevant volatility in China2 – to shed some of their pricey-looking exposure.

But really, who knows?

As Robert Seawright explains on his blog:

Wildfires, fragile power grids, mismanaged telecommunication systems, global terrorist movements, migrating viruses, volatile markets and the weather are all self-organizing, complex systems that evolve to states of criticality.

Upon reaching a critical state, these systems then become subject to cascades, rapid down-turns in complexity from which they may recover but which will be experienced again repeatedly.

This phenomenon was discovered largely on account of the analysis of sandpiles.

Scientists began examining sandpiles and discovered that each tiny grain of sand added to the pile increased the overall risk of avalanche.

But which grain of sand would make the difference and when the big avalanches would occur remained unknown and unknowable.

For passive investors, the best way to combat the unpredictable is to control what you can – your exposure – by rebalancing your portfolio from time to time.

This way you’ll trim more expensive (and perhaps more vulnerable) asset classes over time and top-up cheaper ones, without having to try to make potentially ruinous market calls.

The other thing to remember is that volatility is great for long-term savers.

We’ve discussed this many times before, but I’m always up for new ways of hearing the same important thing.

This week The Escape Artist did the honours:

Lower prices mean better value and higher future expected returns for investors. So the longer that share prices are low during our period of net saving, the better for us…even though it doesn’t feel that way.

So when investing, it’s best to be more aggressive and buy at times when share prices and valuations are lower… even though we may be feeling rattled by recent price falls.

Check out his table comparing the returns from investing into a rising market with putting money into a volatile but overall flat one if you fancy exhaling “ah, I get it”.

You might even treat the next round of market falls with a smile.

You’re here for the long-term

What is not advisable is panic.

To this end, The Reformed Broker Josh Brown has delivered a good one-two-er on the psychology of investing through volatility.

His comments on the wisdom (or otherwise) of passive saver-investors trying to turn themselves into market timing geniuses when stock markets fall is on-point for everyone saving for their retirement:

…accept the fact that risk is a given no matter what.

But you have a choice: You can decide when to take the risk, today or in the future.

Rational investors would prefer to take investment risk today, accumulating assets while coping with drawdowns and fluctuations in value.

Only an insane person would choose to take their risk at the back end of their life – being short of money in old age when it is nearly impossible to earn more money.

You can risk the volatility today or the chance of being broke later, your choice, but you must choose.

Sitting in cash may temporarily feel better because there is a sense of security that comes over us when the value of our account ceases to fluctuate.

But you’re not safe, you’re merely gaining the stability of a unit of currency in exchange for the risk of losing future purchasing power.

Even presuming there is a bigger crash coming that it would be profitable to sidestep, once you decide to sell up your portfolio on the hunches of analysts, you’re going to have to be right at least once more if you’re going to stay invested.

Or, as Brown put it in pictorial form:

This is going to hurt… a bit

The obviousness of all this on a sunny Saturday morning doesn’t mean that it is easy in practice.

Usually quite the opposite.

Once you get past the superfluous complication some try to foist on it, constructing a passive portfolio is easy – so easy a child could do it.

However actually investing regularly, rebalancing, and having the discipline to adjust your allocations based on your stage of life, not on scary newspaper headlines – that can be hard.

So while it might be offensive to some of the Monevator faithful, I do have some sympathy for Brown when he says:

The fact is, most investors cannot tolerate the full brunt of a bear market psychologically, and will end up doing the perfectly wrong thing at the most inopportune time.

You will see how many newly-minted Vanguardians and robo-clients vomit up their equity portfolios toward the end of whatever this market episode becomes.

And so I would say that if you believe yourself to be susceptible to this sort of thing – and there is no shame in being emotional about money, we all are – now would be a good time to make sure you are getting good guidance from an advisor who you trust and who understands what’s happening.

Those of us who have had a lot of contact with investors – whether we are investing bloggers or Wall Street denizens – have seen the foibles of the typical investor more than most people.

And I’ve seen we’re all pretty foible-d.

Is it 2008 all over again?

For example, I’m a believer in passive investing who thinks it’s what you should do, too, but who himself runs his own active portfolio like he’s a wannabe George Soros with a Napoleon complex.

Hard to get much more conflicted than that!

So when stock markets fall fast – and I do even worse than the benchmarks, as has happened so far in 2016 – I get the double pleasure of seeing my net worth dwindle and feeling I should have done something clever to prevent it.

Fun!

Not really – and yet another reason why it’s better you invest passively and to get on with the rest of your life.

/spurious speculation begins/

For what it’s worth though I do not think this is 2008. The US market could and perhaps should come off another 10%-20% given the extent of its overvaluation, but I personally do not see the systemic risks, the economic slowdown, any euphoria, or a global overvaluation in equities that might precipitate a worldwide slump from here.

Still, it could happen. As I said earlier, crashes are normal. If anything it’s weird the US went so long without one.

But understand they don’t all end in capitalism-threatening heart attacks.

To be sure, there are ominous signs. I keep hearing US commentators claiming their economy is safe because unemployment is still falling, for example, but jobs are a lagging indicator.

Low US unemployment actually makes me nervous!

The yield curve still looks okay – which is to say it still slopes upwards. But it has been flattening, and this will only get worse if the Federal Reserve does hike US interest rates four times this year, as was expected. (I think it won’t).

What about commodities?

The prevailing view now is that low commodity prices may be signalling something ominous.

But personally I doubt it.

To me commodities remain a story of oversupply. In the case of oil and some metals, we even know who is deliberately oversupplying the market and why. Add in years of widespread expansion, and it is abundantly clear there’s too much digging and drilling going on.

But I do not see the collapse in demand.

On the contrary I would not be surprised to see low energy and material prices eventually spark a boom in places like India and even China.

One thing that is a bit more worrying is the state of the high-yield market in the US, as I think we’ve discussed before.

Essentially too much money was lent too freely to too many shale drillers at ridiculously cheap rates.

That is now about to come home to roost. However I think the big banks are generally more than capable of taking it.

Another thing I’d note is I’m seeing a bit of strange pricing in some parts of the market. It’s not riddled with strange anomalies like in late 2008, but I believe there is some rapid de-correlation going on.

Such divergence could indicate a market falling apart – or just maybe it’s a sign of capitulation.

Finally, the rolling nature of this market rout has given active investors plenty of opportunity to take cover in cheaper stocks.

Just don’t expect them to feel comfortable!

Since late 2015 for instance I have had more natural resource exposure than ever before in my investing career. True, it’s held on a short leash and I trade it often, but I do think it’s likely to prove a better investment on a five-year view than the supposedly safe household goods giants on high P/Es.

We’ll see!

/end of spurious speculation/

Nothing has changed

So this is a bit of a brain dump on the state of the market in 2016.

I won’t be doing it every week – even if the market keeps falling – you’ll be pleased to hear.

If you do want more comment in a month or three, perhaps just come back and read this post again. I doubt anything much will have changed except the prices.

Overall, my suggestion to most would definitely be to keep investing passively, be glad that shares are on sale, follow my co-blogger’s excellent passive investing posts, and just keep on keeping on.

This is not the time to panic, not least because it’s probably a bit too late to panic for the typical UK investor who will have a home-biased portfolio.

If you’re more actively inclined, there may still be time to react to what I suspect is an ongoing regime change in market leadership. Personally, I suspect the era of large cap growth dominance may well have run its course for now.

But to be frank, even for active investors the odds suggest you’re best off buying and holding quality companies for the long-term – or at least for as long as they’re still doing good business – rather than trying to dance around too much.

Bon courage, or at least bonne chance!

From the blogs

Making good use of the things that we find…

Passive investing

• Cost is the new performance – Abnormal Returns
• Can a low-cost portfolio have too much Vanguard? – Can I Retire Yet?
• Debating with a conflicted [US] would-be financial advisor – W.C.I.

Active investing

• Short-term luck versus long-term skill – Jim O’Shaughnessy
• Macro is hard [Or: Whither the commodity super-cycle?] – A.W.O.C.S.
• Assessing active share and fund returns – Vanguard
• Lessons on shorting stocks from Jim Chanos – 25iq
• When algorithms go awry – Richard Beddard
• A deep dive into forecasting and portfolio construction [Geeky!] – R.A.

Other articles

• Lessons from 20 years as an investor – UK Value Investor
• Check out RIT’s latest London House Prices To Earnings chart – RIT
• Buying a dream home while stock markets crumble – Fire Vs London
• Interview with a lawyer who retired at 33 – Mr Money Mustache
• The corrosion of conformity – The Finance Zombie

Product of the week: ThisIsMoney has reviewed the vast range of cashback credit cards on the market. You can make £100 by spending through American Express’ Platinum Cashback Everyday card in the first three months. But something like the Santander 123 Credit Card is probably better for long-term use.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.3

Passive investing

• Alan Roth: Why I’m buying falling stocks – AARP
• Active management enriches the finance industry at your expense – Slate
• It might be best to blend factor/return premium ETFs – Morningstar

Active investing

• Private equity funds are not worth the fees (or risks) – ETF.com
• High-flyers are leaving hedge funds to go back to banks – Bloomberg
• Is the debut of US drama Billions a contrary indicator? – Bloomberg

A word from the brokers

• How to build an income portfolio using active funds – Hargreaves Lansdown
• The Naked Investor: Educational guides for everyone – TD Direct Investing

Other stuff worth reading

• Stocks for the long run? – The Economist
• Edwina Currie: Young should spend less and save more – Telegraph
• Pension perks for high earners set to be abolished [Search result] – FT
• New smartphone apps for splitting the bill – The Guardian
• Regional house price rises since 1995 vary from 80% to 935% – The Guardian
• Landlord housing wealth eclipses homeowners with mortgages [S.R.] – FT
• Is the PM right that £10,000 is enough for a typical deposit? – Telegraph
• The dubious logic of stock market circuit breakers – The New Yorker

Book of the week: It’s been a while since we’ve had so much crash talk. If you’re new to investing or you just want a refresher I’d recommend J.K. Galbraith’s eternally readable The Great Crash 1929. There is nothing new under the investing sun.

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1. That is, shares and other securities. [↩]
2. I’m not saying the Chinese economy isn’t significant, but its market has boomed and crashed out of sync with ours many times. The volatility it causes seems to be short-term. Also, it’s not even clear the Chinese market is a particularly good indicator on the direction of Chinese economic travel, let alone global stock markets. [↩]
3. Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. [↩]