About 12 years ago, Cabana’s lead engineer David Covington and I were working on our original portfolio and were discussing why we felt like limiting big losses and protecting drawdown was so important to long-term success in investing. The first part is simple math. If you lose a lot in a bad market, you must make up a lot just to get even. The second part is equally important, but a little more subtle. Markets get scary sometimes. So scary that people lose their discipline and what is even worse, they sometimes give up. At the time of this conversation, I personally had experienced that exact feeling more than once. I suspect Dr. Covington had as well. We wanted to build a system that factored in this huge part of the investing experience. That night David sent me a photo that summarized what we were trying to solve for. That photo seems appropriate right about now. Here it is:
I have spent much of the past couple of weeks talking to our partner firms and clients about this very difficult market. Not only has every major asset class been impacted, but a lot of “darlings” have been hammered too. Amazon, Apple, Tesla, Netflix and Facebook (Meta) have all been crushed. Banks, which tend to do better when interest rates rise, have been hit. Goldman Sachs. JP Morgan and Wells Fargo are all mired in a position of pain. Disney, American Airlines and other discretionary leaders are beat up as well. Bonds haven’t provided any help and have sold off as yields have risen in response to inflation and the expectation that the Federal Reserve is going to turn off the money spigot and raise rates aggressively. Even energy has taken a turn after an incredible run up. The point here is that a whole lot of slack has been taken out of this market, and it has been done quickly and without a break since the first few days of the month. According to Bloomberg, the S&P 500 is experiencing the fastest decline and worst start to a year on record going back 90 years. Yesterday morning we saw all the broad indices enter a state of complete capitulation. By noon, the DOW was down another 1100 points. The Nasdaq was down nearly 5% in just a few hours. The panic was palpable…
Then somebody stepped in and started buying. Then somebody else started buying and then somebody else. Over the next three hours, all the losses were recouped, and each index actually finished up. Amazing. What suddenly changed? After three straight weeks of essentially unabated selling and an acceleration of selling on Monday morning, prices suddenly became attractive. Just like that. I have written a lot over the past several weeks about corrections in general and this one in particular. I’ve also written about the very phenomena we witnessed yesterday.
A direct quote from our January 19 commentary reads, “At some point, however, prices will have dropped, and investors will have factored in the negative effects of inflation and foreseeable interest rate increases. At exactly that time, one or more of the broad asset classes listed above will become attractive. Money will be deployed in search of a new opportunity to obtain a favorable return relative to risk. And the world keeps turning. So, when will this occur? How long will this correction last? No one knows. I can tell you what I think, but not much more – and neither can anyone else. I think those assets that began dropping first and have fallen the furthest will be the first to turn. I also think the assets that have not dropped as far may have further room to fall. As an example, small-caps and other growth assets (NASDAQ) typically lead other stocks on the way up and on the way down. This current correction is no different. Next, I would look for bond prices to stabilize and then improve. This all started with interest rates, and in my opinion will end with interest rates.” That is exactly what happened. In that order.
I am not psychic and don’t claim to know much more than anybody else who does this for a living, but I point this out to suggest that there is consistency in how markets operate. There are clues to look for that give us an idea of what is going on. Those clues are important not just for their own sake but because they evidence something more important, like what assets are attractive, becoming attractive or just flat out unattractive. All this of course is driven by fundamentals like interest rates and earnings. In between, there are lots of gyrations and turmoil and emotional pain. It is the in-between where fear and greed comes in. That is also where the clues show up. Yesterday was textbook fear and greed. The sellers ran out of things to sell, and those who were making money being short (selling) had to step in and buy to cover their positions. The bears started getting scared!
What we are living through now is just part of how markets work. It is not fun, but a necessary part of investing. If you want to be an investor, you must accept this and work within this reality. We work hard to always remember the basic and important tenants that Dr. Covington and I talked about all those years ago. We certainly are not perfect and cannot guarantee anything other than our efforts and our belief in the process. There is always something that hasn’t been seen before or something that behaves differently than forecast. I believe those are opportunities to improve and become a more robust and consistent investor. So, as we close out the final week of a difficult month, let us all remember that we are investors not traders. That we are disciplined and brave enough to follow our process even when we are scared and want to quit.
I’d like to share a great clip from the movie Parenthood, which resonates with me as a blueprint for life – and maybe even the stock market. I hope you enjoy it.
