Tuesday, December 25, 2018

The world always changes but history repeats in familiar patterns

It was October 1987, after an incredible bull market run that started in August 1982. In August 1987 the market seemed sluggish and the Central Bank in the U.S. had lately increased interest rates. The economy seemed fine and then during that October the market crashed worse than anything since the 1929 crash.

Famous Fidelity manager, Peter Lynch, was on vacation in England and the crash surprised him completely. It turned out it was one of those economic downturns predicted by the market crash that never materialized. Then it was the relatively new computer trading programs that seemed to have caused the crash. In his book “One up on Wall Street”, Peter Lynch uses the 1987 crash as an example that market timing even for a guru like him is not possible.

December 2018, we seem to go through a similar crash after a period of interest rate increases to ‘normalize’ the costs of borrowing money. This time the situation coincides with extreme tax-loss selling and no recession in sight. The only matter that really worried markets was the spread between short and long term (10-year U.S. government bond) rates - a possible inverted yield curve. 

The crash may also have been reinforced by a government shut-down after Congress failed to suport Trump’s demand for construction funding of his wall between the U.S. and Mexico. And/or the China-U.S. trade war.

In October 1987, we had the worst crash since the Great Depression by June 1989 the market had mostly recovered not counting dividend income which continued to be paid regardless. From a high in August of 2722 to a low in January 1988 of around 1800, the market lost close to 34% much of which on October 19 - Black Tuesday. By June 1989 the market had recovered and continued to new highs.

October 1987 crash and next 25 months. By june 1989 all had recovered

It  was August 31, 1998, the height of the Russian Ruble Crisis. The market lost nearly 17% in less than a month. This is what CNN finance wrote:

 The spectacular sell-off wiped out all of Wall Street's gains for the year and left market experts wondering if the unprecedented bull market of the 90's has finally met its end.
     Investors, still hurting from last week's historic sell-off, found themselves caught in more selling as the political and economic future of Russia remained uncertain and data showed the U.S. economy is slowing down.
Here is the chart:
The 1998 Russian Financial crisis or Ruble Crisis. It was all forgotten by the end of the year.

By December 1998 the whole thing was passé. What should you do in situations like that?  You could have smelled the upcoming chaos in Russia and stay in significant amounts of cash. Say 15% of a $100,000 portfolio. Here is what would have happened:
Holding cash does nothing but smooth the volatility! Unless you used it when the stocks are on sale. But market timing is next to impossible.

Ahmm… Nothing. It just smoothed the volatility. During the fall your losses were reduced and once the bull market resumed at the end of 1998, you would underperform a bit. Now what would happen if you kept investing your monthly savings, say $500 per month, and re-invested the dividends (yielding around 2.2% or $150 per month)? Here is the result:

Benign Neglect. Keep on investing your monthly savings (dollar cost averaging) and reinvest your dividends. Maybe even forget about building a cash position!

Yes, profits!  With 15% cash, you would have a smoothed performance. The Savings invested together with the dividends created outperformance between July and December: The dividends created $1081 in profits, while $3,500 saved between May and December created an additional $251 in appreciation. That is a total of $1332 in extra money. Now what if you hadn’t feared the volatility at all and were 100% invested?  That, would have resulted in $1661 extra money or a portfolio outperformance for doing nothing of 1.66% in just 7 months or an annualized outperformance of 2.8% - most money managers would kill for that! Volatility is your friend and the only thing you had to do was ignore it!
"Now what about the 1987 case?", you may ask. Well that took a bit longer to play out: 2 years or more precisely 25 months. But the story is the same. Over those 25 months the savings were $12,500. Total return with cash smoothing was: $ 7,421. Without the 15% cash, the portfolio would have returned $8,431 including a dividend contribution of $4,605. Yammi!!
"Doing nothing", not even increasing your cash during these markets, something I refer to this as ‘’Benign Neglect”, is best during these times. (BTW, I am sure I didn’t invent the term ‘Benign Neglect’ – I stole it somewhere).

This year’s losses in December were quite substantial from a high for the Dow of 26,813 to today's 21,792 or 19%. On Christmas eve, trading volume more than doubled from 350 million shares to a cool 900 million. Is that the famous capitulation coinciding with the end of tax-loss selling season? I certainly hope so and I also hope that we will follow a similar pattern as the recovery in the 2 years that followed the 1987 crash! It wasn’t until 2001 that the baby boomer bull market finally peaked!

Here is another thought: How much interest expense would you have saved if instead of holding a cash position, you would have used the cash to pay off debt; especially debt that is not tax deductible such as a mortgage on your home?

Usually rising interest rates suggest that the economy is very strong. An economy that is strong enough that the Fed feels it necessary to increase them. The so-called inversion of the yield curve that is so often quoted as a predictor of recessions has not yet occurred. Ask yourself, who causes that inversion? It is due to an over-eager Fed tightening its monetary policies while the market which sets long-term interest rates does not see the necessity for tightening. Today, inflation is not a concern at all like it was in the 1980s and thus the Federal Reserve can easily back-off. The U.S. dollar has shot up like a rocket against other currencies including our Canadian dollar. Both gold and the U.S. dollar have acted like safe-haven. When the Fed backs off, which is now increasingly likely, the U.S. dollar will finally fall and that may be good for many non-U.S. countries, especially those with emerging economies. Gold may, because of now falling or stable interest rates, hang on to its gains or even move higher.
Are there dangers in this market that could spell even more trouble? Sure, but I think the markets have signaled the Fed to back off and for Trump and Xi Jinping to kiss and make up. The world always changes but it does so in predictable historical patterns (I hope).

No comments:

Post a Comment