4Q Newsletter – January 2024

Staying the Course

Many people possess the intellect needed to analyze data, but far fewer are able to look more deeply into things and withstand the powerful influence of psychology. The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.

-Howard Marks

Human behavior is a fascinating subject to ponder upon. Even though most people think that they approach decision making through logic, several studies conclude that up to 90% of the decisions humans make are based on emotions. Think about talking to someone about their phobia of sharks. You may try to use logic, facts, or statistics such as cows kill more humans than sharks do annually to show their fear is unwarranted, but more often than not, this will fall on deaf ears.

This same idea of emotions playing a prominent role occurs in investing. A positive market return day may elicit positive emotions and cause investors to want to put more money to work. Whereas a negative return day can make investors feel squeamish and contemplate whether or not they should lighten up on some of their holdings. However, this is almost the exact opposite of what should be done if history is any guide.

The chart below shows how an investor would have done over the last 40 years if he or she only owned the S&P 500 index on trading days that immediately followed “up days” versus only owning the S&P 500 index on trading days that immediately followed “down days”. If you owned the S&P 500 only after down days, you would be up a respectable 785%. Conversely, if you only owned the index on trading days after up days, you would be up a paltry 17%.

Source: Bespoke

The moral of the story here is don’t let the down days get you too down. Over the years we have stressed our buy and hold philosophy and the chart above gives credence to this strategy. However, let’s look at the other side of this. One of the most common arguments people use to discredit buy-and-hold investing is that from the 1963 to 1983, the stock market essentially returned nothing after accounting for inflation (real returns). This argument is correct and you can see it in the chart below. The 1960s – early 1980s market probably felt like an eternity for investors. However, our question is: what was the alternative? If an investor should not have owned stocks during this period, where should the money have been? Two other places the vast majority of investors could have put their money was in bonds or treasury bills. Interestingly enough, bonds and treasury bills performed worse than stocks over this period.

Source: Factset, Morgan Housel

The wisdom of buy and hold is not that stocks always outperform. They don’t. The wisdom is that stocks tend to be the best-performing asset over long periods of time, and trying to shorten that time by jumping in and out of other assets is an express lane to regret and misery. While market timing sounds nice in theory, if you were to miss just the best five days in the market since 1995, you’d underperform someone who is fully invested by nearly 170 basis points on an annual basis (see chart below). This doesn’t mean you should necessarily just only own stocks either. Each individual’s circumstances are different, but everyone should own enough bonds or other liquid assets to keep volatility from scaring them out of stocks. 

Each down market is different, but we can say with certainty that there will be another down market at some point. We have to prepare not only financially, but also mentally and emotionally for this. No matter the amount of logic / reasoning or statistics we provide here, it still won’t make it much easier from an emotional standpoint when a downturn does come. Nonetheless, we will provide some food for thought.

The table below shows the amount of time it has historically taken to recover from a bear market.

Since 1956, on average, a bear market has resulted in an approximate 31% decline and took 12 months to go from peak to trough. The average recovery time (meaning for the market to recoup all its losses and get back to breakeven) historically has been 20 months from the trough. So, when bear markets occur, investors could be waiting awhile to be made whole from a prior peak. There is a silver lining here if you look at these numbers from a different perspective though.

If it takes a number of months or even years to make your money back, that gives investors time to take advantage of higher future expected returns (see chart below).

Source: Bloomberg, Ameriprise. Returns longer than 1 year are annualized.

For those who are net savers, this means plenty of time to deploy capital at lower prices than what was being offered before. Look at the average returns after a bear market trough, as shown on the previous chart. One year later, the market is up on average almost 50%, while 3 years later the average return is over 20% annualized. (Of course, no one knows when a bear market will trough, but alas.) To be clear, obviously, nothing is a given, but every bear market in the history of U.S. stocks has led to new all-time highs at some point in the future.

So, logically, after looking at this data, why would investors sell out at or near the bottom of a bear market? Well, you don’t need to study the math of future returns to figure out the most likely culprits are due to emotional reasons. It isn’t hard to imagine why someone would want to sell out when it feels like the market will just continue to go lower and lower. Certainly, we are not immune to downturns, but this is why we spend a considerable amount of time determining which investments to include in portfolios. We are searching for companies that we believe will not only survive recessions, but come out of them stronger than their peers.  

Since the end of 2021, Monarch’s core stocks on an equal-weighted basis have seen a median 7% earnings growth and 11% dividend growth. The core stocks as a whole have seen multiple compression and are cheaper today than they were at the end of 2021 with a median price to earnings ratio of slightly over 18x today versus roughly 20x at 2021 year-end. Of course, seeing multiple expansion is more exciting (all else equal, this would mean stock prices are increasing faster than earnings), but over the long-term stocks generally follow their fundamentals. Boston Consulting Group and Morgan Stanley demonstrated this in a recent study that concluded over long periods of time (10 years), growth in sales and earnings per share, along with margin expansion, explain 90% of stock performance.

As expressed in our previous newsletter, there are several potential headwinds for the economy in the upcoming year, but that doesn’t mean there isn’t a way out. With the stock market having a pretty decent year, perhaps now is the time to revisit your asset allocation and ensure it still fits your risk profile. Lastly, the next time you read a negative news headline that strikes fear or see that the stock market has experienced a large down day, try to recall some of the graphics we displayed in this letter and not let the down days get you too down.

Monarch Capital is thankful for our clients, friends, and family and the special relationships that we have gained and fostered throughout the years. From our work family to yours, have a happy New Year!

–Written by Adam Beard