4th Qtr. Newsletter- Jan 2021
Tuning Out and Focusing In
American adults spend over 12 hours per day listening to, watching, reading, or generally interacting with media according to the 2020 Nielsen Total Audience Report. Of that, the average time spent consuming news is approximately 70 minutes per day. Another way of thinking about this is over a 50-year period, the average adult American spends approximately 887 total days or 2.4 years just consuming the news.
I personally have never had an issue watching the news in the past, but the last couple years have seemed more burdensome. There are some days where I would rather stick needles in my eyes than watch the news. It all just seems very noisy. When I turn on the television, all I hear is people shouting at each other regarding their differing views on the upcoming Senate race, taxes, healthcare, immigration, and foreign affairs. Shouting, shouting, and more shouting. It all feels unproductive and, in my opinion, unhealthy for society. I feel a wide range of emotions watching the news. Depending on what is said and who is saying it, in a ten-minute period, I regularly go from thinking “the apocalypse is near” to “things are looking up.” It’s all very exhausting. Then, after fifteen minutes, I walk away fixated on all the negatives rather than the positives.
This idea of fixating on the negatives rather than positives is similar to the idea that after receiving 9 positive reviews and 1 negative review, you often find yourself dwelling on the one negative remark. You may think you’re unusual when a thousand good things happen, but you focus on the one bad thing. You’re not. That’s the way our brains are hardwired. We’re designed by nature to pay more attention and react more quickly and more strongly to negative than positive news. This is known as negativity bias.
In the book, Thinking, Fast and Slow, author Daniel Kahneman wrote:
The brains of humans and other animals contain a mechanism that is designed to give priority to bad news. By shaving a few hundredths of a second from the time needed to detect a predator, this circuit improves the animal’s odds of living long enough to reproduce.
One effect of negativity bias is that we are likely to be afraid of things disproportionately to the evidence. For example, most people who are afraid of flying in airplanes have little fear of driving in an automobile even though their chance of being killed in an automobile crash is much higher than their chance of being killed in an airplane crash.
Loss aversion is another way that negativity bias manifests itself. Potential losses affect people more deeply than potential gains. This can lead to some irrational behavior, as is evidenced by those many times when individuals pass up an opportunity to benefit either financially or psychologically because they are afraid to take the risk of a loss.
Long-term investors who put large chunks of their portfolio in bonds in the past are a prime example. According to data from NYU Stern School of Business, the average annual return for stocks from 1928 – 2019 was approximately 10% versus 7% for bonds. A 3% difference a year may not seem like a lot, but over long stretches of time, it can have a substantial impact. Comparing the dollar amounts (unadjusted for inflation), investing $100 in stocks in 1928 would have resulted in approximately (~) $502,000 at the end of 2019, whereas the same $100 invested in bonds would have been ~$48,500.
The chart below graphically plots 10-year rolling average annual returns of stocks versus bonds from 1938 – 2019 (again, unadjusted for inflation). Rolling 10-year returns for each year represent the annualized return for the previous 10 years. For instance, 1950 represents the 10-year annualized return from 1940 to 1950. Another example would be to look at the year 1980 on the chart. It shows that through the years 1971-1980, the annualized average return for stocks was ~8.5%, while the annualized average return for bonds over this time frame was ~6.2%.
The chart above emphasizes the point about the difference in long-term returns between stocks and bonds. It is important to recognize that we are not saying bonds do not have a purpose in a portfolio. Looking at the graph, you can see bond returns are often “smoother” than stocks and they can provide a hedge for potentially volatile swings in stock prices. If it helps you sleep better at night, we can always increase your portfolio allocation more towards bonds. The decision around stock/bond allocation comes down to risk tolerance, age, financial goals, and a variety of other factors.
Also, we want to stress that we are not saying stocks always go up. From 1966 to 1974, the S&P 500 index was essentially flat and provided a 0% total return. There have been various other periods in time where stocks have gone nowhere over 5 year periods, and it is a real possibility that we could see a stretch of years in the next 5-10 years where stocks provide little or no real returns. There are no guarantees.
However, I would bet several more opportunities have been missed being too bearish than mistakes made being too bullish. Letting bearishness envelop your entire thinking produces an overarching negativity that tinges positive ways forward, which is often much less beneficial in any circumstance. Economies generally grow, markets generally go up, and things tend to get better over time. How am I able to make such an assertion? Well, let’s look at a few observations/charts. The first graphic is from the book The Psychology of Money. The chart shows the rise in real GDP per capita (which is the average level of national income, adjusted for inflation, per person) from 1850 through 2019.
The author, Morgan Housel, wrote:
But do you know what happened during this period [1850-2019]? Where do we begin…
- 1.3 million Americans died while fighting nine major wars.
- Roughly 99.9% of all companies that were created went out of business.
- Four U.S. presidents were assassinated.
- 675,000 Americans died in a single year from a flu pandemic.
- 33 recessions lasted a cumulative 48 years.
- Stocks lost a third of their value at least 12 times.
Yet, [Americans’] standard of living increased 20-fold over these 170 years, but barely a day went by that lacked tangible reasons for pessimism. A mindset that can be paranoid and optimistic at the same time is hard to maintain, because seeing things as black or white takes less effort than accepting nuance. But you need short-term paranoia to keep you alive long enough to exploit long-term optimism. [Emphasis added, mine]
We want to focus on the sentence that is bolded. Of course, it is imperative to stay attuned with what is currently occurring in the economy. We cannot just assume the future is going to be all sunshine and rainbows. Complacency makes a person overconfident, which causes risk to rise. But it is also important to recognize that a lot of the information we see every day is mostly noise. I would note that considerations such as who was/is going to win the presidency play little to no role in our investment process. We invest in businesses we deem capable of surviving and growing over the span of many Presidents, regardless of party. Stay focused on the forest, not the trees. The next chart displays the returns of stocks and bonds over rolling periods of time. The bars on the graph represent stocks, bonds, and a 50/50 portfolio. For instance, if you look at the first green bar on the left of the chart, it shows that the range of stock returns for any one year period from 1950-2019 was between -39% and +47%. The key idea to take away from the chart is from 1950 – 2019 there was not a single 20-year rolling period where the S&P 500 had a total negative return and its worst twenty-year average annualized return was ~6%.
The purpose of displaying these charts is not to say over the next 20 years the market is going to deliver at least a 6% annual return. Future returns could be lower than they’ve been in the past (and a pretty compelling case could be made for this), but it is important to remember that even below-average returns over a 20-year time horizon can produce some pretty impressive results. For example, here are the total returns compounded over 20 years with their corresponding annual return levels:
- 20 years at 3% = 81%
- 20 years at 4% = 119%
- 20 years at 5% = 165%
- 20 years at 6% = 221%
- 20 years at 7% = 287%
So, even if the stock market experiences below-average annual returns in the range of 4-5%, (which is quite a bit better than what bonds are currently offering) over the next 20 years, it would still produce total long-term returns of ~120% to 165%. It doesn’t take too much to see a pronounced effect over time, given you are able to stay the course. This was exemplified in 2020. The market had declined by over 30% in March and things looked very dark. Yet, by the end of the year, the stock market recovered all of its losses and then some (quite amazingly actually). What is the takeaway? Knowing what to do is easy, but doing it is hard. Remember to hold the right information clearly in your mind consistently and don’t let your own fear and psychology cause you to make a needless mistake. The goal is to remain committed to the long haul; this is a marathon not a sprint.
Stocks are pieces of ownership in actual businesses and not pieces of paper that you just trade into and out of every week. To provide a more concrete example, let’s say it has always been your dream to own a farm. So you spend months and months determining which farm is the best for you, wait for the right price, and then decide to buy it. Are you really going to sell it if someone offers you 5% more for it next month or worse, offers you 20% less? Then, why would you become fearful and want to sell stocks when the market falls 20%?
There was an interview from 2018 in the magazine Railway Age that featured Warren Buffett and Matt Rose, the Executive Chairman of Burlington Northern Santa Fe (BNSF) who stepped down in April 2019. The following is a short passage about when Rose called Buffett after BNSF had been acquired by Berkshire Hathaway:
I called Warren, and I said, “Okay Warren, you now own a railroad. Congratulations. What do you want me to do? You want me to come to Omaha and bring a power point and show you what our next five-year plan’s going to be?” And he said, “No, I want you to run this company like you own it, and you’re going to be in charge of it for the next 100 years.”
As the short excerpt above illustrates, it’s not so much the next quarter or two that is important, but the continued growth and sustainability of the business over multiple years.
Another instance of focusing on the long-term can be seen by using the example of one of our core stocks such as Johnson and Johnson. Is JNJ likely to see its stock price increase 100% over the next year or two? No, I would opine that is unrealistic. However, over the past 21 years, the company’s stock price return has been ~235% (compared to the ~155% for the S&P 500). If you bought JNJ stock on Dec 31st, 1999, you would have paid $46.63 per share*. At the time of purchase, JNJ paid an annual dividend of $0.55 a share. Today, the annual dividend is $4.04 per share. This means your yield on cost (just a fancy way of saying the current dividend per share divided by the price per share initially paid for the stock) is over 8.5%. With JNJ having a 58-year track record of consecutive years of dividend increases, our educated guess is we will continue to see increasing dividends per share for years to come, even if the stock market does provide below-average returns over the next few years.
As a whole, our core stocks’ average amount of consecutive years of dividend increases is 29 years. Said another way, our core stocks have an average length of time spanning 29 years where these companies have rewarded shareholders with consecutive yearly dividend increases.
Year in and year out, it is relatively difficult to determine how specific stocks will perform, but over the long run, fundamentals (earnings and cash flow) drive stock prices. If you happen to wonder why some “high-flying” stocks such as Tesla or Moderna are not included in our core stocks, there are a variety of reasons, but the one we want to specifically point to is downside risk / permanent loss of capital.
To finish, I want to quickly touch on investor sentiment and the role it plays in markets. As counterintuitive as it may sound, I am often comforted when I hear consistent predictions that the market is headed for a huge crash. It shows a gauge of sentiment. At some point, the market will crash, but if everyone expects something to happen and they are positioned for it, that is usually fuel for the exact opposite thing to happen. The market has a funny way of humbling even the most sophisticated participants.
Bubbles or tops form when the idea of the market continuing to go up becomes a mainstream idea. We may be closer to that point [a near-term top] than most people realize or we may not be. It seems like the majority of investors assume 2021 is going to be a good year for the economy and the market and that may be a short-term risk as speculative froth continues to build. At the start of 2020, coming off a very strong 2019, lots of people said that the market was overvalued. Then a pandemic came that shut down huge chunks of the global economy, yet the S&P 500 finished the year positive. [It’s almost like] no one knows where the market is headed over any short-term time frame.
We here at Monarch will let others worry about the daily noise and what the next short-term move in the market will be. Instead, we will continue to focus our efforts on finding reasonably priced, durable, growing businesses that we believe will stand the test of time in the best and worst environments.
Stay Safe and Have a Happy New Year!
–Written by Adam Beard