FREE NEWSLETTER
IT’S BEEN MORE than six years since Covid first entered our vocabulary. It goes without saying that investors have experienced a lot, and for better or worse, recent market events provide some useful lessons. The first has to do with the nature of the stock market.
What drives stock prices? Open a finance textbook, and the answer will be clear: The value of a stock should equal the sum of the company’s future profits. This idea is known as intrinsic value, and it’s the textbook explanation of how stock prices work. But there’s clearly a disconnect, since stock prices bounce around far more than the math suggests they should.
How can we square this circle? Over the long term, the data tell us that intrinsic value is a valid idea. Chart the price of any given stock, then overlay the company’s profits, and there will often be a reasonably close relationship. But only if you’re Rip Van Winkle. Over shorter periods of time, anything can happen. Stocks often move far above or far below their intrinsic values in response to the news of the day.
Especially during times of economic uncertainty, intrinsic value analysis is typically cast aside and replaced by some combination of emotion, conjecture, speculation and storytelling. That’s what we saw in the early months of 2020. Stores were closed, employees had been sent home and the economy went into recession. And since no one had a crystal ball, that’s when storytellers were able to step in with their extreme predictions, causing the stock market to drop more than 30% in the space of six weeks.
The lesson for investors: No one can predict when the next crisis will roll around or what form it will take. But there is one very reasonable way to be able to keep it in perspective: by remembering that, at the end of the day, intrinsic value is what matters, and ultimately that’s what drives stock prices. Basic arithmetic illustrates how this can help us manage through the next crisis.
Consider that the price-to-earnings ratio of the U.S. stock market has historically averaged around 16. The average company’s total stock market value, in other words, has been equal to about 16 times its annual profits.
Now let’s imagine that the next crisis results in every company in America losing an entire year of earnings. That’s extreme and hasn’t happened since the Depression, but it’s useful as a thought experiment. In that scenario, what would be the impact to those companies’ intrinsic value? In simple terms, it would be just one-sixteenth, or a modest 6%. What if a crisis were so severe that a company lost two years of earnings? Using this simple model, the impact would be about 12%.
This is meaningful, I believe, because crises typically result in stock price declines that are far more severe than just 6% or 12%. In 2000 and in 2008, the market dropped more than 50%.
While every crisis is different, I think it’s useful to keep these numbers in mind whenever the next geopolitical event causes stocks to drop. When that occurs, storytellers will inevitably take over, and the news will be downbeat. But if stocks drop to an extreme degree, as they have in the past, we can probably view it as an overreaction. That won’t help anyone’s portfolio recover any faster, but it should help us tune out the worst of the forecasters and maintain our equanimity.
How else can you maintain an even keel during a market crisis? It’s important to understand the impact of recency bias. This bias is the tendency to extrapolate from current conditions, to assume that the future will look like the present, and to downplay the possibility that things might change. That tendency is what contributed to the cycle of negative news during the depths of 2020, and this is why I think it’s so important for investors to be aware of market history.
Again, extensive analysis isn’t required. We need only look back across some of the crises the country has weathered, from the Civil War to the Depression to World War II. In each case, the economy recovered and went on to become larger and stronger than before. The lesson for investors: In the depths of a crisis, it’s very difficult to know when or how it will end. But a sense of history can help carry us through.
Those are ways to manage through a crisis. Covid also provided a lesson on how to prepare—specifically, how to prepare our portfolios—for a future downturn.
In 2022, investors were caught flat-footed when popular total-bond market funds delivered surprising losses. These funds are one pillar of the well-known three-fund portfolio and have traditionally been viewed as the default choice for a set-it-and-forget-it bond allocation. But in 2022, when the Federal Reserve hiked interest rates, these funds dropped a surprising 13%. That was during the same year that the U.S. stock market dropped nearly 20%, creating a very difficult situation for those in retirement and needing to withdraw from their portfolios.
The lesson for investors: Total-bond market funds may be well diversified, but they carry risk along another very important dimension known as duration. This is a bond metric that measures, in simple terms, how long it will take for bondholders to be repaid, and it’s a key determinant of risk. The longer the duration, the greater the risk of loss when rates rise. While total-bond market funds have holdings across a broad range of durations, they average out to nearly six years. That’s why they lost so much value in 2022.
What’s the alternative? Short-term bond funds tend to have a duration in the neighborhood of just two years. As a result, in 2022, short-term government bond funds like Vanguard’s Short-Term Treasury ETF (ticker: VGSH) lost a far more manageable 4% of their value.
To be sure, every crisis is different, and it’s easy to rationalize about the past once it’s in the past. But these lessons, I think, can help us better prepare both our emotions and our portfolios for whatever comes next.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Please focus on the financial side of this article, not politics.
What political issue is being discussed?
I expect that if my comments are deleted that a reason will be provided. Making people unhappy is not a reason.
One of the comments that got deleted was an example of the hysteria I referred to: people dropping dead, etc.
We can either be a source of hysteria or a firewall. Too many people were a source.
I noticed that all of my comments have been deleted. They were relevant, thoughtful and honest.
This is strong evidence of a lack of diversity of opinion.
Is there anyone besides me who’d like to see this Covid tangent in the comments go away?
Your wish has been granted 😂
Covid was the lead sentence of the article. I said this ‘crisis’ was caused by hysteria, not a virus. I will not allow that to go away.
The stock market is run on the combination of three things…fear, greed, and stupidity.
It is not my place to convince anyone to agree with that position, and I wouldn’t try to do so, for one simple reason: “People convinced against their will are of the same opinion still.”
It has been known for over 50 years that you cannot time the market, yet people still try it every day.
Evidence shows that fewer than 10% of money managers consistently outperform the S&P 500, yet thousands of financial advisors claim they are worth their fees every day.
Bogle was right. Buy the US Stock Market and stay the course. Anything and everything else is a form of market timing…and it will fail.
Personally, I have 80% in the Total US Stock Market and 20% in the Total International Stock Market because we have no need for bonds or fixed income, as over 145% of our retirement living expenses (not including travel) are covered by Social Security and annuities.
Whenever you get the urge to get creative with your portfolio…or try to play sectors…or think you have an original investment idea that is a sure thing… read the first sentence of this post…and try to determine which one of the three is motivating you.
[deleted by moderator]
[deleted by moderator]
[deleted by moderator]
[deleted by moderator]
I’ll give Charles the benefit of the doubt and say he was only talking about the financial markets.
I was referring specifically to Covid.
[deleted by moderator]
[deleted by moderator]
[deleted by moderator]
[deleted by moderator]
[deleted by moderator]
[deleted by moderator]
[deleted by moderator]
What causes a stock market crisis?
Would a high concentration of ownership constitute this?
One high concentration we’ve discussed is index funds.
Another we haven’t discussed are individuals and their trusts owning too much. For instance, it is estimated that the wealthiest 10% of Americans own 87% of stocks. Perhaps this isn’t a problem because there are a lot of us in the top 10%. But what about the top 1% owning approximately half of all stocks. Is this a danger to the rest of us.
And more to the question at the beginning of the article, how can the market be fairly priced with such a high concentration of stocks in so few hands?
I continue to buy stocks because I figure that we’re riding on the coattails of wealthier more powerful people who are playing hard to increase their wealth by investing ins stocks, but I’m also concerned.
VGSH isn’t a practical idea.
In the last 15 years it made 1.4% annually.
Inflation was about twice than that.
Another myth is income investing.
There is no such thing as income investing.
The best way to test your portfolio is total performance which includes everything.
Many investors, including me, prefer risk-adjusted returns.
Just because a security has 4% distribution, it doesn’t guarantee better performance or better risk-adjusted returns.
Would you mind describing your asset allocation and general (or as specific as you care to) your current funds – index vs active, or specific funds – given it sounds like you don’t include income producing assets in your allocation?
I’m 50/50 stocks/bonds. Yes the NAV of the bond funds fell in 2022, but the monthly interest payments went up. I’m finally getting a decent monthly income from my bond funds. I redirected that money into a money market fund and will take my RMD from. If stocks remain high I may use some of that.
Most news which moves the markets falls in the category of “this too shall pass”, happenings which cause prices to twitch up or down around average returns. It’s always something, and then that’s gone and forgotten. CNBC and most financial media lives on this blah blah blah nonsense. Turn it off and tune it out if you can.
Long-term investors ignore those things to more clearly focus on the small and big cycles which drive cost of capital, earnings, and price. Read Howard Marks fine book “Mastering the Market Cycle” for more.
But then there are the rare, slow-moving train wrecks which rhyme with history, so may play out differently in future. These trends are in clear view but we cannot solve them overnight. I believe debt level and demographics of many developed economies are like that. Both will affect for many years GDP growth, cost of capital, and shape of future earnings, which all eventually impact stock prices after Mr Market sobers up. So yes, stay the course but also stay clear-eyed about intrinsic value and how that could change over time. Keep a margin of safety when you buy. Price matters.
Good read, Adam. The 2022 bond crash you reference made an impression on me and is probably one reason I sleep better with an overweight allocation to cash, especially when it’s paying a decent amount of interest.
I know, I know…inflation eats away at it, but still, what’s the value of a good night’s sleep?
A good night’s sleep is everything. Back in 1994, I sold equities to get ready to buy my first house later in the year. I put the money in a short term bond fund. My plans were to enough cash for a down payment, a new minivan for my growing family, and cash to furnish the house. Then Alan Greenspan rubbed his belly and jacked interest rates up. A lot. I lost about $750 in that ST bond fund teaching me a very real lesson; even a short term bond fund has real risk and a money market may be a much better option for short term holdings.
Just keep these thought provoking articles coming. For me, I follow the Bogle, Buffett outlook. Invest in the S&P 500 and stay the course.
Bogle advocated the full US market.
Your explanation should help us folks understand why we should “stay the course” as Bogle advised.
I get the short-term bond argument but I think the downside should be acknowledged. Quoting the “Bond Market Risks” article in the Humble Dollar Financial Guide, “If you swap into short-term bonds or cash investments, you will reduce the chance of a large loss, but you will pay a price in the form of reduced income.”
Risk/Reward my man, Risk/Reward!
Adam, this is great information to feed the thinking part of our brains when the emotional side is attacking.