In February of 2020 the S&P 500 made a new all-time high of nearly 3,400 points. Then the selloff began that would see an intraday low below 2,200 points. That is a 35 percent loss. But the market has since rebounded recovering to 2,846 points as I write this. This represents an almost 30 percent gain from the low, and has cut the market’s loss in half. In my view, it’s a great spot for investors who have not gotten defensive to sell some stocks and raise cash.
No one has a crystal ball. There are no certainties in investing. It’s possible the worst is over. Maybe this is the start of the V recovery expected by so many. Perhaps the market is pricing in that the worst of the virus is behind us. You could certainly draw that conclusion from looking at the price action of the stock market. But I think it’s far more likely that instead of being well through a V we are far along in a retracement rally that will fail. We are likely to see the prior lows retested and very likely will go to make new lows. Although that is best evaluated if and when a retest happens.
Playing the Odds
The odds of a bearish scenario, where this rally will fail and stocks will resume the prior downtrend, are so strong as to make reducing stock exposure the prudent course for even long-term investors. That is partly because investors are human. By that I mean we have finite lifespans and, unless you’re a trust-fund baby, an even more limited investing span. A lost decade isn’t conducive to successful investing for those with regular investing lifespans. Odds are good, buy-and-hold investors are looking at exactly such a nightmare scenario.
In 2000 the Nasdaq made a 5,000 point high that would not be reclaimed until 2015. The Dow Jones Industrial Average peak of over 350 points set in 1929 would not be reached again until 1954. Since 2000 the S&P 500 has experienced two bear markets, where about half its value was erased with twin peaks above the 1,500 point level in 2000 and 2007. Despite the stock market average annual return statistics that brokers and financial planners like to quote, big losses that take a long time to recover from happen.
Why Fear a Big Loss
So, why fear another big loss? First, as pointed out previously stocks are expensive. Cutting the market in half from its peak would not even make them cheap. In fact, given how expensive stocks became a lost decade is a likely scenario, regardless of a global pandemic. Second, is that not small matter of the present global pandemic, which has caused the shutting down of the economy. Assuming the economy can just be restarted and will have a V recovery seems incredibility optimistic.
Far more likely is a prolonged recession, worse than anything we have experienced recently. Many businesses, especially retail businesses already on the edge, are unlikely to come back. On the other hand, the virus is very likely to come back in the future. There may be future outbreaks. Furthermore, even when the all clear is sounded, customers to many businesses are unlikely to immediately return. The impacts on cruise ships, restaurants, airlines and other impacted sectors may be extended.
Then there are secondary impacts as unemployment builds and individuals, corporations and governments with little financial cushion are stressed. For example, consider the impact on governments, if already underfunded pension funds take a big hit from market losses. Rising taxes, with cuts to government staff and services, is not a great mixture. Also for public companies a move away from stock buybacks as balance sheets are stressed is another new negative factor for the market.
It also appears that a retreat from globalization and reliance on China is going to accelerate. That might be a smart thing to do. But it’s also going to be a disruptive and inflationary thing to do. And I have not even mentioned the impact of drastically lower oil prices on the energy sector and American shale companies, because this trend that by itself would have been considered a recession risk not long ago, is now just an afterthought.
None of this argues for a V recovery. In fact, a recession of the magnitude we are almost assuredly looking at makes the case for a bear market that is at least as bad as the last two. In other words, the optimistic scenario might be the S&P 500 only retesting the lows of 2016 at around the 1,800 point level. But it could take some time to get to our true bottom. The bear market that began in 2000 didn’t finish its bottoming process until 2003. Some may look at the current stock market as three fourths of completing a V. Others can look at it as experiencing its first bear rally before resuming an extended downward trend. My expectation is the latter, but I will change my mind if the data changes.
In fact, this has been my expectation before there was any virus. That this stock market might end with a crash that sees a retracement rally that fails before going on to set new lows is a scenario I have considered likely for years. Why? Partly because valuations became so high that this market could fall substantially and still not be cheap. In addition, since the Great Recession we have experienced some flash crashes—ominous warnings that market makers who provided liquidity in the past, when the market most needed it, have stepped away. As a result, the violent price action we have experienced has not surprised those paying attention.
Prepare for Worse, When Worse is Not Expected
Furthermore, we have seen the prevalence of index products and confidence in buy-and-hold passive investing strategies. But when that confidence is shaken and investors hit the sell button, there is no orderly selling of the weakest stocks. Rather, everything is sold suddenly. We have experienced a little of that. But we have definitely not experienced a “capitulation” event. Such a capitulation event in our era of passive investing has the potential to drive the market substantially further down.
Yes, this stock market got oversold. A rally was not unexpected. But the biggest question I hear from investors is when is the best time to buy? That is not capitulation. That is greed. Perhaps my favorite investing admonishment is Warren Buffett urging to be greedy when others are fearful and fearful when others are greedy. People are still greedy. There is more room for them to do more selling, with stocks they have not yet sold, than space for them to do more buying, with cash they have not yet deployed.
By degree of loss this is a bear market, and bear market bottoms are defined by fear, as investors give up on stocks and hide in cash. We’re not there yet. People don’t hate stocks enough. At the bottoms of the last two bear markets very few were asking if it was time to buy. Instead, investors were convinced far worse was to come. That is the kind of sentiment that bear market bottoms are made, and we’re not seeing it yet. Not only are we seeing too much optimistic sentiment for a V recovery and buying opportunities, we are conversely seeing a negative economic outcome.
Indicators are definitively signaling worse is to come. That is a dangerous discrepancy to ignore. At the very least, caution is advised and a defensive stance merited until that divergence disappears, or better yet flips, with investors panic selling and economic data starting to trend positive.
Perhaps, the best case the bulls can make is to not fight the Fed—that the Federal Reserve will do whatever it takes to save the stock market. This is an argument that should be taken seriously. But there are reasons to doubt it. Based on valuations the stock market was in a bubble that appears to have popped. The historical track record of central banks successfully and quickly re-inflating popped bubbles isn’t encouraging, as proven by our last two bear markets.
I have also long suspected that just as the 1987 market crash was partially created by portfolio insurance products enticing investors to buy expensive stocks on the belief they wouldn’t fall, until they did, so also has the Fed Put or confidence in the Federal Reserve bailing out investors enticed them to buy expensive stocks on the belief they would not fall, until they do. Now that the stock market has fallen and we’ve basically shut the economy down, we are going to find out how seamlessly government can put the proverbial Humpty Dumpty back together again.
I expect it’s going turn out to be far easier to shut down than restart an economy, and the fall in the stock market will run further. This is about the worst possible economic demand shock imaginable. A mere 35 percent stock market decline that is quickly recovered in a V seems incredibly optimistic. It’s an outcome I hope for, but it is not a conclusion I expect or would position a portfolio around. So, hope for the best. Yet, in your investing prepare for worse to come.