Don’t Bet Against the Stock Market (for long)

As the stock market has tumbled, those who had hoped fears of a recession were overblown have found the wind taken right out of their sails. FedEx announced late Thursday that they expected to fall short of their earnings projections to the tune of a half billion dollars due to a slowing economy, with CEO Raj Subramaniam saying he sees this as the start of a global recession. The World Bank agrees that the situation is dire, pointing to central banks in major economic areas all hiking rates at once in an effort to curb runaway inflation and consumer confidence cratering faster than in previous recessionary periods.

And if you still have nightmares about the hellscape that was the economy in 2008, you might want to avert your eyes from the ongoing monitoring Mott Capital Management founder Michael Kramer has been doing.

2022 vs. 2008 #sp500 analog, the final update for the week. pic.twitter.com/HIWszInBtD

— Michael J. Kramer (@MichaelMOTTCM) September 16, 2022

The stock market is, inarguably, rattled. So are the folks at home watching the numbers and headlines. We’ve written before about how panic serves absolutely no one, but it is certainly understandable to be concerned about your exposure to risk assets. The question for many right now is whether or not they should be trying to get out of the stock market before it’s too late. After all, the 2008 crash wiped out over $8 trillion in value.

But it may not be about timing an exit. It may just be about waiting out the clock.

Whenever the stock market takes a nosedive, there are many conversations about how to keep your investments safe. There are constant reminders that diversifying your portfolio is the best way to protect yourself in those types of situations. Some argue that you should be looking at your investments every few months to ensure there are no dramatic changes. Others say a semi-annual or annual meeting with your financial planner will probably suffice. And in the meantime, you have talking heads squawking on the TV about minute-to-minute developments with certainty about their long-term consequences.

Perhaps, then, it should come as no surprise that nearly half of investors check their portfolio at least once a day. What an utterly exhausting routine.

But while the loudest voices in the room promise you that now is the time to make a move, it might actually be the time to pause and consider.

Timing the Stock Market Is a Fool’s Errand

Market timing is a strategy by which investors seek to move in and out of positions according to predictions about future market movements. For example, if I think there is a high probability of violent conflict in a region near a major oil operation, I might take on a long position in oil futures in hopes of turning a profit. If I think there’s going to big a big bump in consumer spending during the holiday season because unemployment is dropping, I could increase my exposure to companies like Amazon or Target.

If I think. That’s the keyword there.

Market timing has a lot to do with what we believe to be true based on available information. To be brutally honest, what we know (unless you’re into insider trading) is not a lot, and for the average investor, it is likely far less than the analysts and managers on Wall Street. They have help that extends far beyond the armies of researchers at their disposal. Many professional investors rely on statistically-guided indicators and automated systems to help them make decisions, but in a world where high-frequency trading means we measure value gained and lost in fractions of a millisecond, the quants live in a dog-eat-dog world, too.

And on their best days, the most advanced algorithms in the world still can’t see into the future. They can’t predict a terrorist attack on a major transportation hub, a whistleblower stepping forward, a hurricane unexpectedly shifting course, or a global leader having a heart attack. Not even the Oracle of Omaha. One of the most successful investors of all time, Warren Buffet put it this way in April:

We haven’t the faintest idea what the stock market is gonna do when it opens on Monday — we never have. […] I don’t think we’ve ever made a decision where either one of us has either said or been thinking: ‘We should buy or sell based on what the market is going to do, or, for that matter, what the economy is going to do.

Hedge fund managers love to say otherwise, of course. Whether you’re talking about a firm with a global macro, long-short, fixed-income arbitrage, or some other flavor of strategy, the promise is the same: alpha.

The best way to understand alpha in this conversation is as returns in excess of an identified benchmark. Different hedge funds will use different indices or mock portfolio configurations as a comparison for the results they are able to generate versus something else.

But can they? After all, this was the promise they were making before 2008, and hedge funds lost an average of 18 percent during the downturn (with the notable exception of managed futures programs). Was it as bad as the S&P 500 drop during the same time period? No. Was it a good return? Absolutely not.

It’s not like that was a one-off occurrence, either. During the (relatively) brief COVID 2020 recession, hedge fund closures were up more than 20 percent year over year, with the average size of shuttered programs clocking in at $650m in assets under management and an average track record of over eight years. In other words, these were not the new kids on the block. So much for having the winning numbers.

In 2022, equity hedge funds, in particular, have failed to deliver. As Yahoo! Finance reported:

2022 has been one of the worst years on record for equity hedge funds. According to data from HFR, a firm that tracks the performance of more than 5,900 hedge funds, equity funds lost close to 8% in the first five months of 2022 amid recession fears. These funds, which manage over $1.2 trillion in assets for clients, had reported losses of only 5.8% in the first five months of 2020, at the height of the pandemic crisis.

So if no oracle, ostentatious hedge fund manager, or overly-complex trading algorithm can effectively time the market, do you really think you are the exception to the rule? Is that a gamble you’re willing to make?

Past Recessions Can’t Guide Your Stock Market Journey

But, but, but, you might want to say. What if I had just gotten out during the downturns? What if I left the market if it was a real recession instead of trying to get alpha or whatever?

Well, yes, mathematically, if you had pulled out of the stock market before a significant downturn every single time, you would have avoided some losses. But on top of the already established fact that you most certainly would not have dodged every bullet, attempts to time a re-entry based on any kind of data is equally ill-advised. In the same way that a stock market downturn cannot be predicted, the initiation of an economic recovery cannot be determined through prognostication.

Consider this: if you look at data from the National Bureau of Economic Research (NBER) stretching back to 1854, there have been a total of 32 defined recessions, averaging one recession every 5.2 years that lasted an average of 16.6 months followed by an average recovery or expansion period of 39.6 months.

That seems pretty straightforward, but then you look at individual cycles. Maybe we’ll never see another three-year recession like the Great Depression, but the so-called COVID recession was only two months. Sure, there was a decade of expansion after 2008, but there was an only a year between two defined recessions in the early 1980s. Should NBER pull the trigger on defining the current state of the economy as a recession, it would mark another instance of just a few months of prosperity between downturns.

You can’t even time a re-entrance according to depth of the decline in GDP. Though NBER uses a number of factors to determine whether or not an economy is in recession, the commonly understood indicator has historically been two straight quarters of GDP contraction. The average GDP drop from peak to trough across these recessions was -12.6 percent, but if you look at the data, it’s really been all over the board.

The flaw in the thinking that you can “re-enter” the stock market based on past recession depths is clear here, but it’s especially clear when you consider GDP shrink relative to the duration of the recession.

Once again, the numbers are all over the place. The most recent defined recessions provide great contrast. The “Great Recession” that followed the 2008 crash lasted 18 months and yielded GDP losses of -5.1 percent. The COVID recession in 2020 lasted only two months, with the GDP drop clocking in at -19.2 percent.

Wait a minute, you might be thinking. The circumstances of the COVID recession were extreme.

Maybe. But before COVID, the argument would have been that the 2008 crash constituted extreme circumstances. In fact, one could say that about nearly every recession on the map at one point in time. Each of these periods could be considered an outlier in a broader data set, but that’s the thing about outliers: they are, by definition, unpredictable. And, as Nassem Nicholas Taleb wrote in The Black Swan, “The inability to predict outliers implies the inability to predict the course of history.”

Unless you have some magical powers you’ve been hiding from the rest of us, odds are that quote applies to you and your re-entry thoughts, too.

Sitting on the Stock Market Sidelines Can Cost You

While the immediate concern with getting stock market re-entry timing wrong is that you could ride the trend further down, there’s another concern, too: you might miss out on the upside.

Let’s assume you decide to play it safe. You wait before you put your money back in the stock market. After all, we know you can’t be sure when the turnaround will begin or whether what looks like a turnaround will be durable. The problem is that you could end up being out of the stock market during the most high-octane part of its resurgence.

An analysis conducted by Merrill Lynch took a look at what would happen if you invested $1,000 in the stock market during three ten-year periods, but then missed the ten and twenty best-performing months because you took the money out. The numbers speak for themselves.

Source:
Merrill Lynch, Focus on time in the market, not market timing

It’s not a pretty picture, but maybe you noticed that top row. In a world telling you to pivot in one direction or another, is it really possible that standing still is the best option?

The Stock Market Might Be the Safest (Long-Term) Bet

Before we get into anything else, let’s be clear: all investments include risk. There is no such thing as a risk-free investment. If you believe there is, we’ve got a bridge in Brooklyn to sell ya.

This being said, the idea that stocks are inherently a “risk-on” play for investors is patently false.

The term “risk-on” is the yin to the “risk-off” yang. What the terms refer to is the pervading investor sentiment in a given investing climate. If investors are feeling bullish about the economy, the market is considered risk-on, meaning investors are willing to put more money on the table and into assets they might not otherwise consider. In a risk-off market, investors are feeling skittish, and are instead putting their money into assets they believe to be safer.

When considering conventional portfolios, stocks are usually considered to be a risk asset, while investments like bonds are considered safety plays. During trying times – like, say, now – the argument often advanced is that investors would be “wise” to shift their assets into safety plays. But is that really the right move? Is that your safest bet?

We took a look at S&P 500 data stretching back to September of 1940. At that point – even considering a brief dip in the months that followed – the economy was back on an upward trajectory following the Great Depression, and a new era of regulation and financial institution development had created a very different market dynamic. From there, we took a look at how a person would have fared had they invested in the S&P 500 and then held steady for a period of six months, one year, five years, ten years, and twenty years on a rolling basis. Here’s what happened.

The results were definitive. On average, the longer you held your position in the stock market, the larger your returns. And yes, that includes the more than a dozen NBER defined recessions during that expanse of time.

Considerations of Stock Market Investing in a Recession

The data suggesting that sitting tight in the stock market during an economic downturn will payoff is solid, but data can be tricky. It is really only valuable when it is contextualized. Before you assign this analysis too much value in your own personal calculus, there are several important questions you should ask yourself.

What are my investment goals?

Depending on where you are in life, your investments may serve a variety of purposes. The relevance of data on waiting out an economic downturn is tied to those purposes. For instance, if you are a young professional with many working decades ahead of you before you consider retiring, you would probably be able to afford the waiting game. If, however, you are already in retirement and rely upon a steady portfolio to ensure that it stays that way, waiting 20 years to see a substantial recovery might not be a wise decision.

What is my available risk capital?

Part and parcel of conversations about your investment goals is the risk capital you have at your disposal, best understood as the number of resources you can reasonably invest. This does not mean the entirety of your wealth; it refers to the amount that can be put into play in a situation where you may accrue losses. If, for example, you are considered a high net-worth individual, you can probably comfortably afford a short-term loss without your goals being derailed, meaning you have a fair amount of risk capital with which to maneuver. If, however, you are in a position where a significant short-term loss in the stock market would cause hardship, the risk capital at your disposal is most likely very low. This sort of calculation is important in any investing situation, but can be especially significant when making investment decisions during an economically turbulent time.

What is my risk tolerance?

This is the tricky one, because risk tolerance can be understood in different ways. If you want to come at it from a quantitative perspective, it might refer to the total amount you are willing to lose in order to access a chance at greater gains. There are a number of ways to calculate this, and it is usually directly tied to your goals and available risk capital. The other interpretation is more qualitative and perhaps more important in the context of a recession: how much of a loss can your heart take? We already discussed what can happen to your returns if you try to time the market, but we’re all human, and feelings can sometimes cloud our judgment. For instance, if a substantial loss – even if short-term – could spur enough anxiety to prompt a reactive portfolio decision, your risk tolerance is likely low.

This is a simplification of how these questions get addressed. The reality of making a decision about what kind of exposure you should have to the stock market today is much more complex, which is why it can be so helpful to consult with a financial planner. They can offer far more detailed guidance on how to make the right decision for you… and maybe push back against the stock market “experts” who promise they know best how to game the system.

Bottom line: it’s probably not wise to try to beat the stock market. Odds are it will just beat you up instead.