It has been over four decades since my discharge from the US Army. During the short time I spent in service to our country, I had the privilege of becoming friends with a number of battle hardened veterans. These were special people who had the ability to face fear, adjust plans and, most importantly, lead others when needed in hopes that all would survive.
Little did I know that these long lost friends would have such an impact on my life. I find that I think of them when I need a little push to overcome my own fear, adjust plans, and do what I can to survive the battles of my career. Although the fear these veterans faced cannot be compared to the investment battles we face in the day to day management of your portfolio, the memories of their ability to make decisions during times of stress have helped me as we attempt to protect you from a permanent loss of capital.
When we are facing a massive sell-off, there is a desperate search to find the reason. Most of these “reasons” have some rationality to them, but when markets decline as rapidly as they have during the past couple of weeks, the cause usually has far more to do with our fear of losing all of our savings than with the words of commentators. I have been through these battles many times over the decades and have survived. Yet even with this experience, fear still finds its way into my mind. However, past survival gives me strength to step back and realize that this time is not much different, and there is no need to give up the fight and run for the hills.
Reason Number One: Oil Prices
The current round of “reasons” for the decline are interesting. First, we have oil prices. While it is true they have declined over 70% from their peak, do you really believe that low oil prices are destroying the world’s economy? If so, the next time you head to the gas station, you should add a couple of dollars per gallon to the selling price in order to do your part in saving the world. It is true that lower oil prices will impact the energy industry and the countries who rely on the sale of oil and gas to survive. But those industries and countries pale in comparison with the billions of people and industries around the world who benefit from lower prices. Enjoy the low price while you can, because as with any absolutely necessary commodity, the supply will adjust to demand in time and prices will rise to reflect that change.
Reason Number Two: The Middle East
The problems concerning the Middle East are another reason given for the decline. If this was truly a major driver of the current sell-off, oil prices could not be at the prices they are. After all, the two countries making the most noise, Saudi Arabia and Iran, are two of the largest oil producers in the world. While the Middle East is a breeding ground of terrorism which creates fear in mankind and conflicts between governments, these fears have little to do with the ability of companies to manufacture and create products needed for all.
Reason Number Three: North Korea
The actions of North Korea and the great lie of setting off a hydrogen bomb are also blamed for some of the decline. If North Korea did set off the big one, I believe their neighbors China and Japan would have a little more to say about it. As far as the economy is concerned, North Korea is broke with a population living in a state of poverty, and they have no impact on world commerce.
Reason Number Four: China
This brings us to the pundits’ ace in the whole, China. As it is the second largest economy in the world, we should take note of what is happening there. We have known that for the last couple of decades, China has been the world’s greatest growth story. Yet we also know that over the past few years China has reached the limit of its need for infrastructure, and has made an effort to focus on increasing the standard of living of its citizens. The impact of this change in focus on the world has already been felt by those industries who supplied the raw materials to build this infrastructure, and China will not be able to continue to grow at the same percentage rate it has in the past. For the economist this is a slowing economy, yet in nominal dollars is that really true? Think of this: a 10% return on $100 is $10. A 2% return on $1000 is $20. Can $20 buy more than $10? China’s growth rate as measured by economists is less than half of their historical average, yet their ability to add value in spending is thousands of times larger than a decade ago. The vast majority of the Chinese population live in poverty. I believe that the change in focus from building infrastructure to enhancing living standards will bring more rewards than the commodity driven rewards of the past, and not only for the people of China, but for other industries and countries.
Reason Number Five: US Government & Federal Reserve
If oil prices, the Middle East, and China fail as reasons, we can always blame our US Government and the Federal Reserve, right? It is true that our government has taken actions over the past decade that have kept growth slower than average following a financial crisis. Our government has failed to address our tax code which we can blame for the $2 trillion corporate America has kept offshore. We can blame the Federal Reserve and the zero interest rate program for our banks holding $2.2 trillion in excess reserves. And we can blame the government’s massive increase in regulations for hampering business formation. However, these actions have been going on for more than seven years. They have already been factored into the markets’ valuations.
Seeds for Future Growth
I could argue, however, that these actions have planted the seeds for a massive increase in future growth. How would our economy change if taxes were lowered and corporations were able to return those trillions of dollars to US shores? What would happen if regulations were changed just enough to make it easier to form a new business? What would happen if businesses could spend more on increasing productivity instead of filing paperwork to verify compliance with all the additional regulations placed on them? With just a few changes perhaps the banks would have a reason to lend. With $2.2 trillion of excess reserves they have the ability to lend as much as $22 trillion. The ability to grow rapidly is here and now. We just need to make a few changes to give people the ability to better themselves and this great country.
You only gain the title of “battle hardened” through experience. I find it useful to relive the past to help me with current struggles. The fact is, the vast majority of you have also lived through many of the very same investment battles I have. I do not wish to have you recall the fear of those battles, but rather the sense of victory you experienced afterwards. Here is some information on our shared battles of the past few years:
Some may be concerned that I am only showing the years since the recovery began. Yet over the past thirty-six years, the declines for each calendar year have averaged 14% while the gains have averaged 9.78%. The average loss of selling at low or holding on over these 36 years is $23,780, not so much of a difference from the past five years that it should cloud our judgement.
Selling into declines has caused far more damage than just holding on for a little while. Of course it would be impossible to verify, but my experience leads me to believe that selling into a decline based on fear has damaged individual wealth more than all other reasons combined. We do have some measurements of results. The average nominal return for common stocks per year is close to the 9.78% of the past thirty six years as mentioned above. According to Michael Mauboussin, the author of “Think Twice: Harnessing the Power of Counterintuition,” the average investor has earned between 60% and 70% of the market returns, and the difference is due somewhat to cost, but the greatest loss has to do with selling low and buying high. I agree.
I want to add one more table for your review. This has to do with a shorter time period, but it may give you a little comfort. This again represents returns of the S&P 500, only this time it shows the results of the year following a year where the S&P results were almost flat. These are the years where the S&P returns were between -2% and +2% since the end of World War II:
We have tried to prepare you for the battles to come. We have shown you in dollars how much you should expect your common stock holdings to change in price on any given year. We have mentioned that a 15% negative and 15% positive change in value during any given year is not only possible, but highly probable. Even with this knowledge, fear can grab hold of us. If you want to talk about your portfolio, please feel free to call us at any time.
As a battle hardened veteran of the investment wars, I know that opportunities will open up during the fray that if taken can lead to victory. We began building cash two years ago and continued building over the past year. Our reasons were based on valuation. Our approach has been to buy great companies at low prices. As we have shared with you many times, prices have not been cheap, nor have they been overly expensive. Cash built as we took profits. Without the ability to buy cheap and maintain diversification, we have had to wait for opportunities to unfold. Currently cash balances average about 30%. Your individual portfolio will hold between 20% and 40% in cash. If the current sell-off continues, we should be able to find some bargains.
One final comment. When we make an investment, we only have control over the price we pay for that investment and the time and price when we sell that investment. If we know the investments we own, and are confident in the fair value we have identified for those investments, we have a powerful advantage over the other market participants willing to buy and sell at any given day to day value set by all the noise out there. Personally I will not allow others to take that advantage away from me. I hope you do the same.
Until next time,
Kendall J. Anderson, CFA
Kendall J. Anderson, CFA, Founder
Justin T. Anderson, President