What If Stocks Crash And Don't Bounce Back?

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Includes: DIA, IWF, QQQ, SPY
by: Eric Parnell, CFA

It is among the most common principles heard among investors today. And it is a belief that many hold with so much confidence that they assume it is simply a given when setting portfolio strategy. It is the belief that stocks will go up over any reasonably long-term period of time. Under this notion, it is suggested that investors ignore short-term economic, market, geopolitical and policy risks, for as long as they select companies based on long-term fundamentals and have the ability to withstand any short-term downside volatility along the way, they will be rewarded for it. And even if the stock market crashes just as it has twice now in the new millennium, it will eventually bounce back in relatively short order and achieve new highs with a growing stream of dividends being paid to those that have the discipline to stay the course along the way. The steadfast belief in this approach is certainly understandable, for we have a lifetime's worth of investor experience supporting it as truth. But the experience during our lifetime can sometimes obscure the unpleasant realities. To this point, one of the greatest and most unforeseen risk facing many investors today is the possibility that the stock market crashes and simply does not bounce back.

Before going any further, I believe it is important to take a moment to share my own investment philosophy and perspective. I am a fundamental value stock investor at heart. I believe in identifying outstanding companies whose stock is trading at a discount to its intrinsic value and purchasing shares with the idea of holding them indefinitely. And prior to the financial crisis, I owned shares of a number of high quality companies such as ExxonMobil (NYSE:XOM), PepsiCo (NYSE:PEP), Kimberly-Clark (NYSE:KMB), Sysco (NYSE:SYY) and Emerson Electric (NYSE:EMR) continuously for almost a decade. So in short, I am neither a doomsayer nor a permabear wishing ill on financial markets. In fact, the exact opposite is true, as I believe in owning stocks and anticipate returning to an investment environment someday where one can do so sustainably over long-term periods of time once again. But due to the persistently aggressive and continuous policy interventions by global central banks, we are unfortunately far from any such place at the present time. And risks are building that the unintended consequences of these unprecedented policy actions is not only wildly distorting capital markets but has meaningfully raised the potential for a major market accident the likes of which we have not seen in our lifetimes before it is all said and done. I am dismayed by these facts, and such is why I believe they merit close attention as we move into the future.

So then, what is the potential that the stock market (NYSEARCA:SPY) could crash and simply not bounce back for years if not decades? An initial glance at market history would seemingly dismiss the mere idea of such a question. The following chart below shows the S&P 500 dating back to the end of World War II in 1945. This represents 68 years of market history. And what we see is that with the exception of a few short-term blips along the way, stocks have experienced a steady march higher over this very long-term time period. Thus, for any investor that is aged 86 years or younger, this is the only investment environment they have ever professionally known. The only way for so many of us to know is through our own life experiences, and nearly all of us have been conditioned to expect a stock market that may go down in the short-term, even crash, but soon bounces back to take the next step higher.

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But just because this has been true for nearly a lifetime since World War II, should we simply assume as given that it will always be true? After all, recent history has already debunked a similar notion for another asset class on which the fortunes of the stock market greatly depends. It was just six short years ago back in 2007 that investors were singing a similar refrain for the housing market with the statement "we've never had a decline in house prices on a nationwide basis". This wasn't just anybody making this claim at the time, for this exact quote came from current Fed Chairman Bernanke himself during an interview back in 2005. It was based on what seemed like sound reason at the time. After all, national housing prices had only fallen in three calendar years since World War II with declines of less than -0.5% on two occasions and less than -3% during what was by far the worse year in recent memory in 1991. Otherwise, it was nothing but higher each year since World War II for home prices with an average annual gain of 5.3% from 1945 to 2006. But then the financial crisis hit and the unprecedented happened (at least since World War II), as housing prices fell a cumulative -35% over the course of six years from 2006 to early 2012. And even with the relentless flow of monetary stimulus coursing through the veins of the U.S. economy, housing prices still remain more than -20% below their all time highs today. For someone who purchased a home as a long-term asset at the peak of the market with a 20% down payment, or perhaps even less, the subsequent decline in prices has been a remarkably painful experience that remains ongoing.

Here's an important lesson from the housing market that can be applied to stocks today. The world did not start at the end of World War II. And although we have enjoyed a lifetime's worth of consistency and prosperity for nearly three quarters of a century to date, we should beware of falling victim to recent bias. For just as we learned from the housing market over the last several years, just because something has not occurred in our most immediate past does not mean that it cannot subsequently take place in a major way as soon as tomorrow.

With this in mind, it is worthwhile to examine what the stock market might reasonably provide us if we turn back the dials of time a little bit further. After all, one only has to go back a few decades prior to World War II to see that house prices could fall by a lot over extended periods of time. So suppose then an investor allocated to the stock market in September 1929. With stocks trading at just over 20 times trailing 12-month earnings at the time, the decision to make such an allocation would certainly not be considered egregious by today's standards. After all, the average trailing price-to-earnings ratio on the S&P 500 over the last quarter of a century has been over 20 times on an as reported basis. Thus, one might easily have been making an investment allocation under the premise that as long as they were purchasing a fundamentally sound company with a reasonably defensible valuation, they would be able to weather any short-term downside that might occur along the way and could rely on the growing dividend yield for sufficient compensation in the meantime.

But for the investor making such an allocation in September 1929, subsequent crash was absolutely gut wrenching. And perhaps even worse, it took a quarter of a century for the subsequent bounce in stock prices to fully materialize.

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What about those growing dividend payments to soothe the pain of waiting? While just as with stock prices we have been conditioned in our lifetime to expect that dividends will increase on average each and every year - prior to the financial crisis dividends had experienced only four brief periods of low single-digit year over year declines since World War II with each pullback quickly reversed by the subsequent increases - such was not at all the case prior to the 1940s. While dividends on the S&P 500 Index did manage to rise for more than a year after the initial market correction, they eventually plunged by -40% on a year over year basis and took roughly two decades to return to previous levels. When was the only time since that we have seen dividend cuts of a similar magnitude on the S&P 500 Index? In the aftermath of the financial crisis from 2009 to 2010, of course, where dividends were being slashed by more than -20% on an annualized basis before the sedatives of monetary policy fully set in and stopped the bleeding.

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Unfortunately for investors during the late 1920s, the outcome was far worse when accounting for inflation. On a real basis, it would have taken an investor that first allocated in September 1929 over 56 years in 1985 before they would finally achieve a permanent price gain on their investment. And while investors would have eventually been compensated with dividend payments on an inflation-adjusted basis along the way, a number of far more attractive alternatives existed over this entire half century time period to generate income while waiting for stocks to regain their real footing.

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None of this is to suggest that we are going to see a 1929 scenario unfold again in the future. But because we have not seen such an episode take place in our lifetimes does not mean that we should simply dismiss it as a possibility either. For the reality remains that were it not for the extraordinary intervention by global central banks in the wake of the financial crisis in late 2008 and early 2009, chances are we would have seen an outcome far worse than what took place during the Great Depression when it was all said and done. And while the U.S. Federal Reserve was indeed successful in pulling the global economy back from the brink, the story remains far from complete at this stage with a Fed balance sheet that continues to expand seemingly out of control five years after the initial outbreak of the crisis with an economic recovery that remains sluggish and fragile at best. Thus, a scenario where the stock market crashes and takes decades to bounce back cannot be completely ruled out. For we find ourselves today in uncharted territory from a policy standpoint, and if another sharp market decline were to take place today, policy maker options are now scant relative to late 2008 with so much of fiscal and monetary stimulus firepower having already been deployed at this point. And even if policy makers persist, just as we have seen homebuyers less willing to pay the same amount for a house today that they were willing to spend in 2006, what is to say that investors will only be willing to pay 12 times earnings in the future for a stock market that they are paying 19 times earnings for today. These are the challenges and risks facing today's overvalued stock market today.

Fortunately, great opportunity exists for those investors that can stay disciplined and resist the seemingly endless floating tide that continues to lift stocks higher today with little fundamental support at this stage. With stocks trading at considerable premiums to their 12-month trailing and 10-year cyclically adjusted price-to-earnings ratios among others, one could reasonably conclude that stocks are expensive from a valuation standpoint and are overdue for a meaningful correction. While this does not mean that one should simply abandon the stock market, nor does it mean that investors should feel compelled to be fully invested either. For investors should rather have a cash war chest at the ready to capitalize once the correction finally arrives, even if it takes a few years to materialize. After all, if acclaimed value investors such as Seth Klarman and Warren Buffett feel comfortable holding higher than normal allocations to cash in the current environment, one can at least rest assured that they are moving to the sidelines among reasonably good company.

Investors today would benefit from the perspectives of those that came in the generation before us. Indeed, it has been a wonderful lifetime of investing for those born over the last 86 years. But for those that came before, they had a decidedly different perspective on the stock market. Irving Gerring, my grandfather for whom my company is named, would have turned 101 years old this month were he still alive today. His introduction to investment markets did not come with the conclusion of World War II like the oldest among us today. Instead, it came with the end of the Roaring 20's. And instead of buying at the top of the market like so many did at the time, he waited until after the market had fully crashed in 1933 to make his first stock purchase in General Electric (NYSE:GE). For him, the discipline to resist rushing in with the crowd at the top and waiting until the correction had taken place proved far more rewarding for many decades in the future. This same discipline served him equally well at the end of his life when the tech bubble finally burst in 2000. Today, a whole new generation of investors have the potential to set the course for their own investment future, but only if they have the patience to wait for the truly good opportunities to present themselves in the aftermath. It is this very discipline that will set them on the road to long-term success in the end.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am currently long stocks via the SPLV as well as selected individual stock positions. I also hold a meaningful allocation to cash and cash equivalents in the current environment.