Note: This podcast contains strong language. The transcript has been edited for clarity.
Today's episode is recorded on Christmas Eve after a recent market correction. No interview today, just my own personal thoughts and commentary. If you're a seasoned investor and not worried about the market correction, this episode is not for you. However, if you're not a full-time investor, and you're worried or overwhelmed by the recent stock market decline, I think it's crucial you listen to this podcast or read this transcript in order to cut through the emotional noise.
Hi, this is Eric Schleien and you are listening to The Intelligent Investing Podcast. Today, we are going to talk about the recent market correction. For those of you who consider themselves very experienced value investors who really aren't worried about what's going on -- this episode probably isn't something for you. However, if you are someone listening who has either been a fan of the show or a new listener to the show and you have some concerns [regarding the recent market correction] or confusion about what's going on, then this episode is definitely for you.
I'm not going to be giving advice on this show or tell you what you should or shouldn't do. Hopefully, I can give you some clarity so you can be empowered to make intelligent decisions on your own.
So, let's get started.
For a little background, the Herald-Tribune posted an article on their website tonight titled: What does it mean when stocks enter a bear market? This is by Alex Veiga.
He says that:
Wall Street's sharp downturn beginning in October has pulled the Nasdaq composite index into what's known as a bear market. The benchmark S&P 500 index is in what Wall Street calls a correction, and is headed toward a bear market, threatening to end the more than 9-year US bull market run.
A correction is Wall Street's term for an index like the S&P 500, the Dow Jones Industrial Average, or even an individual stock, that's fallen 10 percent or more from a recent high. A bear market occurs when the index or stock falls 20 percent or more from the peak.
Corrections are common during bull markets, and are seen as normal and even healthy. They allow markets to remove speculative froth after a big run-up and give investors a chance to buy stocks at lower prices.
The S&P 500, Dow and Nasdaq entered a correction this month. The Nasdaq slid into a bear market Friday as a sell-off in Apple, Google's parent Alphabet and other big names weighed on the technology heavy index.
It's the first year since World War II that the S&P 500 has had two corrections in the same calendar year.
All told, the Dow fell 414.23 points Friday to 22,445.37. That's 16.3 percent below its record close of 26,828.39 on October 3. The S&P 500 index slumped 50.84 points to 2,416.58. It's now down 17.5 percent from its high of 2,930.75 on September 20. The Nasdaq tumbled 195.41 points to 6,332.99, or 21.9 percent below its peak of 8,109.69 on August 29.
So I'm not gonna read the rest of the article, but I wanted to delve into.
One thing I'll be discussing during this episode is whether the notion of holding cash is a good idea.
One of the things is that any time one of these corrections happens is that you'll have these talking heads come on CNBC and you'll have these fund managers who are holding lots of cash, and they're all gonna look like geniuses.
The thing is though, most of these people were not holding cash every other time. So if you have a marketplace with millions and millions of participants, there's going to be someone who held cash this time and then there's going to be a smaller percentage of those people who also held cash during the previous recession. Those people are bound to exist statistically and are going to look brilliant.
There are lots of people who are making economic predictions but if you're going to make money from a macro thesis, you have to be right about a lot of things. So first of all, you actually have to be right about your thesis. So you have to say, "Okay I think this will happen in the economy which then will cause the market to decline."
So you have to be right about that.
On top of that, not only do you have to be right about the actual events which you believe will happen but you also have to be right about what kind of assets that are going to make you money.
Here's an example.
Ten years ago, there were a lot of people, including myself, who were worried about the Federal Reserve continuing to print lots of money.
One of the ways that people played that was through the purchasing of commodity companies and gold mining stocks while selling off a lot of wonderful companies. Many of those people are still in that trade from ten years ago, and, they might be celebrating right now because the market had a 20% correction. However, they've also missed on the growth from 2008 all the way up to 2018. Corporate profits are up quite a bit since that so that is real intrinsic value growth over the past ten years that some of those people have missed out on because they were perma-bears who believe that there is always some kind of market crash that's about to happen and occasionally they get it right. However, their portfolio track records tend to be pretty bad long-term.
So that's the other thing.
Not only do you have to be right about the macro-picture, you actually have to predict what's going to work to make money off you being right about your prediction which is harder than it seems.
The third part of this game is that you actually have to get in at the bottom. Everyone says they like to buy low and sell high, but typically what people do, is they sell low and buy high.
I read a statistic that the average individual investor tends to only capture about 20% of the market return over an investment lifetime. That means if the stock market returns 10% a year over a lifetime, that average investor tends to make just 2% a year. That includes lots of day trading and lots of portfolio activity in general where you're going to trigger lots of short-term capital gains taxes. Even if you're going in and out of stocks every year and a half, that will still trigger a lot of capital gains taxes in regardless. On top of that, people tend to want to put in more cash at the worst time and then get out at the worst time.
Right now there are going to be people liquidating their portfolios, selling off everything because they're scared that there's going to be another decline correction and decline in their portfolio values. And that might be the case. However, what it doesn't take into account is asking themselves the question, "what is the intrinsic value of the assets in my portfolio?"
Most people don't have a clue.
On the notion of holding cash, is it a good idea?
I generally veer on the side of not holding cash and being fully invested unless there was really nothing to buy.
However, if you're someone who is either doing fundamental analysis and you're dealing with a portfolio of under 100 million, you will probably find things to buy. You can do quite well being fully invested most of the time.
There's a friend of mine, Travis Wiedower, who has been on the show a bunch of times. Travis wrote a good article dated January 25th, 2018 on his blog, and it's called, "Is Holding Cash a Good Idea?"
Over long enough time periods, the stock market has always performed well. There are plenty of bumps and bruises along the way, but the overall trend has always been up and to the right. In fact, the worst total return in history over a 20-year period was +54%. The worst 30-year return was +854%. We've all seen images like the one below that show this never-ending march up.
Even when markets are high, as many people believe them to be now, the future expected returns from the stock market are still positive. I think this is an important distinction because I've talked to many people who think that because the market is high a crash must be inevitable and thus future returns will be negative. If the market is in fact too high right now [which we won't know for another 5-10 years when we can look back], that means that future returns will be lower than historical averages--but not negative. Though I don't put much value in people's opinions who try to estimate future stock market returns, almost all of the estimates I've seen are in the low to mid-single digits--call it 4%. 4% isn't great, but it's a hell of a lot better than earning 0% in cash.
If the above is true and the stock market always has a positive expected value, shouldn't we always be 100% invested? The usual reasons given from investors [myself included] to hold cash are:
Cash is optionality. If the market tanks, holding cash allows us to be nimble and quickly take advantage of cheap stocks.
There is nothing cheap to invest in [definitely been here before, like, right now for example].
Behavioral / psychological reasons [peace of mind, etc].
The third one is very personal to each person's situation and mindset, but I'm not sure the first two hold up to scrutiny. If the broad market is a bet that wins more often than not and it's a bet we can always make, then anytime we want to own cash, shouldn't we just own a broad stock market index fund like SPY (SPY) instead [SPY is an index fund that tracks the S&P 500]? On the first point from above, SPY might as well have the same optionality as cash because I can buy and sell it instantly [SPY's average daily volume the past three months is over $20 billion dollars]. On the second point, even if there are no good individual stocks to invest in, a broad stock market index fund that has a positive expected value is better than cash at 0%.
Whether conscious or subconscious, I feel like a lot of investors [again, myself included] actually hold cash as a way to time the market [even though none of us claim to do it, maybe some cognitive dissonance here] or because we manage other people's money and are embarrassed to invest in an index fund [which makes sense, paying someone to invest in an index fund does sound pretty stupid]. But market timing and/or pressure from outside investors aren't great reasons. I believe very, very few people can time the stock market consistently and thus the rest of us should probably just be 100% invested and benefit from the market's inevitable march upwards over the long-term.
If an investor averages a 10% cash position per year [which is low for a lot of investors] and the stock market returns 8% per year over the long-term, that investor is costing themselves 0.8% per year by not putting their cash into a broad market index fund. If the starting account value was $100,000 and 10% was in cash, that'd be $10,000 in cash to start. If the $10,000 is always invested in broad market index funds earning 8% on average, that $10,000 would grow to over $43,000 by year 20. If put in cash, that $10,000 would grow to exactly $10,000 by year 20. Okay, you'd probably get a little interest on the cash. If the cash was able to somehow earn 1% per year, it would grow to just over $12,000 by year 20. $43,000 vs $12,000 is a big difference! Missing out on 0.8% per year doesn't sound like a big deal, but it can add up to a lot of money.
I asked several money managers I talk to about their views on holding cash and got some quality input. I thought Fred Liu did a great job of describing the trade-off mathematically:
"The other way to think about it is yes, you're giving up say 8% a year, with the trade-off that a recession / bear-market should bring it down [call it] 40%. With the assumption you can call a bottom [a big assumption], you're basically assuming a bear market will come in the next 4.5 years, if you're holding cash today. But note at the core, this is a market timing call."
My take away is that for it to be mathematically correct to hold a meaningful cash position, one has to believe the market is going to have frequent and/or very deep downturns. The above also generously assumes the person invests their cash position near the market bottom, which we know isn't usually the case. A lot of investors would actually have a bigger cash position at the bottom because the 40% drop they just experienced scared the shit out of them. I think an attitude of always being 100% invested can protect a lot of investors from these kinds of behaviors and cognitive biases that can hurt their long-term results.
Of the money managers I talked to about this, every single one cited some sort of behavioral or psychological reason for wanting to hold cash. Samir Patel brought up an interesting point that I hadn't considered myself:
"In theory you always want to swap the apparent 17% IRR for the apparent 21.6% IRR, but in practice I find that it's usually hard to value things that precisely or anticipate when that value will be realized. As such, I find it hard to rob Peter to pay Paul - it's easier for me to manage the portfolio when the decision to buy/sell one stock is mostly discrete from another [assuming no overlapping exposure, I.e., if I own FOGO, I don't also want to buy a bunch of some other restaurant.]."
I think that makes a lot of sense. I've gone through that process many times where I'm 100% invested and want to add a new position. Then, I have to figure out what holdings to trim or sell completely to make room for that new position. That decision making process may very well be improved if those buy and sell decisions are completely discrete and not influenced by each other.
Two other investors I talked to about this brought up holding Berkshire Hathaway (BRK.a) (BRK.b) as a placeholder for cash, but they also mentioned that selling Berkshire may be difficult to replace with another company [that isn't run by arguably the best investor of all-time]. Thus, Berkshire in theory sounds like a good placeholder for cash, but it could easily turn into a normal position. My hunch is that owning SPY would not have that same psychological commitment, but maybe not. SPY is still a distinct position you have to sell to make room for something new. And if your SPY position it down, it may be difficult to sell thanks to how averse humans are to taking losses [loss aversion].
As I've been thinking about this concept the past few weeks, I went back and looked at some of my own purchases from the past year and three stood out. First, the big addition I made to my Franklin Covey (FC) position in mid-2017 that took my sizing from the low teens to the high-20s was when I had a big cash position. I wonder if I would have made that same addition if I was 100% invested and buying more Franklin Covey required me to sell other positions. I sure hope I would have if all I had to do was sell SPY, but I don't know.
The other two purchases that stood out were almost identical--Calloway's Nursery (OTCPK:CLWY) put out great earnings after market close, so I put in buy orders immediately [because I had cash sitting around] and was able to get a small number of shares at the market open. I've made similar small additions to positions several times over the past couple years, but it's only possible in micro-caps [where new information isn't immediately reflected in the stock price] and when cash is sitting in the account. If I had all my "cash" invested in SPY, by the time I sold SPY and tried to buy CLWY at the market open I may not have gotten my shares--who knows. So if you invest in micro-caps, I think this is a very legitimate reason to have a small amount of cash sitting around [3-10% maybe? ], but those opportunities are never available in larger companies.
Despite what the above sounds like, always being 100% invested isn't yet an investment philosophy of mine [though I think the logic is sound so far]. I've held plenty of cash over the years, but whether or not that's a smart thing to do is something I've been challenging myself on recently. "Cash is optionality" is one of those market truisms that almost everyone believes, but I'm not convinced it's right in the long-term. I think "liquidity is optionality" is closer to the truth--and a lot of things other than cash are extremely liquid. My current thinking is: If the market always has a positive expected value, there's no reason to ever hold a meaningful amount of cash [vs a broad, liquid index fund].
"Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves." - Peter Lynch.
I think that's very powerful. Now there's a variant view out there. I got an email just the other day from a friend of mine, and I'm not going to say his name on the air, but I'm going to read you one of the emails he sent me just so you can get an idea of the thinking of people who do think they can market time, and are concerned about the economy.
This is the email that I got two days ago on December 22nd at 1:56 AM.
There are multiple asset bubbles and systemic risk within the banking system related to fraud and money laundering that will bring down everything [check the Panama Papers and look at Deutsche Bank and Goldman]. Corporate profits are meaningless with these systemic threats. The market, pensions, and home values will collapse which triggers lower consumer demand which affects all companies regardless of the strength of their underlying business fundamentals. This will be much much worse than 2008. That was just mortgages. This is also mortgages plus corporate debt plus student loans plus pensions plus sovereign debt, all in the context of trade wars, nationalism, and declining population in the EU, Japan, and the worst population growth in the US in 80 years. I completely pulled out of the market in May. I told the board of my company in January 2008 that we needed to sell the company because the economy was going to collapse in the fall... [t] hat was not a popular opinion at the time but it was 100% dead on.
He goes on to say:
... [I've] stressed pensions and Medicaid. This will turn out to be 100% accurate. The corporate profits we have had, have been fueled by $1 trillion in deficit spending. There is very little growth in the voluntary economy. The implosion of multiple asset bubbles + demographics + trade wars = complete meltdown. I have been discussing this publicly since May. Only now are people starting to take it seriously.
Most people run on post World War II assumptions regarding the performance of the markets with the US as the hegemonic power. Far better to examine the last 6000 years of history.
So, basically, what he's saying in a nutshell is that there's a lot of terrible systemic issues going on in the world and this is going to lead to a complete meltdown with the implosion of some of these asset-bubbles, plus trade wars, plus negative demographic trends and that it's a fallacy to look at the United States and look at the stock market with these post-World War II assumptions as the market just always goes up and that it will be a major power in the world.
That's his view.
I responded to his email and said:
I get all that, but I don't get how the profits say of Google or See's Candies [which is a Berkshire Hathaway sub] can be deemed meaningless. I think it's incredibly unlikely that a company like Google won't be making more money in 10 years. I don't make the connection that all corporate profits are BS.
It doesn't matter about over 10 years. The point is to buy low and sell high. I don't believe that Google or See's are immune to a massive financial collapse. The point is to buy the right things at the right time.
Google is down 30% this year. I think it goes down another 25-50%. Why would I buy Google now, when I know that the things that are going to drive the market over the next 6-12 months will bring down Google with it? I have been telling people this for months, almost no one listen and they've all gotten rekt. We are nowhere near a bottom. I see no value in holding my money in assets whose value will be determined more by corrupt banks and politicians than on the merits of the performance.
So there are a few things about that.
If you look at what determines values of an asset over time, it's the intrinsic value of that underlying business.
For instance, let's say you make an investment in the bonds of a stable company such as Berkshire Hathaway or Johnson and Johnson. Say you purchase a 10-year corporate bond from one of these companies and you know the coupon rate on the principle of the bond. Let's say the bond sells for 90-98% of par. You know how much will get paid out per year. Now let's say there's a financial collapse and the prices on these bonds decline by 40-50% and the bond has not been impaired. Now, your interest rate simply goes higher. The value of the bond is not being determined by a corrupt bank or a politician, because at the end of the day, as long as Johnson and Johnson can make that coupon payment, that's what's going determine the value of that bond [how wealthy you get in the end], and not what a trader is gonna do, even if that bond goes down even more. [This only matters if you are forced to sell the bond].
With a stock, these principles still apply. However, with a stock, you don't have a coupon rate printed on the stock certificate, you have to get a sense of what that will be by figuring out some kind of range of the intrinsic value of that given security. It won't be precise like a bond since you won't be able to exactly predict the precise growth rates of free cash flow and corporate earnings for the next 20 years.
I replied to that email and said:
I think this is where our fundamental understanding differs. The value of Google is all the cash flows it will ever produce discounted back to the present at a certain discount rate. That's not an opinion -- that literally is what the intrinsic value is of a cash flow producing asset whether it be a stock, bond, farm, or buying a rental property down the street. The principle still applies. I'm not saying to buy or not buy Google now. However, for instance, there are some properties that I have ownership in that are publicly traded and are traded for about 60 cents on the dollar of their private market value. At the CURRENT price, I get paid a 10% yield on my cash just to sit there and wait without any kind of growth. If the market goes down and that security goes down along with it, I'll be able to buy more at an even greater discount to the intrinsic value of those properties while the business can also buy back their own stock at higher and higher yields. To squabble over a 10,20,30% change in the price of a company when you believe the business to be significantly undervalued doesn't make much sense and makes the game much harder.
Sure, if you don't believe Goldman's book value or corporate earnings really exist than paying a discount to book with a high earnings yield when you believe they will have a much greater haircut in both book value and profits, and you don't believe that's the actual yield you'll get on cash, then sure, I can understand that.
Also, if you have a business that is below intrinsic value + has lots of liquidity + has intelligent capital allocation than in a scenario where there is a huge market decline and/or an actual macro headwind against the business such in the case you bring up, then that scenario will actually INCREASE owner's earnings and INCREASE intrinsic value, not diminish it. You have to be right about both a market decline and then again timing the bottom. If you look at people with track records that go on for decades, it's VERY VERY VERY hard to find people who have done this successfully over time. And usually those people who called something correctly like that are not able to replicate the call again, and/or their track records are miserable as they miss out on a 300% increase in the market over many years and then they get to be right about some kind of 50% market correction years down the line [which is bound to happen regardless]. So, not saying you're wrong. I have no idea either way. What I'm saying is you can still be right about the economics and still not end up with a very good long-term personal investment track record over time. And you understand math. For compound interest to really take effect, you need to be thinking in decades... You can also be right economically but then not know how to take advantage of it. Say you thought the FED was gonna be printing lots of money and then you wrongly predicted hyperinflation years ago. Or maybe you see a rise in commodity prices but you buy gold miners whose equipment prices rise faster than the price of gold... All these variables that you have to be right about, pick the right security, and then actually time the bottom and the top. Is it possible to do all of that, yes... Sure... Maybe. To do that correctly consistently for a lifetime of investing, VERY HARD game. The latter is just a much easier game even with a knowing you'll end up buying securities that may end up having corrections of 50% or more in a given year. I mean, hell, Charlie Munger was down something like 74% in the mid 1970's and he still finished out the decaded outperforming the market by something like 7x. Berkshire has had corrections of 50% or more three times since 1965 and you still finished out 50 years with a return of over A MILLION PERCENT [this compares to a ~12,000 percent return for the S&P 500 during that time].
Doesn't answer at all whether you should sit on the sidelines now and re-enter after the collapse...
So here is someone for an example where, yes, he's right in the sense that you'd perform better if you re-enter only after the collapse. What he's not saying is that you have to be correct about when a given collapse will hit bottom is and then actually have the guts to invest and not be run by fear. Usually, by the time the macro-picture clears up, you've already missed the bottom.
If you need the cash in two or three years, it's probably not appropriate to be buying stocks in the first place because you can have a correction of 50% or more in a given year.
If you have a holding period, of say, five years and certainly ten years or more, you should not be worried about whether there is a correction or not. And quite frankly, if you've been speculating and you just lost a lot of money then what I'm about to say applies to you. First off, when I say speculating how I define speculating as buying an asset when you really don't know what the underlying intrinsic value is. That's fine by the way if you don't know. The problem is that a lot of people will invest in a company because they think that a given company or industry has a great future.
That's nice, but is the market already factoring that great future into the price? And furthermore, you could have been right about the technology industry or the growth of the internet and still lost a lot of money in the '90s. Decades ago, you could have been right about semiconductors and lost a lot of money in semiconductor companies. Or a century ago, you could have been right about the automobile industry, yet the car companies you invested in went bankrupt or produced lousy returns over time.
So if you were doing that before the correction, what you were doing was essentially gambling in the stock market. If you lost money doing that, then I would say to be grateful and let this be a lesson to you and actually feel the pain of losing a lot of money and have this be a wake-up call that if you choose to invest in any kind of asset, you should have some kind of understanding of what you believe the asset to be worth, and what you believe the asset will be worth in five or ten years down the line. And generally, if you can't make analysis and can't come up with a gauge for intrinsic value, then you either need to learn how to do that, find someone who does, or just buy an index fund and go to sleep for 50 years.
If you look at financial history, during every correction there's some fear of something and sometimes it's justified and sometimes it's not justified. However, at the end of the day, what is going to impact securities prices is not a corrupt banker, a politician or a market manipulator or short seller. Politicians love to blame those kinds of external factors on market prices and find scapegoats.
What's going to move markets over time is that actual intrinsic value of an asset, whether it's a bond, a company in liquidation, a piece of real estate or a rental property, a farm, or a stock. That's really how you have to think about things and that's all I have to say about that.
If you have any questions for me, you can contact me at firstname.lastname@example.org.
You can also find me on Facebook or LinkedIn and please feel free to shoot me a message if you want. I can offer book recommendations and connect you to other good money managers. And I'm more than happy to give you a list so you can speak to a quite a few of them and talk to them and make up your own mind.
I'm not going to give advice on the show, but I hope that for some of you have been confused, that this has provided some kind of clarity and again, you can always reach out to me if you have any more questions. I love helping people. This is a field I'm passionate about what kind of pains me quite frankly is when I see people get terrified and scared and almost paralyzed at during these times. So I hope this helps. If you have any feedback for me, feel free to email me as well. I appreciate you listening.
For those of you that celebrate Christmas, I hope you guys have a Merry Christmas. I'll be probably eating Chinese food tomorrow, as I'm Jewish. Merry Christmas, thanks for listening, and have a great rest of your 2018.
Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.