Oh That Feeling: When Down is Up and Up is Down

The US Stock market has not experienced a full-fledged bear market (defined as a drop from peak to trough of 20%+) in nearly 10 years. It is not a matter of if, but when, such a drop will occur. That is not necessarily a bad thing – all asset prices move up and down in the near term, some wildly, some less so, but US stocks have consistently marched upward over long periods of time, albeit rarely in a smooth line.

Even without a technical bear market in nearly a decade, there has been plenty of carnage in stocks at large (post-Brexit for example), and for specific securities and even entire industries (think of oil which collapsed from over $100 per barrel to around $26 between 2014 and 2016, causing wreckage in the oil and related industries including putting many debt-laden companies).

We have written extensively about the importance of matching investments with time horizons: need money for lunch tomorrow or your mortgage a year from now, keep it in cash or short-term equivalents. Saving for retirement which is 5 years or more away (not to mention the need to support a retirement lifestyle for hopefully decades thereafter), then high quality stocks should be a big part of your portfolio.

But money is an emotional thing, and we don’t always act rationally, or at the very least we feel like doing something now that is likely not in our long-term financial interests. So an examination of common human emotions during market cycles helps us learn from the mistakes of others with the goal of not repeating them (or if you work with an investment professional, understand his/her temperament which is hopefully characterized by tremendous calm, rationality, and discipline which will help you get through the inevitable storm).

Bear markets feel terrible. You feel stupid, or you think those you have entrusted have lost some IQ points over night. “Everyone saw this coming” you will proclaim, conveniently forgetting that ‘everyone’ has been saying the bear market will arrive since shortly after the last bear market ended nearly 10 years – and several hundred percentage point gains on the S&P 500 – ago. You may feel sad and depressed and have the desire to ‘do something’ with the hopes that it will just ‘go away.’ Often people stop opening up their monthly brokerage statements (which is not necessarily a bad thing if that keeps someone from taking ill-advised action) as they don’t even want to know what is going on. Others become fixated with moment-to-moment price movements, their moods shifting with each tick up and down in the market.

You are not the market. You are no less intelligent because some investors you don’t even know decided to sell, just like you are no more intelligent because stock prices are going up (if that were the case, we would all gain about 7-8% IQ points per year over time). Your brain and your emotions are playing tricks on you. You are driven by fear that the carnage will never end, that you will be wiped out, and that life as you know it will end. That causes many to sell stocks at the very wrong time, which is why the average investor vastly underperforms the market. They buy high, they sell low, based on emotions, not a well thought out financial/investment plan.

If you have a solid plan in place and the basics of being well diversified and matching your investments with your time horizon, then you have precisely nothing to fear. The broad market has returned to prior highs after a bear market on average within 18 months. If you need cash in the next few years, make sure it is set aside long before stocks go down (you should have the discipline of having near term needs covered with cash regardless of market conditions). If you are a net buyer of stocks – either by virtue of the fact that you are contributing to a retirement or other account, or you are not pulling cash out but rather reinvesting dividend regularly: you should welcome near-term declines as they tend to lead to higher income and returns in the future for reinvested dividends.

People tend to over-complicate things; investors are often their worst enemies. They spend their lives waiting for bad things to happen (the collapse of the dollar, etc. – I’ve heard them all for 30+ years) rather than preparing emotionally and financially for natural market cycles, then when a bear market hits, they take action counter to their interests. Simply put, if you need money in the near term, have it in cash, thus short-term stock price drops are not of concern. If you don’t need the cash for years, then near-term price drops are of no concern.

You need to train your brain just like your body. If you are going to go ski moguls after a year of not hitting the slopes, you don’t (or shouldn’t) just show up without any preparation, rather you train your legs for months so you can handle the additional muscular stress. You need to train your brain the same way – picture yourself on a big down market day, visualize yourself being calm and confident with your plan in place.

Wall Street Follies

I get asked regularly if I pay attention to Wall Street analysts’ recommendations. My sincere answer is that they can be a great contrarian indicator. Like clockwork, after a stock drops, analysts downgrade a stock like lemmings to “Neutral” or “Hold” or whatever other euphemism they use when they can’t tell you to sell as they risk losing valuable, often conflict ridden investment banking revenue. This downgrade often occurs near the stock price’s very nadir. Then, after the stock has rallied significantly, they upgrade their recommendation to “Buy” or “Overweight.” Another in a string of examples was Morgan Stanley’s downgrade of PCG to its equivalent of neutral, after the stock had plunged over 50% in recent weeks due to the CA fires and potential liability. Morgan Stanley had a stock price target of $67 for PCG which they promptly lowered to $31. So as the stock was dropping day after day, they told you to buy. Then after it dropped, they told you (in Wall Street parlance) to sell. Of course the damage had already been done, and to add insult to injury for investors who follow such advice, the stock rallied over 35% the next day.

It is very important to remember conflicts of interests, what the messenger of information’s motives and incentives are. TV pundits get paid to sell advertisements, not manage your money. Newsletter writers make money hawking subscriptions, not giving you specific advice based on your circumstances. The real bread and butter for Wall Street firms is not selling analyst recommendations (you can get these for free in most cases), but to woo companies willing to pay them big bucks for various investment banking services. I was the CFO of a company that ultimately went public. I can assure you the company was not about to hire an investment bank to underwrite the IPO who was going to turn around and slap a “Sell” recommendation on the stock.

Happy Thanksgiving everyone, count your blessings before you count your bank account balances.

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