Dear friends,
After a lengthy bull market, it appears that we are now entering a bumpy market and for now, a bear market (typically defined as a drawdown of over 20%). If this virus passes faster than the market thinks, it could be very positive for the second half of the year as low interest rates and low energy costs would be very stimulative to the economy. Both JP Morgan and Goldman Sachs have predicted a very weak second quarter, followed by a strong third and fourth quarter of the year.
However, if the spread of the virus ends up taking more time to resolve positively, it might cause stress on the credit markets and on the economy, and the market seems to currently be scared of that.
I will get right to the point. What am I doing with the portfolio that I have nurtured for the past 25 years? I am not changing my current approach. I am waiting this out. Bear markets last for about a year or so on average, and have occurred 32 times in the last century. While they are happening they feel absolutely awful. We check the news and the sky is falling and everything seems to be negative, at times confirming what we think our fears are. However, the skies ultimately clear, investor panic ends, and the path resumes for further economic growth and continued innovation.
A premise of our investing has been that 2008 was similar to the Great Depression, and the Fed treated it so. Their TARP program and other actions caused banks to be better capitalized. Typically, that kind of structural trauma happens once in a generation. Resolving some of that structural imbalance should cause smoother ground going forward. The US consumer has also been very strong with relatively low household debt, until the virus happened.
Although we are drawing down significantly here, with the Dow Jones down 32% from the highs and the industrial, financial, and energy sectors down 35%, 38%, and 55% in the past month alone, this is not a structural event that the markets are trying to price in. This is a transitory virus that will hopefully be dealt with sooner than later, and pent up demand and consumption will most likely return. There is also the energy price war between Russia and Saudi Arabia which is not sustainable either, as both of their breakeven costs are significantly higher than energy prices currently.
However, the stimulus and fiscal policies the central banks and countries are currently indicating could end up being very good for the economy, as seen in this graphic:
So there is reason to be very optimistic going forward.
Why not "sell everything at the top"? First of all, timing these things is nearly impossible because the markets reaction can vary wildly. Second of all, many of our consumer staples are now up very nicely. It is very hard to predict share price action.
An example: Because of fears of Amazon dog food and other issues, General Mills went from 70 in 2016, to 38 in late 2018. Now it is back up near 60. Anyone who held General Mills has already experienced a major bear market, experiencing a drawdown of 45% until it came back up with good sentiment and fundamentals.
I would venture to compare General Mills to our entire portfolios. There are doubts and fears about the economy, but it should find its way through just as it has in past bear markets. Central banks are very concerned that the economy makes it through this malaise and pandemic, which certainly took everyone by surprise.
The most effective way forward, in my view and experience, is to stay the course and hold through the drama. We can collect the dividends and either use them as retirees, or reinvest them for those in the accumulation phase. This too shall pass as the many bear markets that the world and the US has experienced have shown us.
Every bear market is different. In 2008, you could still go to Starbucks even if you didn't have a job. Now, it is challenging to even go out, for the time being, under quarantine. This will effect lodging real estate directly and we can expect some dividend reductions in hotels. Low energy prices might see some dividend reductions there until a final washout in shale, resulting in higher prices and more consolidation, which will result in higher energy prices and more profits. I am not expecting large reductions in aggregate in the sector, but preparing for some.
However, I do not want to sell these positions because they are high quality and when their sectors do well, we will likely be highly rewarded. As we have discussed, energy is also an effective inflation hedge, and central bank printing will probably result in higher inflation down the line. I also expect dividends to remain robust in aggregate for the year.
This is why we diversify. Experiencing a big drawdown is not pleasant, but it is as natural as the weather. Sometimes, the mood is euphoric, and other times, the mood is downcast. By staying the course and holding through the volatility, we will be able to reap the rewards of business ownership.
We are seeing a lot of stimulus from all central banks which should be bullish in the short term. However, longer term, the market will probably want to see the virus peak and fall. That will probably be a good sign that the drama has lifted.
Finally, people are curious if they should add or pull back on investing. I think that continuing to average into the markets if possible is the most effective way of dealing with them on a long term basis. We don't know if the economy will boom back up in the second half, or if it will continue to consolidate and rebase further down the line to future growth.
Where is the bottom? Hard to say. The markets might remain chaotic until we get an indication the virus has peaked. We could fall 15% further according to some technical analysts. In the Spanish Flu of 1918, I recently read that while the market was only down 10% 4 months after its start, the interim drawdown was 37%. Currently the Dow Jones is approximately 33% down from the highs of the year. Maybe we will only fall 4% more.
The only way I know, is to hang tight and ride the drama out. I have done so in 2008, experiencing a 50% drawdown which ended up much, much higher in the long run. I have also done so in Fukushima nuclear meltdown in Japan, Eurobond crisis, taper tantrum, earnings recession, energy crash of 2016, etc. My dividends received have also improved mightily over time.
Just because there are external events that are chaotic, it doesn't mean that I should sell good businesses. It is also worth mentioning, that just because a business is volatile, that is not a true reflection on its intrinsic value. There are many factors here at play, including PTSD from 2008, new investors who have never experienced this type of volatility and are selling fearfully, lack of clarity around this virus and fear exacerbated by social media and the press, election year anxieties, free trading causing less friction between buying and selling, index funds dragging down whole sectors, margin calls, and so on. But by owning good businesses for the long term, we end up with a nice income in aggregate and pieces of ownership in some of the best businesses in the world. I am excited to continue to invest with you for the long run. Best regards, and please keep healthy and safe.
Sincerely, Joe
https://www.summerfieldsinvestments.com/