ising animal spirits in 2017 brought an
uninterrupted string of nine positive annual results (including
dividends) for the financial markets. The S&P 500, the standard index of
U.S. stock prices, set over sixty new record highs over the course of
the year, while the popular Dow Jones Industrials beat its previous
record about seventy times. For the first time since 1928, the S&P
logged a "perfect" year, as each month of 2017
saw gains. Even as the markets climbed, the variability of prices was
unusually subdued (the calmest since 1964), producing strong "risk
adjusted" returns for those with a statistical bent. For others with a
more traditional view of investment risk — the permanent impairment of
capital
— the relentless advance of security prices caused some
consternation as it was accompanied by ever-higher valuations, by some
measures surpassed only by the speculative excesses of 1929 and 1999.Given
the strength of the stock market since 2009 and its stretched
valuations, it is not surprising that some voices have raised warnings
about the possibility of a serious market downturn. While we generally
pay little heed to market forecasts, we certainly agree that securities
are richly priced. Accordingly, we began to ask ourselves what we would
do if this year's calm were in fact to be followed by a period of
tribulation. Although we have experienced difficult market conditions
before, the circumstances are always different.
We
always find history to be a useful source of insight when pondering this
question, and by chance, as we began these deliberations, we encountered
some excerpts of the old
Wall
Street Week with Louis Rukeyser Friday night TV show from the 1980s.
We were gripped by a wave of nostalgia as the old videos reminded us of
our early days in the investment business, a time whose "quotron" machines seem as distant now as the old-fashioned ticker-tape printers
did then. To be sure, technology had by that time made significant
inroads into Wall Street operations
— even computerized trading was well
established
— but those were the days before the Internet, high-speed
trading, and electronic order execution. It was also a time before
scandals and investigations changed
— probably forever
— how Wall Street
firms present themselves to the world. In those days the firms seemed to
have answers to the ordinary person's investment questions (some may
remember the adverts confidently proclaiming that "When E.F. Hutton
talks, people listen."), and analysts and investment "Gurus" of that
time commanded more interest and respect than their current, largely
ignored successors. Wall Street was a very different place thirty years
ago, and
Wall Street Week was
known for giving airtime to some of the biggest names in the business.
Re-watching the shows broadcast immediately before and after the great
market crash of October 19, 1987, the events of that day thirty years
ago seem relatively minor — especially when one looks at a long-term chart
of stock prices. Although beyond Wall Street the event had in fact
little economic impact, on "Black Monday," when the Dow Jones Industrial
Average fell by 22%, many people were traumatized. On the show broadcast
the previous Friday, commentators were suitably impressed by the market
declines that had already taken place that week. Caution prevailed, and
one commentator even referred to the possibility of a crash (proving
that forecasters tend to get it right only after a catastrophe has
already begun to happen).
It was
the program broadcast after the 1987 crash that we found most
interesting. Rukeyser had three guests: the CEO of a big Wall Street
wire house, an investment strategist from another major firm, and the
founder of one of the largest mutual fund companies, who was known for
his long-term take on investing. Having three of the most significant
players in the business on the show provided an opportunity to hear
their thoughts on the dramatic events that had just taken place.
Their
recommendations to average investors were interesting and very
instructive from an historical perspective. The CEO counseled "caution," although he did suggest that investors consider buying some stocks, or,
at least, "improving their portfolios." The strategist, employing a very
reasonable and reasoned argument based on the potential economic impact
of the market turmoil, advised buying bonds. It was the mutual fund
executive who offered a more philosophical approach, stepping back from
the hue and cry of the moment to argue that in ten years or (stunningly
for a Wall Street Executive) forty years, the economy would be many
times bigger, generating profits that would impel future stock prices to
levels many times what they had been even at the peak in 1987. As a
matter of fact, he said, the Crash had created a wonderful buying
opportunity as long as the investor had the patience to endure the
inevitable short-term tumults. Unfortunately, from our own point of
view, he weakened his case by advising investors to wait until the
markets "settled down" before making any moves. It usually takes a
significant recovery for markets to becalm themselves, meaning the
investor would pay a price by giving up potential gains in the meantime.
A cynic
could argue that these guests on a widely followed TV show were simply
defending their own businesses, by trying to discourage customers from
defecting at a difficult time. We would agree with this assessment to a
certain extent, but with the exception of the strategist, who downplayed
the big picture and focused more on short-term moves, the views
expressed were basically sound. The views were offered in the midst of a
market crisis, and had viewers followed the advice, they would have done
fairly well over the long term, or would have at least avoided turning
paper losses into real ones at a particularly bad time. Things could
always have turned out differently, however, and no one knew what would
happen —
during periods of discontinuity the future always looks like a
scary place. Yet during such times decisions must be made — even doing
nothing is a choice —
but how?
Here
the interviewees offered clues. The strategist relied on
speculation — trying to predict what would happen in the future — which was
precisely what was not needed at the time. Strategists had largely
failed to foresee a crash, so why should they be relied upon to predict
the aftermath? The mutual fund executive, with his knowledge of history
and historical perspective, was much more helpful. By reminding the
audience that over many decades, markets had suffered numerous sharp
setbacks and had always recovered and gone on to establish new highs, he
was able to convincingly argue that "this, too, shall pass," and that in
the long run it has never paid to panic, lock-in losses, and bet against
the continued growth of the economy.
So,
what would we do? We would not liquidate out of fear of a downturn. The
notion that one can sell in anticipation of a crisis is usually
misguided, as it cannot be done consistently. Likewise, succumbing to
fear and selling in the midst of a panic is a losing proposition;
rationally, investors should actually be buying during a crisis in order
to lock in low prices and future gains. (If selling is to be done, it
should be done when times are good, prices are advancing and the threat
of discontinuity seems distant.) Being prepared for untoward events
means understanding that in the long run disruptions pose no significant
threat to one's investments. Avoiding speculation and relying on sunny
prospects that wilt when the clouds of calamity appear is a must. If we
can maintain such an investment stance, then we can remain confident,
take the ten or forty-year view, and benefit from an economy that most
likely will continue, with interruptions, much as it has before.
With
the exception of an unprofitable iced tea vendor from Hicksville, NY,
whose shares bounded 500% after adding "blockchain" to its name,
financial markets were more or less "rationally exuberant" in 2017,
producing another bountiful year for investors almost everywhere in the
world as total equity market value grew by $9 trillion. This came in
spite of various threats in the political and economic spheres, threats
that did not materialize as many had expected. U.S. equities were
notably strong, rising 15% to 30% depending on your index. If this
continues, the power of compounding will mean that shareholders will own
the entire planet in a few years. We wouldn't count on that happening,
however, as such potential outcomes tend to meet with unexpected
difficulties. Just because markets avoided trouble in 2017 does not mean
the risks were not there, or that they have simply gone away. The more
the markets rise, the more risks pile up as players become complacent in
the expectation of continued advances. 2018 could prove to be an
interesting year, indeed.
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