Bear Market
Finances,  Investing

Investing During a Downturn

Investing during a downturn, whether a correction or a bear market is always tough.

You’re coasting along, getting a rush off the returns you’re seeing, potentially calling yourself a master stock picker and then suddenly this happens.

Investing During a Downturn

Hopefully you’re just playing the paper game at this point and can stomach the sudden drop. However, if not, it’s nice to have a cash cushion or an emergency fund in case things continue to get worse. Even being diversified is a tough road right now as almost every asset class is down.

These times are never fun, no matter how or when they happen. The pandemic is still around, there’s conflict in Europe and other supply chain issues and the fed is more rightly more concerned about getting a handle on inflation than putting a bottom in asset prices.

It’s a big change from the easy money policies we’ve seen in the past few years that have led to amazing returns and likely a shock to many new investors.

All that leads to an ugly chart and that’s just the S&P 500. The more tech heavy Nasdaq is down 23% YTD and there are plenty of individual stocks that are down 50% or more in a matter of months.

Many have seen months and sometimes years of gains washed away in a flash.

However, that is the reality of investing. That’s the truth of it all. When you’re in the middle of a bull market, it’s easy to forget that the path in investing isn’t always easy. It’s been a while since we’ve had a prolonged downturn and investing in one is a whole different animal than buying during a bull market. It really requires a whole different skillset and is more about mental toughness than market timing or anything in that realm.

Sure, many tenured investors remembers the near 50% drop in the early 2000s but it wasn’t just the pain of that massive drop that hurt but how long it took to recover. And that’s talking about the index and not the many individual stocks that got killed during that time frame? Remember when AOL was a thing and when it was valued at $200B before basically ceasing to exist a few years later?

And yes, most investors probably remember the 50%+ drop that I graduated into around 2008. That was a great time for new investors like me to to buy(assuming they didn’t lose their job) but that entire period wasn’t an incredible time for investors nor was it a good time for the economy as a whole. After all, a prolonged downturn doesn’t just lead to lower stock prices, it can lead to economic pain, hiring freezes and layoffs too.

Even if you don’t recall those, I think even the newest of investors remember the pandemic drop of 2020. That one didn’t last long and saw a swift recovery and an aggressive bull market right after.

Of course, downturns aren’t always as big as those three. Do new investors even remember the 10-20% corrections in 2018 or know the fact that the current market meltdown is the 10th correction since 2000 and the 54th such disaster since 1928?

The point here is that what’s happening right now is not unexpected, nor is it that particularly rare.

Now most of these downturns of the smaller variety, if you can call a 10-20% correction small. While the Nasdaq has officially entered a bear market(defined as a 20%+ drop), the S&P 500 isn’t quite there and is in correction territory(defined as a 10% drop). In either case, both are still quite a ways away from some of the disastrous bear markets we’ve seen in the past.

I say to that warn you that if this feels particularly awful, just know that it could get a lot worse. That’s not a fun thing to think about but something that investors have to be aware of if they invest in the stock market.

Some of these downturns can take your breath away. The worst of those was the Great Depression which saw stocks fall 83% from the peak. More recent bear markets include the two I mentioned; the tech bubble right after the turn of the century which saw the market drop 49.1% and the 2008 recession which saw a 56.8% reduction.

Some are short such as the 13 day correction in 2018 and some take forever to recover. The Great Depression bear market took 783 days to bottom and the 2000 tech bubble finally burst and started to rise after 929 days. The 2008 recession was no slouch either clocking in at 517 days from top to bottom.

Perhaps it’s why this one, only in it’s 5th month, feels so different despite the smaller drop than what we saw in the pandemic; because it hasn’t been marked by a swift recovery like the last few corrections(the longest being 95 days at the end of 2018, the other two being 13 at the start of 2018 and 33 during the start of the pandemic).

After all, while technically a bear market, even the Nasdaq is just back to April 2021 prices and still 30% above pre-pandemic prices.

It’s easy to say buy the dip when the market dips a few months. What happens when it dips again and keeps dipping for more than a year or even longer. That’s certainly never out of the realm of possibility when it comes to stock market investing. It’s been nice to see those paper values soar in the past few years but investors feel the pain of loss much more than they feel the join of gains especially when that downturn is longer and longer.

As an investor, it’s important to know this history and be prepared for what could happen.

And that’s just the S&P 500. Some individual stocks can take far longer to recover. Microsoft, a marquee name, hit a price north of $50 in 2000 and then fell and didn’t crest $50 again until 2015. Yikes, that’s quite a long time.

Now it’s certainly paid off handsomely since then but it was a long wait for some investors to get that return. Many other stocks never saw the heights of the 2000 tech bubble and I wouldn’t be surprised if some of the recent tech darlings meet that fate this time around too.

That’s just the reality of individual stocks.

So the question this time, as it always is, what’s this one going to be like and when will it be safe to buy?

Well, the answer to both questions is simple. No one knows. People can speculate, point to historical returns during times of high inflation and rising rates but the future, as always, still remains murky and impossible to predict. After all, if I asked you, what’s the economy going to be like 6 months from now, the answer would be the same and that is the main driver of what’s going to happen to the market in the short-term.

And that last word is key, the short-term.

As while short-term price predictions are near impossible, there is one trend that an investor can always count on when it comes to investing. While the S&P 500 graph I showed above looks ugly, the one below tells most investors all they need to know.

The long term trend is up.

As time passes, the S&P 500 goes up. That is a statement that is backed by more than one hundred years of history. Technically, the S&P 500 as we know it came into being in 1957 but it was tracked as a smaller group of companies until then.

Going back to 1928 and including the recent drop, the S&P 500 generated an annualized return of ~9.7% with re-invested dividends. $100 invested in 1928 turned to ~$650,000 today. That’s not adjusted for inflation but that $100 would become $1,681 if it was just inflation adjusted. I’ll take the stock market return over that anyday.

Sure, maybe the 1920s aren’t all that relevant to today and If you don’t care about the market that far back, the return starting in 1990 is even better at 10.2%.

Hell, even those buying at the end of 2007, right before the market tanked 37% next year during the Great Recession generated a 9.1% return if they kept it all until today. Those who bought at the end of 2008 after the market tanked did even better with a 13.4% return.

I guess it does help to buy when the market dips but even those buying at supposed market tops did pretty well.

It’s certainly hard to do so as the market keeps dipping but historically, it’s been an excellent time to generate better long term returns.

All that is to say, that investing in the S&P, without regard to market conditions is solid. After all, you have to consider all those periods included times where the market dropped much more than it’s dropped so far as visualized below.

Now that might not make you feel good today. After all, it’s possible you’re staring at another 20-30% drop ahead of you but that chance is inherent in stock market investing. However, on the opposite end, it should at least make you feel better about your chances of making money 10-15 years from now even if you bought the S&P 500 at the recent highs.

After all, those investors who started in 1990 went through fifteen drops of 10% or more including the 49% drop during the tech bubble and the 57% drop of the great recession and yet they generated returns that turned a $1,000 investment into almost $23,000 today.

That’s not too bad. Of course, a person would have had to stomach a bunch of massive drops and keep invested but that’s the entire idea of being a long-term investor.

It’s quite likely that if you bought at recent market highs, you’re staring at a similar path to get to those 10% long term returns. This is just part 1 of 15 of your journey to your investment goals. It’s never going to be easy but it is how you’ll get there.

This market volatility is also a reason why even more outsized returns are possible as investors can keep buying during all those massive drops and generate even bigger returns.

This can be a good thing if you’re just starting your investing journey and much more painful if you’re well on your way. If you’re in the latter camp, hopefully you have an asset allocation that matches your risk tolerance and a cushion in case economic conditions lead to job loss because those long term returns are only possible if you don’t sell. That’s the key part in all of this.

Naturally, it’s not always going to be that rosy. There are sometimes worse times to buy than others. Valuations do, in fact, matter. The good thing is that valuations today are better than they were just a few months ago.

That means those buying today will have a better long-term return than those buying a few months ago. Think about how you were feeling when you invested half a year ago when stocks were rising? Do you feel worse today? You sure do even though you’re buying at a better valuation.

You didn’t know the future back then and you don’t know it now so why are you upset about the prices today when they’re lower than they were just six months ago? It doesn’t make sense and that’s the mental struggle that makes investing so tough and why buy-and-hold investors do better long term than those who trade actively.

Now, again, valuations do matter.

For example, those who bought at the end of 1999 right before the tech bubble burst only generated a 6.8% return which lags most market projections you see. Not terrible but certainly not the 10% everyone always assumes the market will generate. Those who were in individual stocks around that period sometimes never recovered.

It’s possible it’s the same today. Those who bought at the start of the year will likely have a lower long-term return than those who buy today but as long as you’re constantly buying and earnings keep growing(even if they shrink in the short-term), returns will be positive in the long run.

Again, most of these discussions revolve around the index, whether it be the S&P or the NASDAQ because those indexes are far less risky than individual stocks. Naturally, they offer less upside but also far less risk.

Still even with an index, I’m sure many people have the feeling that this time it’s different. This is the big one, this is the one that never recovers and while there’s certainly always a chance of that happening, it’s likely that a market that never ever recovers means we have much bigger problems that your portfolio.

Plus, it is my opinion, and the opinion of many, that the index will likely always recover as long as the world continues to function. That’s because growth is inevitable and human ingenuity and growth will always push humanity forward.

Unless you believe this is the absolute peak of humanity, it’s quite likely that the index will be just fine in the long run. It will certainly have bumps along the way, some longer than others, but the long term trend should still be up.

That’s because they represent a bevy of companies and the long term trend of the earnings of those companies is positive. Just look at the graph below.

Investing in a down MarketDoes that look familiar? Is it a coincidence that the long term trend of the market is up if the long term trend of the earnings of companies in the market is also up?

Now that’s not to say that these will always go up. After all, you can see the multiple dips during certain periods that naturally go hand in hand with the various corrections, recessions and bear markets we’ve seen in the past century.

It’s important to remember this as you invest. That’s because economic slowdowns, shocks and other issues can and will arise and that will certainly have an impact on short term stock prices and the short term earnings power of these companies. While the long term trend is up, it’s not straight up.

When these slowdowns happen, they can have a massive impact on stock prices as they already have but the other thing to remember about those slowdowns is that they often impact stock prices negatively in two ways.

Not only do earnings drop(and we’ve already seen slowing GDP although it’s hard to tell if that’ll lead to a recession), multiples also contract causing a double whammy when it comes to stock prices.

Those multiples can also shrink as alternative investments such as bonds start seeing higher rates and lead investors to pay less for stocks. Currently, we’re seeing contracting multiples based on expectations of rising yields and slowing growth but we haven’t yet seen contracting earnings in a big way which could lead to further drops if that happens.

That can also explain why stock prices can move so erratically during a time like this. It can be even faster now than before(both in terms of the crash and the recovery) due to the advent of algorithmic trading.

I’ve outlined how to picture that below.

You can see that double whammy I mentioned as prices can drop quite a bit during a period of contraction as not only do earnings take a hit but so do multiples.

That means if expectations are for growth as shown at the top then a stock price of $39.60 in year two is possible but if that growth doesn’t emerge and earnings actually shrink, a 50% drop to $20.3 isn’t unreasonable as multiples contract as well to reflect that new earnings paradigm. You can see how those expectations can lead to massive disparities in pricing in year three if a long term recession happens when not expected.

Is it crazy that certain individual stocks have dropped 60-80% in just a few months? Not only are we seeing slowing growth compounded with worries of a potential recession and the shrinking earnings that may come with that but also a repricing of multiples due to that fact and rising rates.

It’s great when multiples expand during a bull market as they had in recent years but it certainly hurts when the reverse happens. Combine that with the potential for an actual recession and a reduction in earnings and you’ve got a problem.

That’s the market we find ourselves in today and it’s not an easy one to navigate.

However, it’s important to have the historical context when you invest because panicking is often the wrong move. Yes, the market could keep moving down for months and months but it could also start to recover before you know it’s happened. You can sell and maybe you’ll be right but when do you buy again to ensure you lock in better returns than if you just kept coasting along.

That’s the hard question that people just haven’t found the right answer to in all the years the market has existed.

What’s the right answer right now? I don’t know but it’s important to be ready for times like this when they come so you’re not caught in a position that’s too risky for your risk appetite. If you’re panicking today, your investment strategy is likely not right for you and it’s one you need to revisit because it could get a lot worse.

That’s just the reality.

However, in the end, it will eventually get better and any buys today, which might be in the negatives for a while, will eventually reward investors years from now. The stock market is a long term game. It is for money you don’t need soon but money you want to grow across decades. It has proven to be able to do that in the past.

It always has been that and will continue to be that. Invest wisely with that in mind.

Disclosure : I am long the S&P 500 and MSFT. Investing comes with risk of loss and you should discuss with a qualified investment advisor before investing your own money.

Investing during a downturn

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