"Fear of Crashing"

In September 1995, legendary fund manager Peter Lynch wrote an article (“Fear of Crashing”) where he addressed the two questions that people ask incessantly during every bull market: Is a sell-off on the horizon? And if there is, what should I do about it? This was Lynch’s primary takeaway:

“The Dow’s passing 4,700 has brought new worries about a nasty correction. The worrying started as soon as we recovered from the last nasty correction, in 1990… Let me go on record with [my] prediction: Another big correction is on the way… Assuming you agree with my forecast, how can we prepare? Mostly by doing nothing. This is where a market calamity is different from a meteorological calamity. Since we’ve learned to take action to protect ourselves from snowstorms and hurricanes, it’s only natural that we would try to prepare ourselves for corrections, even though this is one case where being prepared like a Boy Scout can be ruinous. Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”

Lynch’s discussion feels timely. Much like in the 1990’s, we’ve lived through an enjoyable and extended run for equity investors; but with heightened market volatility over the past 6-12 months (a fancy way of saying “stocks have gone down”), there’s great angst that the party is finally over. With a seemingly endless list of macroeconomic and geopolitical concerns, market participants are now questioning whether stocks will trade even lower in the coming quarters. (The one difference between when Lynch addressed this question back in 1995 and today is that, in our case, the “crashing” has already begun.) The key question asked in “Fear of Crashing” seems applicable: for long-term investors, how can we intelligently navigate difficult stock market environments – particularly at a time when many have concluded that even more severe macroeconomic headwinds lie ahead?

The first response most people have is a desire to do something; the problem, as Lynch explains, is that most of the prescribed solutions (when “something” is translated into concrete decision-making) are just a variation of market timing – an activity that has proven time and time again to be a net negative for the vast majority of people who engage in it. (“Recently, Forbes published its hit parade of the richest people in the world, and I was reminded that there's never been a market timer on the list. If it were truly possible to predict corrections, you'd think somebody would’ve made billions doing it.”)

If you take that answer off the table, what are we left with? While I agree with Lynch that there’s not much to be done once you’re in the storm, I do think there’s a lot of value in preparing for these tough times before they arrive.

First and foremost, we need to start with a discussion on asset allocation.

As discussed in “Mo’ Money, Mo’ Problems”, I personally advocate for a structural asset allocation. Determining the proper allocation is a financial planning decision that is reflective of one’s personal financial situation (age, income level, expected contribution / withdrawal rate over the next 5-10 years, etc.), as well as your ability and willingness to bear risk. In my mind, the outcome from that exercise should drive all future asset allocation changes (through periodic rebalancing). Naturally, during a period where equities are generating mid-teens annualized returns, as they did in the decade through year-end 2021, that would mean you are a net seller of stocks. On the flip side of the coin, when we go through a period like the past six months, you will be allocating additional dollars to stocks. This is a simple, yet effective, approach for navigating volatility over the long run. By the way, there is a market timing component as part of this strategy (on the margin); the difference is that the decision isn’t at the discretion of the individual – it’s dictated by the “rules” of the allocation, which pushes you to be “fearful when others are greedy and greedy when others are fearful”.

As a byproduct of a structural asset allocation, security selection within a given asset class is an exercise in opportunity costs; personally, I’ve found this acts as a forcing function that leads to more thoughtful and deliberate decision-making. With a structural allocation, you can’t just buy ABC because it’s cheap or sell XYZ because it’s expensive; the need for funding (to buy a new stock) or reallocation (after selling a current position) within a given asset class frames the decision through a different lens (as Sid Cottle once said, investing is “the discipline of relative selection”). In summary, I view a structural allocation as the least bad alternative – and unless you’re willing to engage in market timing, which I’m not, it’s effectively your only option.

On individual security selection, my North Star is unchanged: the goal is to own high-quality businesses with sustainable competitive advantages operating in attractive end markets with strong balance sheets and best-in-class management teams, in addition to ensuring the equity trades at a reasonable valuation (likely to deliver attractive long-term returns). The one asterisk I’d include, as discussed in “Volatility and Portfolio Construction”, relates to diversification: while I’ll always remain cognizant of the standalone merits of an investment, with the goal of owning large positions priced for attractive forward returns, that isn’t my sole focus. The companies I’ve invested in, along with their weightings, will be considered in the context of the overall portfolio. A notable current example is Dollar General, which I’d expect to continue reporting strong underlying business results if the U.S. economy faced short-term macro headwinds. It may not offer expected IRR’s that rival my favorite ideas, but it’s additive to the portfolio on other attributes (counter cyclicality); that’s played out as expected as of late, with DG outperforming the S&P 500 by ~2,500 basis points year to date.

The solution I’ve outlined above isn’t a bear market playbook; it’s the framework that I look to employ across all market environments.

What this will hopefully position me to do, regardless of whether the S&P 500 is making record highs or is down 30%, is to ensure that the next decision I make is both thoughtful / unemotional and consistent with my investment philosophy and long-term portfolio objectives. Admittedly, even when starting from a strong foundation, that’s still difficult to do. Currently, I’m uninterested in selling names like Meta, Spotify, or Netflix (which are all down 40%+ YTD). On the other hand, I continue to believe I should be very thoughtful about pulling capital from companies like DG, Markel, or Berkshire, which provide the diversification benefits discussed above (but also look more expensive on a relative basis), to keep reallocating to the other names in the portfolio. It’s a conundrum for which I do not have a great solution.

As with many things in investing, there isn’t a one-size-fits-all answer to these questions. I think the most important thing that an investor can do is to ensure they’ve implemented an approach that will allow them to remain committed to a thoughtful, long-term investment strategy regardless of what the economy and / or Mr. Market throws at you over next three months (or three years).

For me, a concentrated portfolio consisting of a few high-quality companies that I believe are positioned to weather any storm and meaningfully increase their per share intrinsic value over the next 5-10 years passes that test.

The unease that overcomes many investors when experiencing a difficult market environment reflects an inability to honestly answer that question (to find an approach that they’re committed to throughout a full market cycle). The shock and fear that they feel - and react to - as a result of stock price and business volatility is simply at odds with any reasonable idea of what it truly means to be a long-term investor. As a result, they ultimately live and die by the daily swings of stock prices, not their own independent assessment of the long-term value of a business. (“I’m amazed how many people own stocks where they wouldn’t be able to tell you why they own it… If you really pressed them, they’d say ‘this suckers going up’, and that’s the only reason they own it.”) To paraphrase John Maynard Keynes, these people are speculating (“forecasting the psychology of the market”), not investing (“the activity of forecasting the prospective yield of assets over their whole life”).

Conclusion

Risk management, as I define it, is ensuring that investment decisions are made in consideration of one’s ability and willingness to bear risk. With stocks, that means accepting the uncertainty of sizable and long-lasting drawdowns. As Lynch noted, one’s ability to bear risk is inextricably linked to their time horizon (by the way, since “Fear of Crashing” was published, the S&P 500 and the Dow have both more than sextupled, before dividends):

“In telling you this, I'm assuming you're in stocks for the long haul. Never invest money in stocks if you are going to need it for some other purpose in the foreseeable future. Twenty years is a reasonable horizon for investing… As soon as you realize you can afford to wait out any correction, the calamity also becomes an opportunity to pick up bargains.”

The key question to answer in this bear market, and the ones that will undoubtedly follow it in the decades ahead, is whether you’re truly a long-term investor; can you accept the fact that stocks will periodically decline by 20%, 30%, or more? If you can, the answer is to structure your portfolio accordingly (to survive whatever tomorrow brings). And when those tough times inevitably arise, it’s worthwhile to remind yourself that the good times will come again. This too shall pass. (“Over the 13 years I ran Magellan, the market went down nine times by 10% or more. Every time it went down, the fund went down more. So, I just didn't worry about it.”)

But if you simply cannot accept the vicissitudes of the stock market, I only see one effective solution: you should greatly limit your equity exposure, if you own any stocks at all. This current bout of volatility will offer an important lesson for another class of Mr. Market’s “students”: if you don’t come to that conclusion on your own, he will happily teach it to you.

NOTE - This is not investment advice. Do your own due diligence. I make no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report. Any assumptions, opinions and estimates expressed in this report constitute my judgment as of the date thereof and is subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. The TSOH Investment Research Service is not acting as your financial advisor or in any fiduciary capacity.