THE CORRECTION BLUES
The performance of stocks through April month-end was not only painful, but it was also significant. The first four months of 2022 marked the worst January to April swoon for US stocks in history. The S&P 500 Index ended April down 13.31% from its’ December 27th, 2021, peak. The tech heavy Nasdaq composite index is off 23.18% since its November 15th, 2021, peak, officially putting growth stocks in bear market territory.
Before probing the specifics underpinning this correction, one must recognize that not all corrections are created equal. In this report we will examine the four elements of a correction, attempt to assuage the pain that paper losses inflict, and lay out strategies for damage control while searching for green shoots that can lay the foundation for an economic recovery.
As happens with most corrections, it seems that everyone with access to Twitter has been telling us, with the benefit of perfect hindsight, just why the markets have reacted so badly for so long, and why trying to fight the Fed or to ‘catch a falling knife’ is a bad strategy. As for the so-called fundamentals that are driving the downward slide, there is plenty of choice: rising interest rates, surging inflation, recession angst, Ukraine conflict, COVID lockdowns in China and continuing supply chain friction.
Each day, stock prices react to a maelstrom of trigger points that cause short-term shifts in sentiment, exacerbate volatility and, in most instances, lighten pocketbooks. What we learned in the January to April period is that trying to value stocks in a vacuum is not a viable investment strategy.
So, it is helpful to start by looking at periods where markets experienced similar trajectories. While there is always the possibility that this time is different, historical perspective helps us understand corrections in terms of their longer-term impact on the economy rather than the short-term pain to one’s pocketbook. At a minimum it provides a roadmap to navigate the twists and turns with as little pain as possible.
To that end, the accompanying table looks at the last six market corrections in the S&P 500 that were greater than 20%. In four of those scenarios, the selloffs preceded the onset of a recession (see grey area). The average duration from peak to trough for corrections that preceded a recession was 675 days. We are only 123 days into this sell-off (as of the end of April) which implies that the market is weighing the probability of a recession but has, so far, not concluded that one is at hand. And there lies the rub! Whether this sell-off continues now depends on how entrenched recession fears become.
If a recession becomes the base case, there will be few places to hide. Even now we see that with fixed income assets that have traditionally been a safe harbour. Driven by a revival of long-dormant inflation and the associated raises in central bank rates, bonds have declined in lockstep with equities since the beginning of the year. The iShares 20-year Treasury Bond ETF (symbol TLT), fort example, is off 18%, while the iShares Canadian Bond Universe ETF (symbol XBB) is down 10% year to date (see chart).
As for stocks, much of the damage so far has been the result of market rotation. Investors have moved away from growth stocks and into value plays as a hedge against rising interest rates. We do not see that as a harbinger for recession, but as an investment strategy that has historical precedence.
In an environment where recession fears become dominant, stocks – whether growth or value – will decline in much the same way as a hurricane sinks all boats.
To put some odds on the likelihood of a recession, we are mindful of recent comments from Fannie Mae that proposes the United States will experience a modest recession in 2023. Their economists argue that, with inflation at a 41-year high, the Federal Reserve will be forced to raise interest rates precipitously to choke off demand. On that point, we have seen similar commentary from Goldman Sachs, Bank of America and Deutsche Bank, which are all warning of an impending economic downturn.
Fannie Mae also cited the inversion along the 10-year to 30-year points on the Treasury yield curve. According to Fannie Mae, “an inverted yield curve means investors don’t have confidence in the future.” Fannie Mae economists are looking for additional pressures on the short end of the curve as the US Federal Reserve (FED) raises rates to slow demand and hopefully curtail higher prices. According to Fannie Mae, the FED plans to push short-term rates from near-zero towards two percent by the end of the year, which fosters their case for a modest recession in 2023. On a positive note, Fannie Mae does not expect the 2023 recession to be anywhere near as bad as the 2008 Great Recession.
The challenge for investors is the emotional roller coaster they face encapsulated in one word: losses! Investors are inherently risk averse. The agony of defeat far outweighs the thrill from investment successes by a factor of three according to most studies. What we need to do is remember that the puppy is still sleeping on our lap and, in the investment game, taking the good with the bad is key if we are to have a fighting chance at success.
By recognizing that corrections are part of investing and by understanding their role gives us perspective on where we are and where we are heading. To get there, it helps to dissect the frequency, length, depth, and the time it takes to recover from market selloffs in order to replace the mental fog of loss into the construct of rational thinking.
The Frequency of Corrections
Wes Moss (www.wesmoss.com) did an interesting study on the history of market corrections. He noted that, counting the year-to-date correction, there have been 53 market pullbacks of 10% or more in the past ninety years. “That’s an average of one correction every 1.7 years. Sure, there have been multiyear stretches where we were correction-free – such as from 1991 through 1997, and, more recently, from late-2011 until mid-2015. But, on average, we see 10%+ pullbacks every one-to-two years.”
We define a major correction, often referred to as a bear market correction, as a period where financial markets fall by 20% or more. There have been 20 of these pullbacks since 1928 – about one every 4.5 years.
After categorizing corrections as standard 10% pullbacks or 20% bear market sell-offs, Moss distinguishes corrections that lead to a recession versus corrections that simply resulted in a reset of financial market pricing. Stated another way: corrections that occur when the economy is already slowing versus those that happen when the economy is percolating. Not surprisingly, corrections that precede recessions inflict significantly greater damage.
There have been eleven recessions since 1928 (1929-33, 1927-38, 1948-49, 1953, 1957-60, 1968-70, 1973-74, 1980-82, 1990, 2000-2002, and 2007-2009). “The average drawdown for the 53 downdrafts is -22.5%. The average correction without the onset of a recession is -17.1% (we are down 13.1% as of the end of April). The average drawdown for periods where a recession was imminent is -35%,” writes Moss.
What these numbers suggest is the importance of categorizing corrections into those that precede a recession and the ones that do not by identifying the macroeconomic environment, which should help us assess the potential damage the correction is likely to cause.
What does the current 13.1% decline imply if the economy is showing no signs of going into recession? Knowing that the average drawdown for a non-recession correction is 17.1%, at current levels we should be close to a bottom.
The Length of Corrections
The second element of a correction is duration. How long will it take for stocks to recover – quality stocks generally recover – where investors recover their losses? According to Moss, the 10% – 20% garden variety corrections take about 112 days to go from peak to trough. The 20%+ market corrections last about 373 days before they trough.
Over the past ninety years, the time it takes to recover from a severe (average -35%) combined market correction and recession is about 6.34 years. However, that number is misleading because it includes the twenty-five years that stocks were underwater following the Great Depression. When Moss took out that period, the average time for a recession-correction to recover is 3.8 years (see chart source: www.wesmoss.com).
Fortunately, when looking at non-recession corrections, it takes less than a year to recover, or an average of about ten months, writes Moss.
The Depth of Corrections
So far, according to Moss, we haven’t talked about the worst-case scenario – a correction where stocks decline by half or more. This happened during the Great Depression 1930-1932 (-83%), and during the years of 1937-1938 (-84%), 1973-74 (-48%), 2000-2002 (-49%), and 2007-2009 (-56.8%). Unfortunately, despite the infrequent nature of these worst-case scenarios, they resonate with investors, inducing the worst fear and anxiety.
You might find solace in the fact that the worst-case scenarios were, for the most part, caused by financial malfeasance. The Great Depression was the result of excess margin, while the 2007-2009 Great Recession was the result of over-extended real estate investments backed by questionable accreditation and marketing practices.
In all cases, the epic freefalls were the result of massive imbalances. Moss notes that “once we went through the depression and the last shoe dropped for markets in 1937 (when we were down 54%), we didn’t suffer another 50% tumble for more than 60 years.” However, given the stability of the financial sector, we doubt the current challenges will result in a worst-case recession scenario.
We would be remiss if we did not recognize the impact on investors of the ten ‘garden-variety’ corrections in the past twenty years. While painful, these corrections were all less than the 20% threshold, which historically is expected to occur once every two years. Even if the current correction blows through the 20%+ threshold, remember that, on average, we expect a full recovery in about four years.
Moreover, it is important to understand that our investment plans are designed with baked in correction protection. Underpinning the investment philosophy is our belief in the resiliency of the stock market to push through periods of emotional trial and tribulation. Our portfolio structures cannot eliminate all the pain, but they do provide a way forward to abate those visceral feelings of loss.
Make no mistake, that while recession-induced corrections are dire, non-recession corrections are bearable. We believe the markets are signaling the latter, which is to say a non-recession correction.
We say that because the three harbingers of a recession 1) a leading economic index near zero, 2) an inverted yield curve and 3) wage inflation above 4% are not flashing red… yet! According to Moss, the three harbingers of impending recession are “at green, yellow, and green.”
So, for now, we would be well served to take a deep breath, relax, and enjoy the growing range of more normal post-COVID activities.
ASSET MIX AND WEALTH CREATION
Most investment professionals will tell you that 85% to 90% of a portfolio’s total expected return is the result of the asset mix – the percentage of the portfolio invested in stocks, bonds, cash, real estate, and alternative assets (e.g., commodities). The knowledge of asset allocation’s importance in portfolio returns has existed for more than fifty years but has only really been adopted with great enthusiasm in the last twenty years.
Just when we thought that asset mix was the beginning and end game in the investment business, the world is changing… again. We are not diminishing the importance of the asset mix decision within the context of your portfolio, but rather we now are framing it within the context of the impact of other portfolio factors on wealth creation. The asset mix decision, while important, only contributes about 15% to wealth creation.
We have done volumes of work about wealth creation and, aside from re-evaluating the asset mix decision, we have discovered other factors that have a significant influence on your wealth.
We have done volumes of work about wealth creation and we have discovered other factors that have an outsized influence on your wealth. Marshalling all these factors for your success requires a financial plan that includes, among other things: budgeting, tax strategies, insurance needs analysis; plus a strategy to implement the plan. That includes annual financial checkups, portfolio monitoring and regular reviews with your financial advisor to ensure you are comfortable and keep it all on track.
In this report, we will start with the asset mix decision in terms of its role in portfolio management. In future reports we will examine the other wealth creation factors and, by spotlighting their specific roles, we will connect the dots that lead to your financial independence.
The Asset Mix Decision
Before getting too far into this discussion, let’s understand what we mean by asset mix. When we talk about assets, we are talking about things you own that have financial value to you and others; not intrinsically invaluable pieces of your life such as the picture of your wedding or of your child’s first steps.
In terms of your personal statement of net worth, as mentioned, these assets must have value to you and to someone else. Ideally, your assets should be worth more than your liabilities, which defines what we owe and are presumably borrowed against your assets. There are two basic asset classes, which we will define as (1) household or consumer assets, and (2) investment assets.
A car is a household asset, and so are your appliances and your furniture. You also own clothes, but we don’t normally think of clothing as being a household asset because, aside from the fact your clothes might look good on you, they have very little value to someone else.
We also own assets that have value only in terms of what they are worth to someone else. For example, a twenty-dollar bill is simply a piece of paper. It has no value as paper, but it does have value in terms of commercial currency.
Its value is as a medium of exchange because you can exchange it for something else of value, which the person who you have made the exchange with can also exchange it for something else. As such, the twenty-dollar bill, as part of your total cash balances, is considered an investment asset.
For anything we own to be seen as an investment asset, it must satisfy two conditions: (1) the asset must have tangible value in that it can be readily exchanged for something else, and (2) your only motivation for holding this asset is to enhance your wealth.
Using our two-condition model, could your automobile be considered as an investment asset? A vehicle certainly has tangible value, but it does not enhance your wealth. It depreciates and is expensive to drive, maintain, and repair.
Having said that, certain vehicles are collectibles. These are vintage cars, which can increase in value over time. Jay Leno, for example, has a warehouse full of mint-condition vintage cars. Does this mean a car qualifies as an investment asset?
The answer is that while these vehicles may increase in value, that by itself does not change the position that cars are a household asset. Classic or vintage car collecting simply does not satisfy our second condition (that the only reason for holding the asset is to enhance your wealth). Most people who collect classic vintage cars do so because they like classic vintage cars. That those cars might appreciate is a secondary issue.
Much of our discussion on cars could also be applied to furniture. Normally, furniture depreciates over time. The exception, of course, is antique furniture, which can appreciate. But like our vintage car example, that fact alone does nothing to change our view that antiques are not investment assets.
From our perspective, Art, and other collectibles, fall into the same camp. While the purchase of an expensive piece of art may be justified because it is seen as an asset that will appreciate, the fact remains, that is unlikely the only reason for holding the asset.
We went down this road, to lay a foundation for an asset that many people believe is the most attractive long-term investment. We are talking about your principal residence that is seen by many as the primary wealth creator for most average Canadians.
While we would concede that the family home is the largest single asset for most Canadian families, we are not convinced that it meets our criteria for an investment asset. There are many who would not agree with that assumption, and to be fair we are drawing a fine line, especially because in Canada any profits from the sale of your principal residence will accrue to you tax free.
However, considering the two-condition model for investment assets, the family home doesn’t cut muster. The family home simply does not satisfy our second condition, in that the most important reason for owning a principal residence is to have a roof over your head and a place to raise a family. That value exists independently from its ability to create wealth, meaning the family home is a household asset.
We want to focus on this point for a moment. We are not saying that real estate is not an asset class. In fact, real estate is an important investment asset, if the conditions for buying it are driven by your desire to enhance your wealth or, for rental properties, produce income as opposed to finding a place to live.
Now that we have divided your household assets into asset classes and underlying possessions, we have the necessary framework to move to the next step, which is determining the mix of your household assets.
Your household asset mix describes what percentage of your personal statement of worth is tied up in the family vehicle, the diamond necklace, and so on. We are simply putting a price tag on each of the possessions and then weighing that in terms of the total value of all your household assets.
The question of course is do I really need to know what my household asset mix is to become reasonably adept at investing?
Believe it or not, understanding how you allocate money to personal assets can tell you a great deal about your investment personality. For example, the percentage of money you commit to each class within the household asset mix speaks volumes about your lifestyle. If, for example, your car represented the largest single component of your household asset mix, you would have a very different personality, or be at a different stage in your life cycle, from the person who has the bulk of their non-investment assets tied up in their principal residence.
Investment Asset Classes
In essence, the household asset mix illustrates the approach we will take to categorize your investment assets. We have already defined investment assets as having value and whose sole purpose is to enhance wealth. Investment assets can enhance wealth in one of three ways: (1) interest, dividend, or rental income, (2) capital gains resulting from the sale of the asset for more than you paid for it, or (3) a combination of both capital gains and income.
One long-standing investment metaphor is that of the fruit and the tree. We think of capital as the tree. If the tree produces fruit, we think of that as income.
In many cases, however, the tree will not produce fruit for many years, spending the early years growing (effectively enhancing your wealth through capital gains). And, later on, the tree may both continue to grow and produce fruit, satisfying our goal of wealth creation from two sources.
Again, as we did with our household assets, we can extend our definition of investment assets to include the underlying securities. Note that we use the term securities, rather than possessions, to define the component parts of our investment asset classes.
Guaranteed Investment Certificates, for example, are a type of security that we classify as a cash asset in much the same way as Government of Canada treasury bills. Longer-term government and corporate bonds are considered fixed-income assets because they can provide both income and capital gains. But they can also fluctuate in price sometimes to the detriment of wealth creation – note our previous discussion on the performance of fixed income assets through April month-end 2022.
Real estate as an investment includes commercial or investment properties, real estate mutual funds, and real estate investment trusts (REITs). Investment properties might include a triplex that you own and collect rent from, or perhaps a commercial building. If you don’t live in the building, then your only motivation for holding the real estate is the potential for wealth creation.
It is the same situation with real estate investment trusts. REITs typically represent shared ownership in multiple real estate projects or, in some cases, mortgages on commercial or residential properties. REITs trade on an exchange just like the stock of General Motors, IBM, or Bell Canada.
REITs are unique because, instead of owning part of a company that manufactures automobiles or computers or provides telecommunication services, you own shares of a company that invests in real estate. Profits are distributed to shareholders in the form of dividends. The profits represent the amount of rental income that is more than the cost of carrying and maintaining the properties in the REIT’s portfolio. Of course, if the underlying value of the properties in the trust rise, then it is possible that the per-share value of the REITs will rise as well.
The other major class of investment assets is equity. If you own shares of General Motors, that would be considered a security classified as an equity asset. So too would shares of IBM or of a good Canadian mutual fund or exchange traded fund (ETF) that invests in stocks.
Returning for a moment to our tree and fruit analogy, we need to understand that the total return we expect from each investment security is the combination of the tree’s fruit (income). The total measure of investment performance, then, reflects all sources of wealth creation: interest income, rental income, dividends, and capital gains from our investment assets.
To understand total return, consider an investment asset you buy for $10 a unit. You earn 50 cents in interest income, receive a 25-cent dividend, and sell the unit for $11.00. You will have realized a total return of $1.75 (50 cents interest + 25 cents dividend + $1.00 capital gain) or 17.5% before costs.
Understanding your investment asset mix – what percentage of your investment assets are in equity, fixed income, cash, and real estate – is critical for building wealth because that mix has such an important bearing on your overall return. As we said, 85% to 90% of your portfolio’s return can be related to your asset-mix decision, another 5% to 10% comes from market timing (that is, shifting in and out of investments in response to economic changes), and the remaining 5% to 10% from selecting one specific security over another (for example, buying IBM rather than General Motors, or Microsoft rather than Apple).
In other words, by determining what percentage of your portfolio is committed to fixed-income assets, what percentage to equity assets, and what percentage to any other asset class, you have laid the basis for controlling 85% of your total return.
To make the point, consider a hypothetical two-asset portfolio of Canadian securities that includes the iShares S&P/TSX 60 Index ETF (symbol XIU) and the iShares Canadian Bond Universe (symbol XBB).
XIU had a compound annual rate of return of 9.94% over the last ten years, while XBB returned 2.28% over the same period. If we assume that we invested $100,000 ten years ago, the following table examines six portfolios with different asset mixes. Note how dramatically the end value changes with only small shifts in the asset mix.
Forgetting for the moment that Portfolio F, made up entirely of fixed-income assets, would have provided stability, it may not have generated a sufficient return to deliver a decent retirement nest egg over the period in question. But look at what happens when we move from Portfolio F to Portfolio C, which is made up of 60% equity assets and 40% fixed-income assets.
Portfolio C returned 6.876% (an increase of 4.596% compounded annually over Portfolio F with an end value that is $69,159.96 higher) an improvement based entirely on the asset-mix decision, rather than the selection of securities.
The $100,000 invested in Portfolio C would have been worth 55% more than Portfolio F at the end of the 10-year period. If we assume similar annual returns going forward, at the end of twenty years Portfolio C would be worth $378,097.52, compared with $156,969.18 for portfolio F. At the end of 20 years then, Portfolio C would be worth 141% more than Portfolio F, which is what we mean when we talk about the magic of compounding.
Richard Croft, Chairman & CIO