Catching The Falling Knife: Investing Into A Bear Market


With just a couple of days left in 2018, it appears extremely likely the stock market is going to end the year in negative territory.  As of writing this blog post, the S&P is down around -7.59%.  This will not go down as a stellar year for stock market returns… but it is well within the bounds of “normal” for a single calendar year.

Of course, this fact does nothing to make individual investors feel better about losses.  The market value of your assets is going to be less than what you started the year with.  That doesn’t make anybody feel good.

In my case, this amounts to a paper loss on the order of several hundred thousand dollars.  Ouch!  This is a HUGE emotional bummer for most investors, and it will typically cause investor behavior to change — to one of risk aversion.

This is exactly the opposite behavior good investors need to engage in!  Good investors don’t turn away from stocks when prices are down… they invest MORE when prices are lower.

Of course, coping with the economic cycles is never easy.  Natural emotion and risk aversion get in the way.  It’s simply part of our human nature.

So how can the average person invest into falling markets WITHOUT trying to time the market and WITHOUT making huge emotional mistakes?

 

Understand The Nature Of Volatility

Let’s start with the calendar year.  When you think about it, marking investment returns based upon a arbitrary calendar year is a very silly practice.

How we mark the rotation of the earth around the sun has practically no bearing on what the stock market does.  If the year ended in mid-September, I would have been writing that the market was up 13% instead of being down for the year.  Instead, our year ends in December and the market is now down around 20% from the annual high-point in September — which is the technical definition of a bear market.

Simply put, if you sliced a 365 day calendar one way, you’d be feeling extremely “bullish” about stock returns.  Slice it another way and suddenly your emotions about the market will be “bear-ish”.

Such are the vagaries of stock markets.  They’re volatile and the arbitrary start and end markers we put in place can make us feel emotion.

Those emotions are not a predictor of future returns, yet most investors will become more conservative in a bear market.  Silly isn’t it?

Furthermore, it’s not uncommon for a stock to swing +50% or -50% in any given 365 day period.  All this volatility is perfectly normal behavior.  Anyone who desires to be invested in stocks needs to be comfortable with this level of volatility, because valuing those assets isn’t easy.

That’s really what markets do — attempt to put a price on the value of an asset.  This is typically done in business school by trying to predict the sum of future earnings discounted back in time by a reasonable discount rate.  It’s called a discounted cash flow analysis.  The problem is, very few people can predict future earnings accurately.  Most estimates of future cash flows are GIANT guesses.

(Note: If you have a working time machine or perfectly accurate crystal ball, please contact me immediately!  We need to talk!)

Company earnings can literally change based upon thousands of variables.  Along with those earnings changes come varying estimates of the stock valuation.  It’s no wonder stocks are volatile — a simple news report even suggesting one of those variables could change might send stock prices into a tailspin.

Some investors attempt to smooth out all this volatility by buying bonds and other assets less correlated with the stock market (but with lower average returns).  Other investors try to profit from the volatility — attempting to buy low and sell high (and usually getting it wrong).

Could there possibly be a better way?

 

Find The Midpoint Earnings

It’s been said that stock analysts are either super negative about a company’s earnings prospects or overly optimistic.  Neither the twain shall meet.

As an investor in a falling market it behooves me to find that middle ground regardless of whether it’s a individual stock or fund.  Why do I say that?  Because that investment’s earnings will ultimately fluctuate around a economic midpoint over a long investment time period.

Think about it — during a good economy, unemployment is at a low (around 4%), and times are good.  Companies are growing, profit margins are good, and earnings are up.  This is the earnings high-point for an investment.  During a recession, the opposite is true.  Earnings are down (along with the stock price), profit margins are down, and consumers typically spend less.  This is usually the low point of the earnings cycle (think about the Great Recession in 2008)

To make a simplification — recession earnings can easily be 50% of “boom time” earnings.  (This is going to vary from company to company, but it should give you a rough idea of what to expect.)

Before I make any investment, I try to understand where the mid-point is between these two economic extremes — because my long-term return is actually defined more by the midpoint than it is by the extremes.

pendulum
The economy works much like a pendulum – swinging from one economic extreme to the other. At some point the economic pendulum will ultimately pass the midpoint going in either direction.

For example — Imagine a stock investment I’m considering earns $8 per share in 2018.  That’s an all-time high EPS for the stock.  Now, where are we in the cycle?  I’m fairly certain these are boom times because unemployment has been under 4% most of this year (historically that’s quite low).

Conversely, I also know that during the last recession profit margins for this stock were cut in half.  It’s realistic to believe that under similar recession conditions this investment might earn $4 per share.  (This is a vast simplification of course, but you get the idea).

Based on these extremes and further data points in annual earnings, I can therefore guesstimate the midpoint earnings to be around $6 per share.  If I happen to be looking for a minimal earnings yield of 10%, I realistically don’t want to be using $8 or $4 per share.  These are extremes in our dataset.  $6 is going to be much closer to what I should be using to estimate a valuation, giving us a rough midpoint valuation of $60 per share ($6 divided by my minimum earnings yield).

 

Don’t Catch That Falling Knife

When markets begin to turn into “bear” markets, you’ll often see the news media using the phrase “catching a falling knife”.  Why?

Most investors are not able to time the market perfectly.  They’re going to get “cut” trying to catch falling stock prices a just the right time(aka ‘timing a buy’). The problem is, you’ll never know the exact high or low point to which a stock will rise or fall.

Predicting the future is hard.  My advice — don’t even try!

Simply wait until the investment falls into your acceptable price range, computed using a reasonable ‘midpoint’ of earnings and a reasonable valuation level.  Then BUY at your price and don’t worry about trying to capture the exact the low point.

What if the price falls further?  Assuming you’re still comfortable with your estimate of the midpoint, just BUY MORE.  At some point the earnings pendulum will begin to swing past the midpoint and eventually be worth more than what you paid during the bear market.

It might take a couple of years, but it does happen.

For example, if you bought during the Great Recession anywhere in 2009 (or even as late as mid-2010), you likely did very well when the economic pendulum swung back into positive territory.  There was no need to get the valuation perfect.

If you’re an index fund investor and wondering where to start buying into the bear market, these principles are still going to apply.  Pulling up multple.com we can easily see that historically the S&P 500 trades at median PE of around 15.  Furthermore, it’s a relatively simple affair to find historical earnings numbers for the combined S&P 500.

(I’ll leave it as an exercise for the reader to determine today’s earnings midpoint for the S&P 500.)

Interestingly, a hypothetical PE of 15  for the S&P 500 implies an earnings yield of 6.7%… which is absurdly close to the 7% historical rate of return derived from investing in the S&P 500.

Coincidence?  Probably not.  The earnings of an investment and the price at which you buy ultimately determines your long term rate of return.

 

Forward Looking Thoughts

Obviously my approach to investing in bear markets by thinking about “midpoint earnings” is unconventional.  You won’t find many investment professionals recommending this approach, but you will find mention of the economic midpoint in Howard Marks’ new book Mastering The Market Cycle.

It’s also worth saying that this approach has been greatly simplified for the purposes of this post. There are numerous factors not mentioned here, such as future growth rates, inflation, tax rates, and other considerations you might want to think about before comparing today’s earnings with those of yesteryear.  (In fact, I don’t even use EPS to do the vast majority of my investment valuations.)

Honestly, I think every investor should take the time to think about what earnings look like during different parts of the business cycle.  Maybe even read Mark’s Mastering the Market Cycle to further understand how markets and valuations work during boom and bust cycles.

If you’re not interested in reading investing books, I still highly recommend Howard Marks’ free memos — They’re relatively short, and a great resource for investors.  Marks is a very a insightful investor/writer and his investing record really speaks for itself.

I know, I know… most people don’t have the time or inclination to read a bunch of investing books — In which case, I recommend simply spreading out your purchases “evenly” during a bear market and rely on the law of averages to get you close to the hypothetical investing “midpoint”.

Under most conditions this works great for the average Joe and Jane investor.  It’s not easy to continuously invest into a falling market, but it is what you need to do.

Oh, and before someone asks in the comments — No, I’m not going to be telling what price I think everyone should start buying the S&P 500 at.

However, I will say this…  My big fat cash pile remains very large and very fat.  Indexes like the S&P 500 could easily fall another 20% before I’d consider putting my cash pile to work.

What we’ve seen so far is merely a ripple in the water.  The waves have yet to come.

 

[Image Credit: Flickr1, Flickr2]

15 thoughts on “Catching The Falling Knife: Investing Into A Bear Market

  • December 29, 2018 at 5:56 AM
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    Interesting way to look at things Tako.

    I have never heard of this before and will try to use this on a couple stocks going forward.

    Always reassuring hearing the “big boys” with big paper loses keeping at it.

    keep it up Tako.
    cheers

    Reply
    • December 29, 2018 at 12:27 PM
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      Yep, paper losses don’t matter much. It’s real capital losses that should be avoided.

      Reply
  • December 29, 2018 at 6:08 AM
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    Love the title of the post. To me this year had been one big yawn. A decline of 7%, very mundane. I’ve been through years like this many times and as you say it’s unspectacular.

    I’m going to definitely use some of my cash on the side to buy more, but I also want to maintain as close to possible my allocation of stocks/bonds/cash, so I don’t want to go overboard. I’m hoping my side hustles take off more so I can use that income to buy.

    Happy New Year Mr. Tako!

    Reply
  • December 29, 2018 at 10:43 AM
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    I am always interested in your point of view. It’s like looking at something from a different angle, but I have thought about this a lot and looked back on many different time frames. It seams like the best thing to do is just keep dollar cost averaging your buys over time. Nobody really knows how high prices are going to go. If you just look back at the bear market low for the S&P 500 in Sept. 1974. From that low you would see that you would have to wait 27-28 years before you would see a 40% decline, and even at the bottom of that decline prices would still be much higher than if you had been investing a little all along. I know that P/E ratios are much higher now, but it is still an unknown. I will continue to dollar cost average into positions as I have in the past, business as usual. If we get a 40% or 50% pullback, great, more shares at lower prices, if we don’t, great, more shares at somewhat better prices. Other than that I will just do a little rebalancing of the bonds in our portfolio to keep it with our proper allocation.

    Thanks again for another interesting viewpoint.

    Reply
    • December 29, 2018 at 12:28 PM
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      Thanks Bob! History doesn’t repeat itself, but it does occasionally rhyme. Historically most investors would have been fine if they had a long enough time horizon and kept dollar cost averaging in down markets.

      Only time will tell if its going to work today. Good luck!

      Reply
    • December 29, 2018 at 12:33 PM
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      Thanks Angela. Many investors are still fairly optimistic. After a few more years of negative returns we’ll see if that optimism holds! 🙂

      Reply
  • December 29, 2018 at 2:39 PM
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    This is the reason I continue to read financial blogs because there is always something new to gleam.

    I like the concept of using the mid economic point as a guide on when to invest. I would assume just because of inflation and other economic factors this tends to creep up but certainly not as volatile as the market as a whole.

    Catching a falling knife and dead cat bounce are two economic concerns a lot of people have when things go south.

    Reply
  • December 30, 2018 at 3:44 AM
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    Clearly this was a good warning. High swings like 24th-27th are a sign just like 2008. We another 15-20% to fall.
    I’m looking at 2016 lows and see the same valuations. Happy to be 100% cash.
    We have all be warned and manipulation with no sound reason to prop up the markets is another sign.

    Reply
  • December 30, 2018 at 7:50 AM
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    I definitely agree that if you have the fundamentals right, a further price drop means “buy more”. That can be a little nerve-wrenching, but it’s been very rewarding over the years. If you get something at a good discount, and then some more of it at a steep discount, you should be celebrating. Just make sure you have the fundamentals right, right? 🙂

    Reply
  • December 30, 2018 at 8:51 AM
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    About slicing the 365 day calendar, I do think that there are several factors that affect prices in December. Many investors are selling for tax loss harvesting. There are people whose 401K contributions have “run out” depending on how their contributions are spread during the year. I also saw an article that the big uptick was due to pension managers buying large amounts prior to year end.

    I like your idea of looking at midpoint earnings. We have been so far ahead of that for years and I agree with you that this is merely a ripple in the water. The economy doesn’t look like it’s heading into recession yet, but there is a lot of Fed action that has to be unwound over many years and it’s propped up the market for a long time. I think things are going to be going lower, but I’m not quite sure this is it. Of course, no crystal ball here either, but I do enjoy a good prediction. I’ve been investing since 1986. My observation is similar to my work in control theory. All reactions are overreactions. Be ready.

    Reply
  • December 31, 2018 at 4:44 AM
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    Great article Mr Tako!!

    The title reminded me of the other funny sayings in investing and trading eg Dead cat bounce, The trend is your friend etc…

    It’s always interesting to hear how others determine their entry points. Thank you for sharing your perspective!! There is no one right way for valuation, just as there isn’t one right way to invest. Everyone needs to find a method that works for them and stick to it. It sounds like your method is working great for you!!

    I’m new to your blog and am slowly going through your older posts.

    Ernest

    Reply
  • January 2, 2019 at 12:44 PM
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    You have a great perspective Mr Tako. It makes me glad I’m the “set it and forget it” type in down markets, because my small deposits are just ticking away month after month, and I don’t even watch the news. The only way I hear about market movements is my dad or FI Twitter haha (or your blog) I do wish I cared just slightly more, because I could have throttled back a bit the last 2 years and had more of a cash reserve to dump in now… but c’est la vie, some is better than none.

    Reply
  • January 6, 2019 at 6:13 PM
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    I’m a big fan of Howard Marks. Still working through Mastering the Market Cycle. Awesome article, and I am so happy to have found this site. Looking forward to digging into your articles.

    Reply

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