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.

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]