This article was first published in the National Post on October 1, 2022. It is being republished with permission.
by Tom Bradley
It’s getting discouraging. The mid-year stock market rally is over, we’re now back below the June lows, and it feels like it’s going lower. At least, that’s what I hear in almost every investment presentation I watch. Phrases such as “stocks have further to go” and “a recession is inevitable” roll off tongues as easily as talking about the weather.
Whether you agree with this sentiment or not, it’s a hard time to make investment decisions. The noise is high, emotions are higher and recent losses are hard to ignore. In this context, here are a few thoughts that may help balance the commentary and lower the temperature.
First of all, it’s important to understand that the media’s negative bias gets even more negative in bear markets. Economists with the gloomiest forecasts get the most attention, as do companies that miss on quarterly earnings. It’s harder to find the good news and opportunities. Reports of companies doing well are buried or completely ignored.
In bear markets, predictions tend to be bold and confident, even though the situation is rapidly changing, and the quality of information is poor. Everyone has a view or statistic to show how overvalued the market is. The late economist Peter Bernstein said market bottoms (and tops) are defined by a “switch from doubt to certainty.”
Comparisons with other cycles are also common. They’re a favourite pastime of economists and commentators, but are of little use. I heard a portfolio manager recently say, “The only people who pick bottoms are liars.”
There’s another bias to keep in mind. It’s a positive one and involves anchoring on a stock’s previous high. The high price is viewed as being the value of the company, even if it was reached at a time of near-zero interest rates, extreme speculation and above-average valuations. In other words, a stock isn’t necessarily cheap because it’s down 30% from its 2021 high.
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There are other numbers to be careful of. Last week, a major brokerage firm lowered the price-to-earnings multiple (P/E) used in its market forecast. I’m sure higher interest rates are a factor, but the thinking is flawed. Putting a low multiple on low earnings is overdoing it.
Most assuredly, corporate profits — the denominator in a P/E — will go down in a weak economy, possibly by a lot, but the appropriate multiple on those depressed earnings is higher, not lower. Cyclical stocks, in particular, will carry multiples well above their historical range when they start to rebound.
In a similar vein, investors tend to reduce their return expectations after significant declines, which runs counter to what’s happening inside their portfolio. Potential returns are increasing because prices drop more than the value of the underlying companies.
Remember, stocks are valued on their expected earnings and dividends over the next 20 years or more. In a discounted cash-flow calculation, a commonly used valuation tool, the first few quarters, even years, have a small impact on the final value.
Discouraging news and red ink always push sentiment indicators into bearish territory. The AAII Investor Sentiment Survey indicator, which measures how individual investors in the United States are feeling, currently shows 61% of investors are bearish compared to the historical average of 31%. Only 20% are bullish compared to the average of 38%.
This contrarian indicator has shifted decisively from greed and speculation in 2021 to fear and frustration in 2022. Warren Buffett is no doubt doing some buying.
Most investors, however, don’t follow Buffett’s lead. They hang in with the stocks they own, but don’t do any buying. They say: “I’m not doing anything. I’m holding off until things settle down.” Unfortunately, waiting for certainty means registered retirement savings plan contributions get delayed, bonus cheques sit in the chequing account too long and opportunities to average down are missed.
Yes, procrastinating beats selling out, but rebalancing is even better. A few small purchases will enable a portfolio to go up with as much or more invested in stocks (percentage wise) than it went down with.
At times like these, the people who are gloating at dinner parties are the ones who saw it all coming and sold their stocks. The question to ask them is when are they getting back in? It’s the hardest investment decision there is, and it’s why bailing out of the market tends to result in short-term peace and long-term pain.