“The stock market is a device to transfer money from the impatient to the patient.” - Warren Buffett
Over the past 70 years, investors have experienced a 15% decline in the S&P 500 about once every three years. A 20% decline has taken place roughly every six years. As of this past Friday, the S&P 500 has fallen by 18% since the end of last year. You already know the following, but I think it bears repeating – markets sometimes fall. Since we know this risk exists, we invest to withstand the downturns while not giving up the opportunity to profit when markets are healthy. We don’t know how long the weakness will last, so we need to resist the instinct telling us to SELL NOW. Eventually, stocks will turn up again.
The catalyst for this recent decline has been inflation, something we have seen little of really since the early 1980s. Annual consumer prices in the US rose more than 8% for both March and April, a far cry from the Fed’s target of 2%. Part of the problem has been excess demand, a result of low interest rates, stimulus packages, strong employment and the reopening of the economy. This problem is the easiest to fix – the Fed is on course to raise interest rates aggressively, and the increase in prices means most people simply can’t afford to buy as much.
The other cause of this inflation, insufficient supply, is a tougher nut to crack. During the worst of the pandemic, companies pulled back on capital plans assuming demand would dry up. Individuals didn’t want to go into work, either for health reasons or convenience, with many quitting or cutting back on hours. To these factors we add two more items: 1) Covid lockdowns in major cities in China, reducing the flow of products we get from the “world’s factory,” and 2) the war in Ukraine, which has curtailed the world’s supply of both Russian oil and Ukrainian and Russian wheat. While the Fed can influence demand, it can do little to improve supply.
Eventually the global economy will recover from this mess. The question that the market is trying to answer is whether a long, brutal recession will be required to fix it. Can the Fed really raise interest rates at just the right pace to bring the economy in for the proverbial “soft landing”? No one knows the answer, but I believe that enough good things are happening in our economy that a recession would be shallow and brief. For example, unemployment is near historical lows, and available jobs outnumber unemployed Americans by almost 2-to-1. Also, the banking system is in excellent shape, with strong capital levels and low loan losses. Finally, the American economy remains vibrant and creative. Given these positives, I simply don’t envision an ugly recession like we saw in 2000 or 2008.
Of course, the stock market may not see things that way for a while, and we may see lower prices for the next several weeks or even months. However, we need to keep in mind how bleak things looked in March of 2009 (when banks like Lehman Brothers and Washington Mutual had recently failed) and March of 2020 (the earliest days of the pandemic). Investors know that the market has always recovered, and it usually takes a seemingly small catalyst to turn the tide. This time it could be the loosening of lockdowns in China, a settlement between Russia and Ukraine, or an unexpected drop in inflation that shows the Fed is making progress. The point is that we don’t know. The best strategy is to be patient, as Warren Buffett advises, and maintain an appropriate exposure to stocks even though we know they may fall some more. In time, we will be rewarded.
In my role as a portfolio manager, I hate to see the market go down. However, as an analyst who looks for stock market bargains, a bear market is a much more interesting environment. You may recall in recent letters that I have noted the challenging conditions for finding new stocks to buy, but that has certainly changed over the past few months. Fortunately, our stocks as a group have performed considerably better than the market overall. As for the few that haven’t, like Alphabet (i.e., Google), I have great confidence that their long-term success will translate to higher stocks prices in time. More generally, I believe the recent downturn has correctly taken a good deal of fluff out of more speculative stocks but incorrectly marked down companies that will be winners over the next 5-10 years. Since we own much more of the latter, I am optimistic about the long-term performance of our holdings.
For those of you who own bonds and bond funds, these have done poorly as well due to rising interest rates. I focus our bond exposure to relatively lower risk securities, keeping both credit risk and interest rate risk at prudent levels. It has cost us some interest income in the past, but our holdings have held up better this year than the most commonly quoted bond indexes.
I hope you enjoy your summer, preferably with a backdrop of an improving global economy and a calmer stock market. Regardless of timing, I take comfort knowing that history tells us the turn is coming, hopefully sooner rather than later.