All bull markets end in bear markets. All bull markets come to an end at some point. The longer the bull market runs, the frequency of the question, “is the market crashing soon” increases. We know for a fact that the market will “crash,” or in other words, the bull market will come to an end. However, nobody can say whether it will happen “soon” or not. Nobody, even the greatest investors, and mathematicians of our time. Speculators mention leading indicators and various signs, but they always talk about them. Every year some leading indicator is flashing red, and nothing happens. So the truth is, this bull run we are currently in could last many more years, or it can all come to an end tomorrow.
Stock prices are high
It is no secret that today’s stock prices are high. Here is the S&P 500 chart over the last ten years.
That is annualized growth of 14.62% at the time of writing, almost uninterrupted. COVID-19 related crash was merely a blip, and the market crashed in March 2020 and was up to the same level by the end of August.
Here is a look at the S&P 500 PE Ratio over the same ten years.
The PE Ratio for S&P500 peaked at 40 in Q2 of 2020 and is now sitting at 31, with a ten-year average PE Ratio around 21. People joining the stock market today through lazy portfolios or Robo-advisors are paying a premium. That is because most lazy portfolios and Robo-advisors have general stock market ETFs like S&P500 ETFs or Total US Stock market ETFs. All of these ETFs are selling at their highest multiples.
Why are stocks trading at high multiples?
Low interest rates are partially to blame. People are always searching for the highest possible yield on their investment. Historically stocks and bonds offered a good balance to achieve good risk-reward. However, post-2008 crisis interest rates have been low, and low interest rates make bonds unattractive. As the stock market continued to deliver better and better results, it attracted more and more people.
The rise of Robo-advisors and index funds funnel people into stocks without considering prices. This means that people who start investing today through these platforms will unknowingly be buying into the market at the highest prices.
High prices are not the problem
High multiples are fine as long as company earnings can catch up. However, the economic or business cycle is inevitable. After seasons of high growth come short seasons of slow down and earnings decline. For more details on business cycles, check out US Business Cycle Expansions and Contractions | NBER. It is a natural part of every economy in the world.
Why we are not worried about the market crash
Since the oncoming bear market is inevitable, there is no reason to waste energy worrying about it or trying to mitigate it. Trying to time the market never works. All the pundits who ring the bell every year and keep saying sell everything and buy gold have been wrong for ten years straight. They will be right sometime in the future and will beat their chests saying I told you so, just like a broken clock. We must ignore them at all costs.
Bear markets are relatively short
Here is a look at S&P 500 history from the 1950s. Since the 1950s, there were 11 US recessions highlighted by the grey lines.
As we can see, they were all quite short in their duration, even the biggest ones like in 1981, 2000 and 2008.
During the 2000s US recession, the S&P500 Fell from 1239 level to 1139 or roughly 9% decline from March to November 2001. However, after the recession had ended, the market kept declining, and it reached its lowest point In July 2002. From there, the recovery started, and the S&P500 was back to what was its record level before 2006.
What if you were new to the stock market back then and bought at the highest level right before the crash?
Over the next six years, you would have made just over 14% return or almost 2% on an annualized basis. 2% is low. If we assume 2% inflation during the period, you would have made pretty much nothing.
But what if we kept investing throughout this whole time of downturn and recovery? Assume we invested $10,000 right before the crash but kept putting in $100/month for the next seven years. I will take S&P500 ETF – SPY as an investment.
Your $10,000 investment would have turned into $24,872 by the end of 2007.
Since we made $100 monthly contributions, we have to calculate Money-Weighted Rate of Return. Money weighted rate of return for this hypothetical scenario is 4.94%. Not bad for investing through a crisis without timing anything.
What if we invested through the 2008 market crash?
Let’s run the same experiment but with a much bigger crash in 2008. Assume we had invested at the peak right before the crash but kept putting in $100/mo throughout this time without trying to time anything. I will take the period from the beginning of 2008 until 2013 and take SPY again as an investment vehicle.
$10,000 invested in December 2007 and $100/mo contribution will at the lowest be $7,268 and turn into $26,650 by the end of 2013.
The money-weighted rate of return, in this case, is 8.97%. Again, without timing the market and entering at the worst time, and investing during the worst time.
The takeaway here is that we would have been much better off if we continued to invest as if nothing happened instead of panicking and trying to time and exit the market at the right time. As the market was going down, every $100 invested at a lower and lower price, contributing to the high overall return during the recovery.
Portfolio during the recession
In 2008, when the global markets collapsed, All-Weather Portfolio returned a remarkable 3.15%. During the same period, the S&P dropped a whopping -36.81%.
We don’t know what the next crisis will be like. What will cause it, and what assets will be hit the most. During 2008, the All-Weather portfolio performed well because it had gold that significantly appreciated during the crisis and fixed income investments that kept generating stable income returns.
Will this be the case in the next crisis? We don’t know. But we know that if we invest in a diversified portfolio and prices start declining and keep averaging down, we will come out ahead over the long haul.
Individual stocks during the recession
For my personal investments, I have two portfolios. The All-weather portfolio is one, and it acts as an easy-to-setup, set it, and forget it portfolio that I contribute a fixed amount into every month.
I also have a portfolio of individual deep-value stocks. These are typically undiscovered, low coverage, low-cap stocks. This portfolio has much higher return expectations. The problem, however, is that this portfolio is much slower at generating returns because value stocks typically take longer for the market to discover them, understand that they are worth much more, and for people to start purchasing them at high volumes. This is especially true for micro-cap stocks.
Check out: Is value investing still relevant?
With this portfolio, generally speaking, I welcome bear markets. If the prices were to decline today due to overall market sentiment going sour, that gives me the best opportunity to buy these wonderful companies that I discovered at a lower price, thus increasing my margin of safety.
Margin of Safety
Warren Buffett has said, “The three most important words in investing are Margin of Safety.”
The margin of safety means that the value of my investment is inherently higher than what I pay for it. I am protected. I don’t care what the price is doing as long as company fundamentals remain the same.
The margin of safety can only exist if you buy an investment below what it is truly worth. You buy a $100 business for $50. It applies to any type of investment, whether it is a rental property or a web site. If you buy a $100 dollar business for $50 and the price declines to $30, but the business is still truly worth $100, do you care that the price dropped to $30? No, you welcome it.
Price opportunities during recessions
It isn’t just deeply undervalued stocks that you can benefit from when the price declines during a recession. Large-cap companies that typically trade for a premium can be bought at more reasonable prices. This is especially true for large-cap dividend-paying stocks. These are incredible businesses with a long history of earning money, paying and growing dividends. During regular times these companies almost always sell for a hefty premium and are considered boring. But during recessions, they can be picked up at a discount relative to their historical prices and fundamentals. Think companies like Coca-cola, PG, General Dynamics, Johnson & Johnson, Kimberly Clark, and many others.
My story from investing during the crisis
Back in 2008, I was just starting on my investing journey. I only began studying Buffet and Munger and was clueless about what to actually invest in. Then the crisis began, and my Economics teacher in high school made us put a report together explaining the crisis. The report I put together wasn’t very good. Still, through this research, I stumbled upon an article that explained how this is a great opportunity to buy some of the historically great performing companies at a much lower price.
The article talked about the usual suspects, but Proctor & Gamble stood out to me for some reason. So whatever little money I had, I decided to buy some PG stock. I also liked the fact that the company was old and relatively boring, something my newfound hero, Mr. Buffett, would probably approve of. I purchased three or four shares 😃. I was ecstatic. This was some time in 2009.
Here is the PG price chart from 2009 until today.
If I held on to the stock, I would have made a 159% return or 8.25% annualized. I sold much sooner than that and didn’t make much money but looking back. It was a really good investment for a kid who didn’t know anything about investing.
PG’s PE ratio dropped to around 10 in 2009, and PG’s average PE before that was north of 22. I couldn’t do an actual valuation of the business at that time, but it seemed like a good deal based on PE alone. Again, I didn’t actually now how to value anything.
Dividend Yield jumps up when prices decline. PG had a long history of paying and growing their dividend. When prices declined dramatically in 2008, the dividend yield jumped up. The company was still paying the same dividend, but the price to pay to receive that dividend has decreased. So the yield was now above 3%. I thought, okay, PE is low, and I can get somewhere around 3% per year in income. Even though I only invested around $400, I was excited about that.
My only regret from that time as a first-time investor was that I didn’t hold on to the stock for longer.
Today, PG’s PE ratio is at 26, and the dividend yield is at 2.31%. If the bear market comes and the price drops, I will be looking at PG and other similar stocks like PG to pick them up at a bargain.
Stock market predictions 2021 and beyond
New investors and casual investors always look towards the stock market and make predictions around the stock market to figure out what to invest in. But a much more productive activity is to look at either portfolio & individual businesses for great opportunities regardless of what the market is doing.
Stock market predictions do not matter if you find a solid portfolio that you can consistently contribute to and remain on the lookout for good deals on great businesses that will only sell at a discount because of market panic.
That is why we don’t fear the market crash. One, it is inevitable. And two, it presents a great buying opportunity. By no means do I want the bear market to come, but I am eager for the opportunity to pick up more Proctor and Gamble or Kimberly-Clark and many other blue chips at lower prices. I hope this will turn your fears into opportunities as well.