Dear Fellow Investors:
When meeting with clients throughout the country, investors ask if we are worried about various well-vetted and well-known negatives. The list includes what the Federal Reserve Board might or might not do, China’s slowdown, emerging market struggles, plummeting commodities, dollar strength and the uncertainty over who will become President of the U.S. in 2017. We think investors are really asking us, “what’s the market’s biggest risk?”
As long duration common stock owners, who practice a bottoms-up stock picking discipline, our main interest in the aforementioned fears is in the opportunities for investment they create and the psychological needs of those who employ us.
Naturally, as long-duration owners we often look at things from a historical standpoint. Over the last century, we’ve observed a fairly consistent pattern associated with major stock market declines and this missive will review them. We will compare today’s circumstance and “well known” negatives to backward-looking and useful explanations for these previous episodes. This will provide historical perspective for the current stock market difficulties and reinforce one of the most important components of common stock ownership—patience. We will make no effort to predict markets or practice market timing or make any effort to pick a bottom in the current normal downdraft we are wading through.
The biggest U.S. stock market declines of the last 100 years are listed below:
A booming economic stretch called the “Roaring Twenties” came thundering to a halt with an 80% decline in stocks that started in October of 1929 and bottomed in 1932. Overconfidence in the economic boom combined with extremely liberal regulation of borrowed money in the stock market ran us into an inverted yield curve (higher short-term interest rates than longer-term rates) in 1929. From a historical perspective, the decline and following economic depression were magnified by a painful move away from employment in agriculture, which started at 29% of adult employment and reached 2% in 1970. There was no place to employ these folks and the banking system collapsed under the weight of foreclosures and uninsured deposits.
A perfect storm of longer-term difficulties hit the stock market from the beginning of 1973 to the end of 1974. The first Arab oil embargo, an oil price spike, gas rationing and accelerated inflation led to an inversion of the yield curve. In turn, a bubble in the most popular growth stocks of the era, “the Nifty-Fifty,” broke, sending their prices down 80% and the average stock down 50-60%. The downdraft exacerbated the sense of despair causing a cloud of pessimism to loom over 1974 as investors and everyone else realized their government, including President Nixon, partook in numerous illegal and unsavory dealings.
A booming economy triggered an inverted yield curve, dropping economic over-confidence to its knees with a 40% decline over a 78-day period from peak to trough. History shows that the 1987 Crash, which culminated in a single-day decline of 22%, effectively reset the stock market and served as one of the three main timeouts in the bull market that started in 1982 and ended in early 2000.
A booming economy tied to a huge and historic bubble in technology stocks burst at the hands of an inverted yield curve causing a two-year decline in stock prices exceeding 40% from peak to trough. This proved to be a major inflection point for U.S. large-cap stocks, which became unduly popular because almost all tech companies associated with the mania were large-cap.
An economic boom tied to a real estate bubble, lax lending standards and booming commodity markets led to an inverted yield curve. A crushing economic and financial meltdown followed, with U.S. stocks falling by 57% from October 2007’s peak to a low on March 9th of 2009. The viability and stability of our entire economy was questioned, examined and cleansed.
We have our share of negatives in the current circumstance but lack many of the key tenants of the major declines in history. First, we are in an anemic economic recovery and a residential real estate environment which hasn’t yet become large enough to drive more normalized GDP growth. Second, the yield curve is upward sloping and the kind of economic strength which would justify an inversion of short-term and long-term rates is nowhere in sight. Third, economic sins tied to the foolish use of credit, lax lending standards, and over-leveraging of households and businesses are also nowhere in sight.
Fourth, U.S. households have cleaned up their balance sheets and income statements to the point of comparing favorably to anytime in the last 35 years. Our banking system regulators are testing bank stresses to legendary lengths. Our major banks are well-capitalized, growing their moats and are well insured. Lastly, we think stocks are in a reasonable band of valuation at 14.5 times 2016 First Call consensus earnings when taking into account inflation and prevailing interest rates.
We believe that rewards will continue to accrue to the long-duration investor over the next five years. Those who prefer to worry should be concerned with booming economic growth, economic over-confidence, silly equity valuations and a tightening of credit which would drive short-term interest rates higher than longer-dated maturities. Otherwise, enjoy your dividends, ignore the noise around you and be patient. Stock market declines of 10% happen most years and 20% declines come about once every five years. Remember, a wise sage once said, “the stock market was invented to move money from those who are impatient to those who are patient.”
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
This Missive and others are available at smeadcap.com