One of our main lessons from the Financial Crisis was distinguishing between when to play offense vs. defense. The Financial Crisis was a collateral crisis where assets (housing and related securities) backing a significant amount of debt fell in value. Until efforts were made to support those assets, the situation worsened. That calls for defense. The current situation resembles a more classic liquidity crisis (so far at least. The Fed has withdrawn liquidity from the system at a nearly unprecedented pace. M21 has fallen year-over-year at a pace not experienced since 1930! Historically, liquidity crises warrant offense because liquidity injections solve the problem. The question is whether current liquidity injections are enough. Do we need more, and is the Fed willing to do what it takes given inflation concerns? Fortunately, authorities have acted quickly and aggressively thus far.
Given the challenges, it’s important to remember the best investment opportunities mostly arise from fear and pessimism.
During the depths of the Financial Crisis (Oct 2008), Warren Buffett wrote a New York Times editorial entitled: “Buy American. I Am”. Here’s an excerpt:
A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful…..most major companies will be setting new profit records 5, 10 and 20 years from now…
A little history here: During the Depression, the Dow hit its low, 41, on July 8, 1932. Economic conditions, though, kept deteriorating until Franklin D. Roosevelt took office in March 1933. By that time, the market had already advanced 30 percent. Or think back to the early days of World War II, when things were going badly for the United States in Europe and the Pacific. The market hit bottom in April 1942, well before Allied fortunes turned. Again, in the early 1980s, the time to buy stocks was when inflation raged and the economy was in the tank. In short, bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price.
Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.
Someone asked Buffett several years later how he knew it was the right time to buy. He replied he didn’t know time, he knew price. Interestingly, in the short term his timing looked terrible. The S&P 500 fell another 26.5% over the next 5 months before bottoming2. Years later, however, he appears to have nailed it. The S&P gained 24% over the next year and compounded at 16% over 5 years and 14% over 10 years. Those short-term losses vanished rather quickly.
This is an important perspective to keep in mind. Currently the S&P 500 remains 18%+ below the highs reached in Jan 2022. Historically, that’s been a favorable starting point. Over long periods of time, the market has gone up and often sits at or near its highs. Markets only trade down significantly when things look ugly. When it comes to future return prospects, the importance of muted expectations often outweighs the visible risks and concerns.
Since the end of 1939, the S&P 500 has compounded at an annual rate of ~11% per year. Over this period, the average 1-year return is 12.7% (the difference is due to using a geometric average (11%) which accounts for the effects of compounding vs a simple numerical average). Further, the average 1-year return improved markedly when the market was 15% or more below the previous highs (as we are now). For those periods, the average 1-year return was 15.6% (23% higher than the full period average 12.7%).
The market is a discounting mechanism that reflects future expectations. When the market is down significantly, it’s because investors have priced in the risks we fear. Sometimes the market declines further, but historical data suggests it makes sense to buy when the market is significantly below its previous high.
The S&P 500 declined 27.5%3 from peak-to-trough last year, which is a more material decline than many bear markets. If we look at periods where the market remains more than 15% below the highs after a 25% or greater bear market, return prospects improve further. In these circumstances (similar to now), the average 1-year return was 18.5% -- that’s 45% higher than the average rate! The average 3-year returns also improve when you’re well off the highs. Over a 5-year time horizon, the returns are more similar. It all comes out in the wash through a cycle, it seems.
The odds of making money also improve when the market is below its prior highs. Historically, over all 1-year periods there was a 78% chance of positive forward returns, on average. When the market is 15% or more below its highs, this probability climbed to 85%. Amazingly, the probability reached 97% when the market was trading 15%+ below the highs after a 25%+ bear market.
No one can predict the future. We don’t know how the current crisis will end, or the path of inflation. We don’t know whether there will be a recession or how severe it will be. We don’t know what corporate earnings will be in the future. We do know the markets were down a lot in 2022 and remain well below the highs. We know historically it’s been best to buy when things look the worst. That might be all we need to know.
1 M2 is the U.S. Federal Reserve's estimate of the total money supply including all of the cash people have on hand plus all of the money deposited in checking accounts, savings accounts, and other short-term saving vehicles such as certificates of deposit (CDs).
2 The time period referenced is from closing price as of 10/16/2008 – intraday low on 3/6/2009.
3 The peak-to-trough of last year (2022) is calculated with intraday prices from 1/4/2022 and 10/13/2022.
The S&P 500 Index is a market capitalization-weighted index of 500 widely held common stocks. Investors cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.
Source: Bloomberg
The views expressed in this report reflect those of Miller Value Partners portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
©2023 Miller Value Partners, LLC
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