Q2 2022 Letter
The following is an excerpt of a letter written to clients during July 2022. Trading activity is excluded in public excerpts. A PDF formatted version is available here.
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We are halfway through 2022 and markets have been anything but favorable. Things like technology and medicine are progressive, while finance is cyclical. Capital markets, a dynamic mechanism reflecting the daily buy and sell orders of countless participants, reliably waver between fear and greed over unreliable time frames. Markets rise and fall, neither going to the moon nor going to zero. Human progress advances. Economic activity continues.
An argument is made that there are just too many question marks about the near future; wouldn't it be better to wait until things clear up a bit? You know the prose: "Maintain buying reserves until current uncertainties are resolved," et cetera. Before reaching for that crutch, face up to two unpleasant facts: The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values. – Warren Buffett, as published in Forbes, August 6, 1979
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A decade and a half ago, while attending business school in Cambridge, Massachusetts, a couple of us organized a trip to visit a legendary investor in Omaha, Nebraska. A classmate and friend of mine, Richard Borja, had written to the investor’s secretary upon our MBA matriculation in Fall 2006. After some back and forth, we secured a date for us and 60 of our classmates for a Saturday in late April 2008.
By the time April 2008 rolled around, credit markets began to show strain. A few hedge funds with subprime mortgage bets had collapsed. The uncertainty was reflected in High Yield Spreads – the difference between yields on high yield (junk) bonds and ‘risk-free’ government bonds – which had risen over the prior year from 2.5% to 8%. For comparison, the long-term average is 4% and spreads hover at 5% to 6% recently.
Warren Buffett discussed many things during the four-hour session in April at Omaha Country Club. He spoke to many of the usuals: incentives and trust with respect to working with people, competitive advantages and margins of safety in acquiring businesses, the unreliability of forecasting, and the importance of understanding the key levers in big decisions (waste neither time nor resources on minutia and avoid false false precision). There was a deep-rooted optimism in his monologue that carried through to his responses during our question and answer session. He was aware of the pending credit crisis. He was just looking past it.
He wrapped up with two proposals.
The first was an offer: “I will pay $100,000 today for a 10% claim on all of your future earnings.” We knew the bet was rigged in his favor. But Buffett’s conviction in our potential was also obvious. I looked around the room. There were no hands going up, a testament to our own conviction in our potential. However, we weren’t special. For years, Buffett has hosted students in similar fashion and provided the same $100,000 offer again and again.
The second was an ask: “If you know anyone with a business that has strong customers relationships, a track record of historical sales, and some reliability in future revenues, please connect them with me as Berkshire Hathaway might be interested in purchasing.”
The two proposals were more alike than different. Buffett knew history was on his side. Populations grow. Technology advances. Productivity increases. Economic activity compounds. His investment platform and his lifetime of wagers, big and small, have relied on these truths. We should rely on them too.
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Nobody builds wealth being overly cautious, sitting on the sideline, and waiting for the storm to pass. History has shown that once the seas are calm, markets will have already repriced and substantial gains will have accrued to those who weathered the storm. Let me provide three examples.
EXAMPLE 1: The Great Financial Crisis (2007-2009)
During the Great Financial Crisis, the stock market bottomed on March 9, 2009. At the heart of this market selloff were 1) bank failures and 2) home foreclosures. Yet, an additional 200 banks were bailed out – via TARP funds – after the stock market had already bottomed. Housing foreclosures, another “ground zero” factor in this bear market, did not peak until 2010, more than a year after the stock market had bottomed. Stocks, as measured by the S&P 500 inclusive of dividends, were up nearly 100% by then. Foreclosures would remain elevated through 2015, at which time the stock market was up by more than 200%. The “easy money” had been made (reminder: it’s never “easy”) and massive gains realized by the time the “all clear” signal arrived.
EXAMPLE 2: COVID Crash (2020)
During the COVID selloff, stocks bottomed on March 23, 2020. First-wave COVID cases did not peak until January 2021, 10 months later. At the time, lockdowns were just beginning: more than half of the United States (32 states total) issued “Stay At Home” orders after March 23rd. Over that summer several states, such as California, extended lockdowns. The stock market was up more than 50% by August 2020 (well before the first-wave peak) and more than 65% by the end of January 2021. Government and central bank stimulus contributed, undoubtedly. Still, markets can be incredibly forward-looking.
EXAMPLE 3: Recessions over the Past 55 Years
The United States has experienced 8 recessions over the past 55 years. In seven out of eight instances, stock returns were significantly positive (the “bottom” was in) by the final month of recession. The outlier is 2001, where stocks rose through the end of the year only to fall further in 2002 (ultimately bottoming in March 2002). Nonetheless, history supports that (large) gains might be realized before news headlines flash the green light.
Exhibit 1: Stock Returns from Bottom by End of Recessions
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How does this year’s stock market compare to others? It’s no surprise that stocks do better after falling into bear market territory. If we look at bear markets – those with greater than 20% declines – since World War II, stock returns over the next 5 have averaged nearly twice that of the long-term stock market average. In all prior occurrences, the next 5 years yielded positive total returns (which include dividends).
In fact, even for investors who bought at the market top, when stocks were at their highest prior to dropping, forward returns were positive in 9 out of 11 instances, although averaging about half the annual rate as long-term stock returns. (We don’t yet know how this 12th bear market plays out, but I have hunches.) Indeed, time and patience are an investor’s friends.
Exhibit 2: There have been 12 Bear Markets since World War II
On a calendar basis (as if stocks care about how long it takes the earth to revolve around the sun), this has been the worst start to the year over the past 50 years and third worst in the past 75 years. Only 1962 and 1970 were worse.
Exhibit 3: This Year is the Third Worst Start for Stocks in the Past 75
For the prior 9 worst starts to the year, returns over the next 1 ½ years were attractive (averaging 18%) although a wider range of outcomes exists: 2 of the prior 9 saw further drawdowns over the subsequent 18 months, one of those during an inflationary period.
Exhibit 4: First Half of Year – the Ten Worst Starts in Past 75
How did stocks do the last time the United States experienced high inflation? From 1973 through 1983, the Consumer Price Index (CPI) rose at an average annual rate of 7.7%. Inflation by that measure peaked in 1980 at 13.6%. Surprisingly, stocks returned more than 30% that year and averaged 8% through the 11-year period. Seven of the eleven years posted positive stock returns. In an inflationary environment, equities reprice to reflect higher discount rates, a fancy term for the imputed rate of return that connect a business’s future cash flows with its stock price.
Over time, most companies can reprice their goods and services. Corporate earnings, the result of revenues minus expenses, will reset. Stock prices reflect the expectations of a business’s future earnings. As those earnings reprice into inflationary dollars, stock prices eventually adjust. Corporate expense components and revenues seldom reset in tandem. Some companies are slow to raise product prices but quick to see higher expenses, while the opposite is true for other companies. The result is tremendous volatility in corporate earnings during the reset period as margins expand for some businesses and collapse for others. Eventually, equilibriums are achieved.
Exhibit 5: Late 1970s/Early 1980s Inflation & Stock Returns
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Following below are the usual tables with various sector, asset class, and economic data. Enjoy the rest of your summer and please reach out if there’s anything you’d like to discuss.
Respectfully yours,
Brian J. Glenn, CFA
Olcott Square Investment Partners, LLC
To learn more: info@olcottpartners.com www.olcottpartners.com 908.573.2200
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