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Markets cause butterflies

May 13, 2022

If markets are giving you butterflies, you're not alone.

What a start to a year. All kinds of eye-popping stats. To list a few:

1. Data firms Bloomberg, Lipper note that only three other times in the past 20 years have investors pulled more than $35 billion simultaneously out of both the stock and bond markets.

2. The S&P 500 has averaged a bear market every 4 years since 1928. Yet this is close to the 4th bear market we've experienced in the past 4 years (though not quite).

3. Cash held by households, according to the Saint Louis Fed, surged by almost 5 times from the end of 2019 to 2021, and that was before the recent market drop.

4. According to the American Association of Individual Investors, peak bullishness was 4/21/21, or within a half year of the market peak (Apparently the wisdom of crowds theory may be just a theory...)

5. And to top it all off, the Wall St Journal reports that as of May 6th, the broad bond market has performed worse in 2022 than any complete year since 1792, except one, which was 1842 and the country was in deep depression (though adjusted for inflation 9 other periods were worse). To put a visual on this, people were walking around with muskets the last time this happened.

But the news isn't all bad. It appears equity dividend payouts are on the rise for 2022, which we care about a lot. And because good investors drive looking through the front windshield and not the rear-view mirror, all those future cash flows are cheaper to buy today than they were in December. And investing is, fundamentally, the act of buying future cash flows.

Even though it's normal, all the jiggling and movement is disconcerting, particularly as it jiggles down. Let's look at a few ways to handle this emotionally.

1. Don't look. This is the classic "don't look at your statements or the market." This is, by far, the best behavior in any market, but I estimate that it's only possible for half the population of investors. The red and green data is simply addictive. Much of the progress we have made with indexing, if not all, has been offset by the proliferation of devices spewing too much information at people. Information easily leads to anxiety, and anxiety leads to poor investing.

2. #1 above may not work for you, and that is completely understandable. So, another technique: stay away from "high water mark psychology." If you register your net worth at the high point of a market, you'll struggle as markets inevitably fall and reset, which they will always do. Instead, if you look at your accounts, multiply the value by 70% in your head, and use that number. Everything above that 70% consider standard market fluctuation.

3. Our favorite approach is to watch your dividends and bond interest instead of the market. Scrolling down on this PDF, you can see why. Look at the stability of the cash flows over time. Actually, I should say the relatively stable *increase* of cash flows over time!

4. Talk to someone. Generally we don't recommend Uncle Jimmy, who, between rearranging sausages on the grill, is convinced "this sucker's going down." That's not going to help. If you're a client, talk to us, it's why we are here.

Dan Cunningham

1. St. Louis Fed - cash held by households
2. WSJ - Bond market since 1792

Things are not predictable

April 15, 2022

Recently on the Internets I ran across this photo:

This seems true, I'm not inclined to go to a fact-check website on it. Assuming the laws of physics don't change between the time you pass under the sign and when you reach the bridge, and assuming you are continuing forward, you know what will happen.

A lot of these types of "signs" pop up in the financial news, and in people's minds. Signals flash. Many times these signals, in the past, preceded something. (Note "preceded," not "predicted.") All kinds of things then dominate an investor's thinking, like recency bias, or confirmation bias, or narrow experience bias.

Let's look at one example. On bond trading floors people like to rattle off the catchphrase "Don't fight the Fed," meaning that when the Federal Reserve is raising rates, stocks aren't going to do well, and you shouldn't buy them. They won't do well, in theory, because bonds will pay more going forward, attracting money away from stocks, and because capital will be more expensive for corporations to employ.

I like the phrase! It kind of rolls off the tongue, and when you don't feel like doing that complicated valuation spreadsheet for your boss because the Yankees are playing at 7 PM and you want to get out of the office, you just simplify down to "Come on, don't fight the Fed."

So how did that work out the last two periods the Fed raised rates, the first being from the start of 2004 to the summer of 2008? The S&P 500 compounded return was about 33%. Maybe that's just an anomaly you say? What about the period from the start of 2016 to the fall of 2019? Oh, hmm, then the S&P 500 gained about 66%. Maybe it's the alliteration of the phrase "Don't fight the Fed" that's attractive, but not the reality.

Perhaps the Fed starts raising rates when the economy is doing well, and in the past two periods that has dwarfed the negative effects on corporations? Or perhaps they raise rates to fight inflation, which is the dominant meme now. But controlling inflation helps businesses as well, as Warren Buffett points out in his 1981 report (1).

The lesson here is to be careful when you hear a financial statement, and someone says X is happening, therefore Y is going to happen. The problem is there are a lot of X's, and no one really knows how they interact, or what weighting to put on each X.

In other words, you may hit the sign, and be fine at the bridge.

Dan Cunningham

1. Click here to read the 1981 Berkshire report which discusses inflation. It's about 2/3 of the way down.

Real Estate and Inflation

March 25, 2022

Some housekeeping to start.

One Day In July is growing and we have several positions open. Though I don't write most of the website anymore, I wrote this careers site. I won't say this is the usual approach but I kind of liked it and no one has been too insulting of it yet. If you know of talented people please forward this link to them. Our selectivity ratio is high - at least 25 people applied for every job in the last expansion round and I'd like to keep it that way.

Real estate has boomed the past six months, driven by a cocktail of low interest rates, second home buying, pre-Covid pent-up demand, regulatory friction facing builders, not-in-my-backyard syndrome, and Section 1031 exchanges trapping capital in the industry. The realtors on this newsletter could probably keep going.

One of the debates in asset allocation and investing is whether real estate itself should be broken out as a separate category. (Keep in mind that a real estate index is broad, covering things like hospitals and self storage and even cell towers - it's not just houses.) Every few years this debate flares up, usually because a paper is published or an exogenous event like inflation surfaces. In 2016 real estate was added as the 11th sector to the S&P 500, with an overall weighting of 2.62%. But should it get even more dedicated exposure?

Someone arguing "no" would say that real estate is already exposed in the S&P 500, and there is not a good reason to give it more - the market has appropriately weighted it, and there is nothing left to do. Why, a "no" vote would ask, should real estate enjoy increased presence while consumer non-durables (like Proctor & Gamble), not get invited to the party? What about health care - you can find all kinds of reasons, like demographics, that health care should be over-weighted.

Someone arguing "yes" would say lots of asset classes are not represented in the S&P 500, so the boundaries that define what that index covers are somewhat artificial.

We side with the "yes" argument for two additional reasons. The financing and operation of Real Estate Investment Trusts (REITs), in terms of their capital usage, leverage, and profit payout, are unique from other businesses. Their response as an asset class to something like an interest rate increase is different from other businesses, and hence they provide diversification.

In addition, REITs protect well against inflation, and because we have always viewed inflation as one of the primary risks an investor faces, it makes sense to have extra security. The primary point here being the scale of the risk.

Dan Cunningham

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