Bear Market Investing

The equity markets continue to selloff into bear market territory as inflation bites. Year to date, the S&P500 is down <red>-24.77%<red>, the NASDAQ is down <red>-32.40%<red> [1]. The Hang Seng is down <red>-26.39%<red>. In Europe the German DAX is down <red>-23.74%<red>. In Canada, the TSX is down <red>-13.09%<red> [1].

Inflation is still a top concern for investors today. The latest U.S August inflation numbers stand at 8.3%, although this is a drop from the peak of 9.1% in June, core inflation remains high. Core inflation, which excludes volatile indicators such as food and energy, rose again to 6.3%, the highest since March, and above market forecasts of 6.1% [2].

In Canada, the inflation numbers look marginally better, but it is still much higher than the central bank’s target. Canadian CPI rose 7.0% y/y in August, below consensus of 7.3%. Core inflation in Canada slowed to 5.8%, down from the all-time high of 6.2% in June [3].

There is no doubt the economy is still overheating, and the Central Banks are doing everything in their power to bring inflation under control. As expected, the U.S Federal Reserve hiked by another 75bps in its latest meeting, making it the third consecutive 75bp interest rate hike [4]. The Fed tightening has also raised the specter of a recession in the near term.

The Folly of Forecasting

You may wonder why we do not change the portfolio based on what we think might happen with inflation, the Fed, the economy, etc. in the coming quarters or years. That’s because to profit from market forecasting, you must not only be right, but you must have better forecasts than everyone else. For instance, if most people expect the economy to grow 2-3%, and you predict 2.5%, and are right about it, there isn’t any profit to be made. On the other hand, if most market participants are expecting 2% growth, and the economy contracts -10%, and you predicted that, then you can expect to make a big gain. However, remember that almost everyone in the world has access to the same macroeconomic data, so the odds are stacked against you that you can consistently have better and more accurate forecasts vs. the rest of the world. In fact, I cannot think of a single person who has proven they can consistently make money this way. You do hear about the odd person who predicted the 2008 crash, but the truth is, you cannot rely on them to repeat this result (and think of the millions who predicted a crash in other years that simply never happened). Further, we need to respect that the economy is an incredibly complex machine with inputs and outputs that cannot be easily modelled.

John Galbraith once famously said “There are two kinds of forecasters - those who don’t know, and those who don’t know they don’t know.

Although it is impossible to consistently make money on macroeconomic forecasting, there is a more reliable and proven way to make money in the market – fundamental value investing. Although it is hard to know more than others on macroeconomic events, it is possible for an investor to have better insight into companies, or have an edge in particularly stocks, that others do not have (this is especially true with smaller companies that are less followed). This is the strategy we follow here. We buy when we believe a stock or asset is trading below its intrinsic value. There may also be extreme scenarios when we believe the whole market is trading at a level that is out of sync with the fundamental intrinsic value of assets, and we may change our portfolios accordingly. However, note we do this based on fundamental reasons, and not based on macroeconomic reasons.

Our Positioning

We believe long term investing is the best strategy to build wealth. It’s important to think of stocks as ownerships in businesses. All businesses have good years and bad years, but most business owners would not dream of selling their businesses because of a bad year. This is the same mentality investors should have with stock ownership.

However, many people have trouble making money in the market because they have trouble controlling their emotions in a downturn. Most winning stocks have been highly volatile. Take the example of Apple. This has been a hugely successful company. The company’s stock price from its IPO in 1980 to today has gone up over 1000x. However, to make that profit you would have had to suffer a paper loss of 80 percent – twice! There were also many drops of 40-60 percent along the way. Many winning stocks have been similarly volatile. It would have been a big mistake to sell some of these stocks due to volatility.

Owning a good business and holding onto it is a proven way to get rich. However, we do understand that clients have diverse needs and not everyone can hold a stock for 15-20 years. Therefore, we do offer different risk portfolios, with differing exposure to equity investments, and it’s also why we have a large sleeve of alternative assets in all our models. These assets have largely helped investors absorb the volatility this year, smoothing out the ride, and reducing our downside capture.

Moreover, we are doing some short-term shuffling to help our clients in the meantime. We have decided to swap some of our stock holdings, such as Carnival Cruise Lines and Intel, for industry ETFs. This is for two reasons. First, selling the stocks at these levels would help our clients reap tax loss harvesting benefits. Second, because in this case both the travelling and the semiconductor industries have seen large paper losses, the upside of owning individual stocks vs. the industry ETFs is similar, while the risks in owning industry ETFs are lessened. Thus, we felt it was prudent to make the switch.

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[4] https://www.bls.gov/cpi/

[5] https://www.statcan.gc.ca/en/subjects-start/prices_and_price_indexes/consumer_price_index

[6] https://www.bloomberg.com/news/articles/2022-07-13/central-banks-rush-to-quell-inflation-crisis-they-helpedcreate?

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