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The Year Without a Santa Claus

Thursday, April 23, 2020

The Year Without a Santa Claus

The Year Without a Santa Claus is one of those stop motion animated TV Christmas specials produced by Rankin/Bass in the 1970’s.   Though not nearly as popular as Rudolph or Santa Claus Is Comin’ to Town, the special has its share of fans, not to mention a terrific horn line in The Snow Miser/Heat Miser Song.  In the show, Santa has come down with some sort of illness and his doctor tells him to switch up his routine by staying home for Christmas.  Santa becomes depressed because he can’t get out and do what he normally does.  Sound familiar?  As I thought about how the COVID-19 pandemic has affected our lives, this will no doubt go down in history as The Year Without ______.  The Year Without School, Concerts, March Madness, The Stanley Cup, Easter in church, Graduations, Wimbledon, Vacations, the Kentucky Derby, Dining out, the NBA Finals, Family Reunions, The Olympics, Flying, and….Toilet Paper.  It isn’t World Wars that have stopped most of these things from happening, but rather a virus .00012 millimeters in diameter.  This pandemic has taught us, or perhaps reminded us, of many things: the importance of teachers, the sound of voices raised together in song, the freedom to hop in the car and go, the hum of a crowded restaurant, and the warmth of an embrace.  It has also been a good reminder that life, and investing, are not without risks.   

 For more than 10 years, we had enjoyed a bull market run.  We had entered the 11th year of an economic expansion, the longest on record.  But most investors suffer from a phenomenon called recency bias.  Recency bias is simply a person remembering things that have happened recently, instead of remembering something that may have occurred further in the past.  When we have a string of very successful years in the markets, investors tend to be “lulled to sleep” by a market that seems to always be moving up.  Dramatic, market moving events like Black Monday in 1987, the bursting of the Dot Com bubble in 2000, and the Financial Crisis of 2008-2009, gradually fade from people’s minds.  But the risk is always there, and it eventually catches up and fulfills its promise to the law of averages.  You see, the average economic expansion lasts 5.5 years—we had gone 11 years.  On average, the stock market experiences a 20% correction every 2 years—we had gone 10.   The numbers suggested we were due, even overdue, for a reversion to the mean, but the cause and speed of the event we could not have predicted.  

 We teach and preach that stocks are for the long run.  You buy stocks because they have higher returns than (safer) bonds, if held long enough to reward investors for the extra risk they’re taking.  Sometimes that risk rises to the surface, and this is one of those times.  The tendency of stocks to beat bonds over time is called the “equity risk premium,” and it has proven to hold true over time.  Since 1900, global stocks have returned 3.2% per year more than bonds, with income reinvested.  In theory, that outperformance is the reward for the volatility of stocks and the danger of unexpected events, including pandemics.  Without a higher reward than bonds, the predictable returns of fixed income securities would be far more appealing than the gyrating swings of stock prices.  Stock investors should demand a premium future return to cover the uncertainty about what the shares will be worth when it comes time to sell them.  Part of that premium return is determined by what price is paid for the shares.  We already mentioned the outperformance of global stocks vs. treasury bonds since 1900, but that gap is even wider when looking at just U.S. stocks, which have beaten Treasuries by an average of 4.4% per year since 1900.  In fact, U.S. stocks outpaced bonds in every decade since 1900 except one, the 2000s.  The reason for this is the 2000s started at the peak of the dot-com bubble, with stock valuations at historically high levels.  So, to earn the equity risk premium, the keys are to, first, avoid buying stocks when they are historically overpriced, and, second, accept that the reason stocks beat bonds is because they are riskier.  

 At FMPWA, we start with the second premise—it’s why all of our accounts have an Investment Policy Statement or Investment Objective.  We never want to take more risk in your account than you are comfortable with.  If you can accept that stocks are riskier than fixed income investments, and the volatility that comes along with stocks, we will invest accordingly.  If stock market volatility makes you uncomfortable, we shouldn’t be investing in stocks.  It’s also the reason why the first question on our Investment Policy Statement asks about any expected upcoming withdrawals or ongoing cash needs.  If we’re doing our job, any funds that we know will be disbursed in the near term will not be subjected to stock market risk.  That should give you some comfort during times like this when equity risk rears its head.  The first key to earning the equity risk premium was to avoid buying stocks when they are overpriced.   One way to help determine if it makes sense to buy stocks is to compare their prospective returns to their main alternative, bonds.  U.S. Treasury bonds currently offer some of the lowest returns in history, a guaranteed 0.75% for 10 years.  Stocks are significantly cheaper than they were just two months ago, having lost a quarter of their value from the February peak.  The Price/Earnings ratio for the S&P 500 has fallen from nearly 20x on 12/31/19 to 16x as of 3/31/20.  The implied annualized total return for stocks over the next 5 years from these levels is close to 10%, while at of the end of the year it was closer to 5%.  Relative to bonds, stocks certainly look attractively priced right now.  But it’s important to remember that the equity risk premium is there because the future is uncertain, and uncertainty has rarely been higher than it is now.  

 Oh, I never told you how the TV show ends!  You see, Mrs. Claus sends some elves out to find proof that Santa is still important to people—and find it they do.  In fact, Santa is so touched by the outpouring of generosity and appreciation he receives, that he starts feeling better and decides to make his annual journey after all.  As the special ends, Mrs. Claus reminds us that “yearly, newly, faithfully and truly” Santa always comes.  It’s a fitting phrase for the situation we face right now.  It seems that yearly there are new challenges for us to face.  Throughout history, the human race has adapted, survived, and thrived in the face of challenges.  In the midst of this pandemic, we’re again seeing the best in humanity.  People are making homemade masks for medical workers, CEOs are taking pay cuts to keep employees on the payroll, messages of hope are being shared on social media, technology is allowing us to connect with friends and family in ways past generations could have never imagined.  From the American Revolution to the Civil War, The Great Depression to World War II to 9/11, this country has faced challenges, and “newly, faithfully and truly” we have emerged stronger.   That will be the case this time as well, and we will be here to help get you through it.  

 

Travis McEowen

 

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