I feel this is my most important post for investors.
Early years I’ll share a bit of my background so that you can better understand where I’m coming from and get the most from this post.
My dad was a math teacher and from as young as I can remember I would always be playing math games with him. I took to numbers very easily and math was always my favorite subject.
My dad would have me do calculations in my head and I would love these types of games with him. In fact, my dad told me never to use a calculator until I got to university and until then to do math in my head or on paper.
Discovering the stock market I got interested in the stock market at a very young age. Fortunately, I was exposed to Warren Buffett almost from the beginning and read all I could about him, his company and his investing philosophy.
My love for investing led me to study finance in university. By the time I started my undergraduate degree, I felt I knew more than my professors but still wanted to soak up as much as I could – especially accounting.
From the time I started university, the goal was always to learn as much as possible, work in the investment industry to make money to best used to invest with and then leave the industry at a young age to invest full-time on my own.
After university I took the Canadian regulatory courses and then found work in the industry. This provided money to invest with and I would work during the day and study businesses at night.
After a few years of this, I decided to take the CFA to get a better paying job in the industry and so I worked during the day and studied at night. There are three levels to the CFA and it takes three years to complete. The good thing about the CFA is that unlike our Canadian regulatory courses that are only recognized in Canada, the CFA is recognized worldwide. In 2014 I left the industry to devote myself to studying businesses on a full-time basis and I put in 40 hours a week on it and sometimes more if I’m into something that I want to finish faster.
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My investment philosophy is not suited for others The way I invest is not suited for others.
My brain is wired a certain way. My investing emotions are wired a certain way: I don’t get thrilled by rising markets or stock prices and I don’t get panicky about falling markets and stock prices. I focus on the long-term. When I buy a stock it is as though I have purchased 100% of that company and it ceases to have a stock price. I often go for long periods of time without looking at stock prices that I own (however I look every day at stock prices of what I want to own).
I take concentrated positions and can do this because of my comfort level with the companies I invest in and my deep research in them before I buy. I hold for very long periods of time but am willing to sell sooner if a better opportunity arises – taking into account taxes as I don’t like to disrupt the compounding. Math always dictates my logic.
I always hold a large cash position (invested in liquid and safe assets). This is for two purposes: the first is that I always want to have access to a large amount of cash for buying opportunities – nothing worse than seeing a big buying opportunity due to a panic in the markets and not having much money to put to use. Lesson learned the hard way in 2008 when I was still employed.
The second reason is that I left the workforce in 2014 and so I don’t get a paycheque and am too young to receive pension money from my past employer. That money is in a LIRA that I invest. The TLV family has to live off what TLV has.
The cash that I do have is divided into two “pots” so to speak. The first pot is solely for investing buying opportunities and this currently represents about 40% of my portfolio (although I don’t think of it this way. I think of my stock holdings as 100% of my portfolio and the cash for buying opportunities as being a separate entity. If I say a certain holding is 20% of my portfolio I mean 20% of my stock portfolio and not of my stock + cash opportunity portfolio combined).
The second “pot” is divided into five parts and invested in laddered fixed income securities. I ladder them for 1 through 5 years. I have x amount for 1 year; x+5% for year 2, x+10% for year 3 etc. The reason why I increase this amount by 5% for each successive year is to plan for inflation.
When I calculate the value of my portfolio I don’t include my 5 years of living expenses nor my cash position (for investment opportunities). I say that I am about 40% cash and this excludes the 5-year TLV family living expenses.
Yes, my way of thinking is very conservative but it allows me to earn superior returns over time as it gives me nerves of steel – I actually get happier when markets are falling – and to capitalize on any buying opportunity if the opportunity is good enough.
All the dividends I get from my stock investments and interest from fixed income securities are either used to buy stock or to increase my cash buying opportunity pot and to await eventual redeployment.
I have staying power in any bad market. The TLV family will not have the lights shut off by the power company if a bear market lasts 20 years as the dividends I receive covers our expenses.
This is why I can be a very long-term investor and why it is not suited for others.
I believe the only person who finds the above remotely enjoyable to read is our good friend Sage the CPA - fellow numbers guy.
Inflation and the intelligent investor I’d like to preface this section by saying that nobody can tell you what will happen in the future. Not for inflation, interest rates, market levels, or life and anybody that says that they do know is either a liar or insane.
Do not take my high cash levels as me knowing for certain what will happen. I don’t. I always have high cash levels as expressed above. It is how I choose to live and invest. It suits my brain and personality and has allowed me to produce above average returns due to my style allowing me to focus on what really matters – the long term.
Note that I do not think positively of market timing and believe no person or AI can do so consistently. While I did sell GIB.A, I had owned it for about 15 years and have held it through a lot of market meltdowns and have done well with it. Also note that even though I believe we are in the making of a deep bear market, I rolled over all of my GIB.A proceeds into a new stock and did not wait for the bear market to be over to try to get a cheaper price
No. That would be stupid. First of all, I don’t know for sure it will be a deep bear market. Secondly, why should I wait for market clarity when the market is never clear? Thirdly, why should I wait before buying this new stock when the price is extremely compelling and will likely be an amazing investment that I can hold for a few decades? I can make a lot of money over time by having bought at the prices I paid and so that is good enough for me. I am not a market timer and I have beaten the market averages by a wide margin. I have a good position at a great average price and simply will buy more if it becomes cheaper. This is the only intelligent way to invest. Logic first.
This is my personal opinion of why I believe it will be a bear market. Again, I don’t know for sure. It is just an educated guess based on my knowledge of market history and psychology:
I feel we will see a strong bear market. There are a lot of moving parts to this (aren't there always) but the major points are:
1) Margins will decrease as a result of cost pressures and the eventual decreased consumer demand
2) Multiple contraction as a result of higher interest rates
3) The period of the year we will be entering soon
As for point three, investors have a tendency to shoot first and ask questions later and this is especially true in September and October. A disproportionate amount of bear markets have ended in these two months as this is where capitulation - brought on by the amplified speed of declines - have occurred. History is full of September and October sell-offs and hitting their bear market lows.
October used to be the worst month but since that is known by investors it has then become September. Eventually it will become August because if investors fear September they then sell in August.
Any investor that is 70 years old or more, as well as students of the market like myself, knows what happened in the 1970's and very early 1980's: Stagflation. This stagflation caused the market as a whole to trade at a single-digit multiple on
reduced earnings as a result of margin compression. This is a double whammy and this is what brings markets down more steeply than the garden variety bear market. If you add to this the psychological aspect of fear from past experience – either lived through personally or by knowledge of it – you get a triple whammy. This may happen as September and October are just around the corner. We are a few months into the market decline brought on by inflation and stagflation concern.
The period of 1973 – 1979 – United States Inflation ended 1972 at 3.3%. Not troubling. It only became an issue in 1973 when it ended at 6.2%.
1972 1979 Inflation 3.3% 11.3%
S&P 500 index 118 108
S&P 500 Price / earnings 18.1X 7.4X
Excluding dividends, the S&P 500 saw its multiple collapse from 18.1X to 7.4X while the market went nowhere for the 7 year period. However in real terms (to allow for inflation) purchasing power declined by 58% in this 7 year period. Put another way, $1.00 at the end of 1972 was only worth $0.42 cents at the end of 1979. So the S&P 500 adjusted for inflation fell from 118 in 1972 to 45 in 1979. This is what inflation does.
Need more proof?
Look at the P/E in 1972 and in 1979. It declined by 58.2%. So while the market average stayed relatively flat, the multiple collapsed by the same amount that inflation rose by. This is not a coincidence. This is math and the market was pricing in the reduced buying power of inflation.
2022 bear market What has the market done so far in the current bear market?
S&P 500 is down 19%
NASDAQ is down 30%
December 2021 to May 2022 Dec 2021 May 2022 Inflation 4.7% 8.7%
S&P 500 index 4,766 3,900
S&P 500 Price / earnings 23.1X 20.0X
You can see that the S&P 500 has fallen by 18.2% since the start of the year and by 19.0% since the start of the bear market.
Its p/e has fallen from 23.1X to 20.0X which is a 13.4% drop. Both the market averages and the multiple have declined by substantially more than what can be explained by inflation alone. This suggests two things:
- The fear that inflation will be more difficult to contain and the markets selling off in anticipation of much higher interest rates for a longer period of time
- The fear that the declining margins and stock multiples and higher interest rates of the 1970’s are starting to materialize today
This fear is the psychological part that I was talking about previously and this is what could turn a moderate bear market into a deep bear market even if inflation turns out to be not as ingrained as we are fearing.
At the end of 2021 the S&P 500 was trading at a very high multiple of 23.1X future 12-month estimated earnings versus a historical average of 15X.
At the end of 2021 the U.S. 10-year Treasury was yielding 1.52% versus and average yield of 6.4% for the period of 1990 – 1999 (I took this period as inflation was not too high or too low for this 10 year period. It was “typical).
At the end of 2021 inflation was 4.7% versus 3.0% on average from 1990 – 1999.
All of the above suggests the market is very overpriced as compared to normalized inflation rates, interest rates and trading multiples.
Canada not the same While our inflation is relatively similar and interest rates are still very low, our stock indexes are not overpriced to the same extent. We also have oil stocks that will show strength and so both coupled together will prevent the major averages from declining to the same extent as in the U.S. However, we are still overpriced and if fear does take hold in the U.S. it will most surely spill over into Canada and amplify the decline here.
Conclusion This is just my educated opinion but I cannot predict the future. Nobody can.
- Inflation will cause a very sharp increase in interest rates
- Inflation will sound scary for the foreseeable future
- We are in a bear market that will see S&P 500 fall 40%+ and NASDAQ 50%+
- Canada will fare better
- The fear and memory of inflation from the 1970’s and the effect of destroying the stock market in real dollars may make the declines even deeper
- In the end inflation will be tamed from the higher rates and modest recession and interest rates will come down again but not to the low levels we have seen
- The market will have been hit very hard due to it trading at very elevated valuations and was ripe for a big airing out
- You should never attempt to market time. Stay invested for the long-term. Just keep cash on hand for buying opportunities. This is where the really big money is made.
I hope this perspective helps investors.