#115 - Guillotines & Sandpaper

What a Bear Market Feels Like

Mar 13, 2022

Hi 👋 - I’ve been thinking a lot about bear markets recently, so I dusted off my notes on Maggie Mahar’s book Bull: A History of the Boom and Bust, 1982-2004. Mahar is a financial reporter who has written for Barron’s, Bloomberg, and Institutional Investor and her book looks at the history of market cycles through interviews with well known analysts, investors, and traders. Today, some key lessons from Bull.

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What A Bear Market Feels Like

The fall of 2008 was a weird time to join Wall Street. I began my career in Sales & Trading in September 2008. My first week, the Dow dropped 7% when the US House of Representatives failed to pass a $700 billion financial bail-out package. A grizzled trader who lived in Staten Island marched up to me and said, “this is all your fault.” In retrospect, this was classic trading floor gallows humor, but at the time I was so green behind the ears that I wasn’t sure if he was joking or not.

I’ve since escaped the trading floor, but the past few weeks have brought back some 2008 vibes. Swooning markets. A steady drumbeat of negative headlines. Fears ranging from World War III to 1970s-style stagflation to a bear market.

All bull markets end. Eventually the music stops playing and the punchbowl runs dry. While markets tanked in March 2020 amid Covid-19 fears, the panic was short-lived. The S&P 500 recovered almost as quickly as it fell, ending the year with double-digit gains. You have to go back to the Financial Crisis to find a more typical bear market, the prolonged type that shreds confidence and frays nerves.

The last decade has been an anomaly from a historical perspective. Typically, bear markets happen every decade or so. They’re often protracted and brutal. For example, from 1971 to 1981 the real return on the S&P 500 was negative. Between December of 1968 and October of 1974, the average stock lost 70 percent of its value. The recovery took almost six years. It was painful, as described by Bob Farrell, a former market strategist at Merrill Lynch1:

“A downturn normally has two stages, and investor sentiment goes through two fairly predictable phases,” said Farrell. “First there’s the guillotine stage—the sharp decline. That creates fear. That’s what happened in 1974. Then, the second stage goes more slowly—there’s the feeling of being sandpapered to death. The investor is whipsawed by a choppy market, and then worn down gradually. In place of fear come feelings of apathy, lack of interest, and finally, hopelessness. That is what happened for the rest of the seventies.”

Bear markets are also sadistic. Stocks don’t go straight down. Instead, declines are punctuated by sharp rallies, luring investors back into the market, only to be sucker-punched again. (This is why bear market rallies are called “sucker rallies.”)

Source: Investopedia, A Brief History of U.S. Bear Markets, October 9, 2021.

It’s easy to look like a genius in a bull market, but bear markets shake the confidence of the steadiest investors. To paraphrase Warren Buffett, the first rule of investing is capital preservation and the second rule of investing is not to forget rule number one. Mahar agrees. She sees conserving capital as the goal of a bear market. Survive to fight another day. Like bull markets, all bear markets eventually end too. When they do, bargains abound for investors with dry powder.

Extrapolate At Your Own Risk

Change is the only constant. The further you zoom out, the more obvious this is. On a long enough timescale, the probability of trends changing - be it to fashion, market cycles, technology, dominant industries, you name it - is 100 percent. It's easy to forget this. Insidiously, market cycles last long enough to convince us that they’re the norm. Additionally, there’s a tendency for people to believe that existing conditions will be permanent. Stocks can only go up, right?

Historical perspective is often lost amid short memories and collective amnesia. Mahar illustrates this point by quoting economist John Kenneth Galbraith, who authored A Short History of Financial Euphoria2:

“For practical purposes,” Galbraith wrote, “the financial memory should be assumed to last, at a maximum, no more than twenty years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to come on the scene, impressed, as had been its predecessors, with its own innovative genius.”

Galbraith’s observation is particularly sobering today. It has been over a decade since the last long bear market. In recent years, markets have soared, pullbacks have been brief (buy the dip!), and the combination of commission-free trading and apps like Robinhood made retail trading frictionless. As a result, a generation of investors has only known bull markets. When the market cycle shifts from bull to bear, as it inevitably will, there’s going to be some unpleasant surprises. (Hey Siri, what’s a margin call?)

Great Technology ≠ Great Stock

Like market cycles, jean widths, or top 40 charts, dominant industries also change over time3:

In each era, you have to ask, “Who are the richest people in the world?” Bob Farrell noted. “In the fifties, it was the Duponts, the industrialists. In the sixties it was Sam Walton—the growth was in consumer stocks. By the end of the seventies, it was the Arabs and their oil—in the eighties, the real estate tycoons, especially in the Far East. Then, in the nineties, you had the technology entrepreneurs. Now, something else is going to generate wealth.

While tech companies like Alphabet, Amazon, Apple, and Microsoft sport market caps north of $1 trillion and their dominance seems entrenched, you don’t need to rewind the tape too far to a time when AOL and Yahoo - companies recently sold for spare parts - were ascendant. Blackberry was once king of the hill.

Nothing is inevitable in business or investing, a point that Warren Buffett stressed at Berkshire Hathaway’s 2021 annual meeting. In 1989, thirteen of the world’s largest companies were Japanese, yet few investors today (myself included) have heard of Industrial Bank of Japan, Dai-Ichi Kanoyo Bank, or Kansai Electric Power. History suggests it’s likely that in 2055, the average investor will be as familiar with Apple as today’s investors are of the Industrial Bank of Japan.

Source: Yahoo Finance, Warren Buffett makes the case for doing what he says, not what he does, May 3, 2021.

Similarly, Mahar emphasizes that great technologies don’t necessarily make good stocks. Historical examples include automakers and airlines. (The list of bankrupt airlines is longer than a CVS receipt.) More recent examples are consumer electronics manufacturers (excluding Apple), food delivery, and ridesharing. In consumer technology, value capture is more difficult than value creation. Instant grocery delivery models like GoPuff, Gorillas, and JOKR are perfect examples. All of the surplus goes to the consumer and the businesses bleed cash.

While markets are cyclical, the factors driving high stock returns are constant. For companies, these include durable competitive advantages, wise capital allocation, and profitable reinvestment opportunities. For investors, buying at an attractive valuation is key. Valuation is cyclical too. As Mahar notes, multiples tend to revert to the mean. Another reason to be patient.