In this second quarter of 2022, individual investors’ sentiment hit levels not seen since 2009. History suggests that periods with historically low investor sentiment (1) usually precede a large tradeable rally, and (2) can create an attractive entry opportunity for longer-term investors. Market tops do not announce themselves beforehand, or even as they happen… and neither do market bottoms. On the contrary, at tops, it seems everyone is positioned for more bull market, and bottoms are often achieved when bullish sentiment is nowhere to be found.
Source: Bloomberg LLP
It’s not just individual investors. Institutional investors now hold the largest cash allocation since 9/11.
Source: B of A Global Research (FMS = fund manager survey)
These past few weeks have been marked by markets where nothing is spared; not even inflation beneficiaries, nor some of the perceived safe havens. Even if the current bear market cycle persists, expect certain areas of the market to see investor money rotate into them. The reason is that values are created during periods that see good companies’ shares fall 30, 50, 70 percent… or more. The bottom may not be in, but after such a rough several weeks for markets, the phase where it can pay to be selective may be where we are.
The negative individual investor sentiment could largely be attributed to the rapidly rising cost of living, and the social discontent that inflation can breed. For all thoughtful investors, both individuals and professionals, there are also the macroeconomic dislocations and geopolitical fears that accompany war. In this letter, we want to help investors understand where we are and where things might be headed, and share thoughts about what to do.
Before we go further into our thinking, we want to remind our clients and readers that we are here to serve. Every week, we invite you to call us with your questions and concerns — and of course, that’s more true than ever during a time of turmoil.
Where We Are: The Key Elements Impacting Sentiment… and Driving Market Volatility
A psychology of fear has moved to the forefront. The long-trained “buy the dip” mentality fostered by endless free liquidity is at an end, and investors are beginning to un-learn that habit. The ridiculous days of Dave Portnoy rolling dice to choose stocks, and boasting on Twitter about outperforming Warren Buffet… those days are gone. More rigor, research, and analysis are going to be required. As we’ve discussed in many recent letters, a slew of economic, financial, and geopolitical forces are operating to slow economic growth, and as for stocks… many individual and institutional investors are starting to doubt the ability of companies to generate growing real earnings.
Looking Back at History
What is happening may be generating new fears, but the fact is, this environment is not so very different from a script we’ve seen many times since our firm was founded in 1971.
- Financial history presents many examples of liquidity-driven excess and deviation from long-term historical price trends, valuation norms, and valuation methodologies.
- Usually, the source was the same as today: central bank policy feeding a nascent mania, or responding to the bursting of a bubble in a way that eventually fed another bubble.
- “History doesn’t repeat but it rhymes” — the confluence of events is different this time, but the essential structure is not different from many past bear markets (particularly the early 1970s, which also featured geopolitical and commodity turmoil, stagnant economic growth, and inflation).
The Market Has Adjusted, But Is the Adjustment Done?
Large price declines came for the most speculative names first, starting early last year; recently they’ve come for the “generals” (the mega-cap leaders, mostly tech stocks). A correction of the excesses is underway — valuations are falling; concentration in the biggest names is falling; interest rates and expectations are rising; market psychology is backing off from its faith that the Fed will ride to the rescue soon. The excesses are being removed — and no, they haven’t all been removed yet.
What Should One Do? Stay Calm and Keep a Clear Head
Stay focused on the big picture.
- Optimism leads to better results, because the trajectory of history is progressive, and we believe a wide view of history bears out this belief. Therefore, track the news and the risks, without letting yourself be swamped by pessimism and cynicism. Stocks are challenging, but there is nothing comparable for long-term returns.
- Opportunities are being created by sharply declining stock prices. This is the number one thought through which to filter incoming information.
- The engine of profit growth remains companies’ innovation and excellence — technological, operational, or both — and innovation is ongoing. Nothing that’s happening is derailing the new industrial revolution and the rise of transformative technologies that will power earnings growth for decades to come.
- Markets have weathered storms like this, and worse, many times in the past century, and will weather this one. There are always solutions that can mitigate risk, even if they can’t eliminate it, and we’ll describe what we’re doing below.
- Active management can adapt to changing circumstances, while passive management increasingly gives the prospect of depressed returns for a decade or more into the future. We choose active, and believe that you should too.
Our Strategy
As we highlighted in last week’s letter titled Time for a Bear-Market Playbook, we advise that investors have “some cash, some patience, and vigilance.” To say a little more about what we counsel, and what we’re working to do for our clients…
- For our clients, we have avoided “Ground Zero,” that is, the most vulnerable industries and market areas, the most exposed to a contraction of valuations and the most exposed to inflation risk — which we identified as a major threat at the very beginning of 2021.
- Since early 2021 we have also counseled exposure to inflation beneficiaries. Some inflation beneficiaries have been working – some, such as gold, are not yet working as we expected they would. But we think that day is coming, and we are patient.
- Be selective. Darts or dice are not likely to help you. Here are two slides from our May 5th Zoom call illustrating who we think actively benefits from inflation, and who is likely to be less impacted or protected from inflation. These are areas where we expect to find better opportunity right now.
- Stay liquid. Maintain a cash balance to both blunt volatility and to provide optionality. Not all assets or all securities will bottom at the same time. After everything has been declining in lockstep together, the breaking of that correlation can be one sign that a bottoming process is underway — so look for divergences.
- Allocate among asset classes according to prevailing economic conditions. Programmatic investment strategies don’t adapt in this way; we’re big believers in supplementing the numbers with a qualitative view informed by politics, geopolitics, and history.
- Allocate a portion to commodities and to commodity producers as long as inflationary and trade pressures remain elevated. We think that will be for a long time. Look for “necessities with increasing scarcity.”
- Be alert to companies whose growth story is intact, and who have defensible intellectual property or operational moats… but price matters. Wait for price to reach or overshoot a long-term norm of fair value on the downside.
- Focus on companies with good earnings and assets, strong balance sheets, and current growth prospects. Now is not the time for “hopes and dreams stocks for the future.”
- If you have the knack for it, tactical trading can capture some gains from volatility.
- Evaluate and re-evaluate all holdings regularly (we do this work every day) to confirm (1) that the narrative is intact, (2) that there has been no material adverse change in anticipated revenue and earnings trajectory.
- Don’t be afraid to trim or even entirely sell winning positions if you believe that remaining upside is limited. That way you can maintain your cash buffer.
- We don’t think this is a time for a rigid “buy and hold” the market mentality. Averaging into high-conviction positions will help reduce the risk that accompanies trying to time the market’s overall bottom.
- If you are still in the income-earning phase, don’t stop making regular contributions to your retirement accounts; indeed, you might want to increase them. It is impossible to catch the bottom exactly, but by making discriminating high-conviction allocations after significant declines, you are more likely to capture the very large gains that accrue once the bottom has been found.
- We also don’t think it’s the right time for investment tropes such as ESG. The data coming in these days show that there is little difference between ESG funds and other funds… besides the higher expenses associated with ESG. The declines are similar and in a bear market, platitudes offer little help. At Guild Investment Management we do employ values-based investing, and many of our clients have individual values-based rules about what securities they want to hold. How we do it is a far cry from just blanket ESG strategies that rely on some ESG “scoring” methodology.
- Remain alert and always looking for opportunity, regardless of market volatility. First find the theme; then study the company’s strategy, management, historical execution, industry positioning, and prospects; then evaluate whether the price on offer is a good one. If not, wait; but don’t forget. The ideas you love may eventually be on sale for a good price; be ready to take the opportunity.
Thanks for listening; we welcome your calls and questions. We will also repeat what we said above: we want to remind our clients and readers that we are here to serve. Every week, we invite you to call us with your questions and concerns — and of course, that’s more true than ever during a time of turmoil.
We’ll be hosting another Zoom call on June 20 — be on the lookout for the link, and please send us your questions ahead of time.
