“Back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he ‘could calculate the motions of the heavenly bodies, but not the madness of the people.’ Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price — and lost £20,000 (or more than $3 million in [2002-2003’s] money. For the rest of his life, he forbade anyone to speak the words ‘South Sea’ in his presence.”
-Benjamin Graham, The Intelligent Investor
As humans, we are wired to anticipate the unknown. It’s a survival mechanism that is baked into our DNA. One of the most common methods we utilize to determine the unknown is through “if-then” statements.
If I complete my “honey do” list around the house this Saturday, then my spouse will be happy, therefore I will have a good weekend. If I do not complete my chores around the house, then my weekend will be bad.
This methodology works phenomenally in many areas of our lives, but not with the publicly traded securities
The publicly traded securities market (a.k.a. the “Stock Market”) is an interesting animal. On the surface, it seems simple; if companies you own are more profitable, then your shares appreciate in value, therefore you have more money. if companies you own are less profitable, then your shares depreciate in value. But this is not what we see.
For Q2 2020 (April, May and June of this year), the estimated year-over-year earnings decline for the S&P 500 is -43.5%, according to the FactSet Earnings Insight published on June the 12th, 2020.
This means that companies are estimated to earn 43.5% less in April, May and June of 2020 than they did in April, May and June of 2019.
The same day this piece was published, the S&P500 closed at 3,041.31, marking a 5.5% increase from when the S&P500 closed at 2,882.73 on June the 12th of 2019.
This means that the S&P 500 was up in value (5.5%) while the earnings of the underlying companies that make up the S&P 500 are estimated to be down (-43.5%).
THIS MAKES NO SENSE, RIGHT?! Well, it doesn’t really need to make sense.
Granted, there are other factors at play here (trillions of dollars of stimulus from the Federal Reserve, optimism around an economic recovery, billions of different people’s opinions, etc.) but either way you slice it, the market does not always react in the way that a logical person thinks the public markets will react. An “if-then” thought process does not always work with publicly traded investments.
So, what do we do now and how do we make investment decisions moving forward?
If you accept the concept that you are unable to predict what areas of the market go up in value at any given time, your best bet is most likely to embrace the concept of diversification. This means that you own a diversified basket of high-quality investments across multiple industries, markets, and sectors.
After all, most people do not need to spend all of their wealth at one time, or in one year for that matter. So the desire we have for all of our investments to at all-time highs all the time is often tied to our egos and is completely unrelated to our actual needs.
The goal of proper diversification is to increase the probability that one of your investments is either stable or up in value in any given year. Should you need to spend some of your capital in a bear market, these are the investments you would look to liquidate to provide for you income need while you wait for the rest of your investments to recover.