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“Rational people don’t risk what they have and need for what they don’t have and don’t need.”
– Warren Buffett
Introduction
Many of the front-page trending articles this past month on Seeking Alpha have been predicting with confidence that investors should position their portfolios for a deep recession or depression. On the flip side of that dire expectation, many in the comment sections of articles (and a few contributors) seem to think that businesses will come out of this downturn in better shape than the bears predict and that the virus impacts with be short-lived. The consensus among the optimistic folks is that, via bailouts and stimulus packages, governments and central banks will be able to prop up stock prices and prevent a deep recession. With the market significantly off its near-term bottom from three or four weeks ago, it’s clear that the trend in recent weeks has been with the more optimistic bulls.
I don’t usually write macro articles that lack a specific actionable stock idea, but I think something has gotten lost in the macro debate and I want to address it, so this article will be a divergence from what I normally share. One of the things I think has gotten lost in the current discussion is that there are more than two potential outcomes for the market. If a person only focused on the dominant debate, they may think we have two choices: one where we go on to make new market highs within the next 24 months, and one where we experience deep, recession-like declines (or worse) during that time. But the truth is, in terms of how far the market might eventually fall, there is still a wide range of potential outcomes ahead of us.
If we only limit ourselves for the time being to a discussion of the potential drawdown of the S&P 500 (SPY, VOO) and think of the potential drawdown in 5% increments, that would give us 20 potential outcomes in terms of the ultimate level of drawdown the index will experience: 0%, -5%, -10%, -15%, etc.
As I write this, we are in between -15% and -20% off the market highs, so let’s say 3 of our possible 20 outcomes can already be eliminated at this specific point in time. That leaves 17 potential market outcomes using 5% increments in terms of how far the market could drop within the next 24 months off its highs (ranging from a -15% decline if a cure is discovered tomorrow to a -100% decline in the event of a successful Marxist revolution). One could, of course, categorize the range of possible drawdown scenarios any way they like, but for simplicity’s sake, I’m going to use three categories instead of 20 (which appears to be one more category than most market commentators are capable thinking about right now).
The first category I’ll call bullish, and I’ll put both those investors who think the market will come down and retest the current -35% bottom and then recover along with those who think the market has already put in a bottom and won’t be revisiting it in the next 24 months. At any rate, the bulls can be summed up as being of the opinion that the bottom is already in.
The second market expectation I’ll categorize as a deep recession that produces market declines on par with market drawdowns during the last two recessions. These folks include those who think some combination of economic contraction and high peak valuations back in February will contribute to a deeper decline in market prices. We’ll describe this wide category of outcomes in terms of a market decline with a range of -36% to -60% from the market highs.
And in the last category we’ll include the expectation of a depression in which the total market decline will be more than -60% off its highs.
Note that I’m avoiding a discussion, for the time being, of what the recovery will look like, and I’m only focusing on the eventual peak-to-trough decline.
Absolutism vs. Probabilities
If there is a single point I want to make with this article, it is about distinguishing between an absolutist mindset versus a probabilistic mindset. If we take the three broad categorical outcomes I mentioned above for the market – recovery, deep recession, or depression-level declines – the absolutists present what is essentially a false choice when they imply that you have to make a single choice between the potential outcomes.
A useful analogy might be to imagine a roulette wheel with three numbers on it, each representing one of our three potential outcomes. The absolutist would have you believe that all of your investment money is represented by a single poker chip and your job is to decide where to place that chip – in the recovery, the deep recession, or the depression square. That way of thinking does not reflect reality for most investors, though. The reality is investors have more than one chip to play.
Instead of thinking of this game with only having one chip to play, imagine having 10 chips of equal value. Now, given you have 10 chips, each representing 10% of your money available to invest, would you place all 10 of them in one category? Unless the probabilities were extremely skewed into one of the three categories, I think placing all of one’s bets in a single category would be irrational for most investors.
So, what we should be asking ourselves is what we think the probability is of each potential outcome. Already, our mind must think differently than the absolutist. We must now consider not just what broad outcome we expect is, but we must also place a number on how confident we are of that outcome. Given the level of uncertainty we now face in the global economy, it’s unlikely a rational investor would be 100% certain of any potential outcome. This should force us to more carefully consider the factors that may lead to a market decline for each category.
My personal estimate right now is that we have a 20% chance of a relatively quick market recovery where the current market trough of a -35% decline remains intact, a 60% chance that the market falls deeper and eventually bottoms between -36% to -60% off its highs, and a 20% chance the market falls further than -60% off its highs before finding a bottom. My portfolio is positioned with those probabilities in mind, and so are my pre-established “buy” prices for individual stocks. If the market falls -36% to -60% off its highs before recovering, I will most likely end up beating the market this cycle. If the market has already made a bottom, I’ll still do pretty well, but I’ll likely underperform the S&P 500 because I’m still holding a lot of cash, and that cash will likely be a drag on relative returns if the market goes on to quickly and makes new highs without first dipping lower. That’s not optimal, but I can live with it because I understand that there is a trade-off to not getting the broad market dynamics generally correct and carrying some insurance in the form of cash. And if the market falls more than -60% and has a depression-like decline, I won’t have good absolute returns, but I won’t be wiped out, and I’ll probably outperform the index and do okay longer term because I will have some cash to invest in stocks at very depressed prices. So, again, I’ll do okay, but not as optimal as if I held 100% cash until the market was down at least -60% and then invested.
It’s important to point out that my strategy, even if it is successful, will not make me rich this cycle no matter what the eventual outcome is. But I don’t think stock investors should expect to get rich off of their investments over the course of a decade. The very best investors might achieve a 20% annualized return over the course of their careers. Unless one starts with a lot of cash out of the gate, even those returns won’t make a person rich in a decade. For that reason, it doesn’t seem rational to me to take on the sort of risk that “absolutist” investors take, like placing all of their metaphorical chips on one outcome.
I will need money from my investments during retirement. I don’t see the need to adopt an investment strategy or an investment mindset that puts my future comfort and independence during retirement at risk, in order for the slim chance I could become fabulously wealthy by picking the best stock at the exact bottom of the current downturn. In other words, my strategy doesn’t risk what I have and need for what I don’t have and don’t need. It’s based on probabilities and not absolutes.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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