The second leg
As with life in general, investing often only makes sense looking backwards. In the moment, events can occur that are positive for asset prices, but over time turn out to be the opposite.
An example could be the tragic and appalling events in Ukraine boosting the prices of energy stocks: this could be negative for these companies in the longer term if they encourage companies and consumers to use structurally less of their products.
Equally, the rise in interest rates around the world feels like a negative in the short term, as it decreases the value of all assets to some degree; yet it could be a positive as it allows existing and future investors access to opportunities at more favourable prices, even after adjusting for higher interest rates. We don’t know either of these things yet, but the answer to most of the current vexing questions in financial markets is: ‘It depends’!
With respect to equities, we are now officially in a bear market. It started in mid-November 2021 and has lasted for around 150 days. It is entirely normal that after such a prolonged period of falling asset prices investors are feeling downbeat and concerned. The questions now are how much longer it will continue, is it too late to sell and are there any opportunities appearing?
It seems to us that we’re now in the midst of a two-legged bear market. The first leg, led by an interest rate-induced derating, is arguably largely over unless inflation genuinely is out of control on a longer-term view. The second leg, led by a recession and earnings downgrades, has just begun. It is unusual to get this type of bear market. Usually into a recession, interest rates are falling, so decreasing profit expectations are offset by falling interest rates, which helps the future value of profits via lower discount rates – one offsets the other. Equally, rising rates are usually at a time of strong economic growth so the negative valuation effect of rising discount rates is offset by rising corporate profits. The removal of this inverse relationship between interest rates and profit cycles is the key reason why equity markets and other classes have been weak; it is hard to make money at a time of rising interest rates and falling profitability.
How long could this second, earnings-led, bear market go on for? Before answering this, one golden rule of investing needs to be repeated: never invest in the present. This is a fundamental mistake that we regularly see investors make. Investment markets look to the future, not the present, typically on a 6-12-month time horizon. Therefore, the key question is not what the health of the economy, and therefore corporate earnings is today, but what it will be beyond that time horizon where markets have yet to discount it?
This is an intriguing question. Looking beyond the currently-discounted 6-12-month time horizon, what will the world look like in the second half of 2023? Will inflation concerns still be prevalent? Will we be in a recession? Will the war in Ukraine have been resolved? The answer to these is subject to much debate. We have no privileged access to the future, of course, but these are the right questions over the right time frame to start the process of thinking about markets.
Sustainable strategies are short carbon and long duration, which has not been a favourable combination this year. Both characteristics have been fundamental and powerful positive drivers of performance over the last decade. On carbon, the path to decarbonisation has been clear with the environmental consequences of climate change becoming more apparent as each year passes. We doubt this has changed, and it may have even been accelerated by recent events when considered over the long term. However, in the short term the social and economic consequences of energy shortages means, maybe justifiably, climate will take a temporary back seat.
With respect to long-duration and growth investing, most structural capital appreciation in investing occurs by investing in the future, not the past. Value investing, which is in vogue at the moment, has some fundamental flaws, the most notable being the finite level of returns it can deliver on a structural basis. Fixing the past, which value investing often is, can be profitable but can only be done once. Creating the future is an infinitely profitable opportunity. Value investing tends to be linked to business models that are weakening due to structural changes in the economy; conversely, growth investing tends to be in business models that are getting stronger.
Of course, both investing styles have their risks. Value traps, which occur when value investing is ineffective, are a consequence of a superficially attractive valuation attached to a flawed business model – with the business model winning out. Growth traps, which occur when growth investing is ineffective, occurs when the business model is strong, but the valuation paid to own it is too high. Both these traps can lead to weak investment outcomes but, in our experience, there is less risk in paying a high price for a good business than a low price for a poor business, whose outlook is structurally declining. Good growth and value investors learn to manage these risks effectively.
It is important to accept that any investment style will have periods of under- and outperformance; that is the price of an identity. Being low-carbon and long-duration this year has not been favourable, but they remain strong in their likely long-term and positive influences on investment returns and we remain committed to them.
Bear market mentality
Investing during bear markets is much more challenging than in bull markets. Any sailor would want the wind on their backs and the sun in the sky. In the same spirit, no sailor would expect not to have to sail in headwinds and rain. Sailors (and investors) do, however, need to be able to deal with both. Here are some suggestions for navigating bear markets:
- Don’t panic! There are no investment circumstances where panic results in a better outcome. Investing is fundamentally a calm and unemotive occupation. We make our best decisions when we have time to think about them and a clear head. For long-term investors, doing nothing has at least the same probability of success as doing something.
- Don’t forget to see the opportunity. Most successful investors sow the seeds of future returns in bear markets. Lower prices are better entry points than higher prices as, over time, economies grow and markets make new highs. In hindsight, it would have been wrong to sell when the Global Financial Crisis or Covid pandemic hit stock markets – indeed, the opposite turned out to be true. Only time will tell if now is a buying opportunity, but at least asking whether it could be is a very effective antidote to the pervasive negativity we are currently seeing.
- ‘Fit body, fit mind’. Unlike bull markets, the relentless downward grind of bear markets is very wearing. Like many companies these days, Royal London now has an overt focus on the wellbeing of its employees. Other than being compassionate, happy and healthy employees are also more productive. Investing in bear markets can be stressful and that is something to be actively managed. Although advice such as taking exercise, getting adequate sleep, and thinking about the food we eat may seem trivial at times like this, these are all effective in helping us to make better decisions and deal with pressure.
Bear markets come and go – this is a feature of investing. Expecting them beforehand helps you to invest in a way that makes them manageable when they come. It also helps with seeing the opportunity within them. Although we can’t predict the end of this bear market, we can see the opportunity in it, which for us is to own some great businesses at lower prices than we would have been able to do so otherwise.
Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.