I’m sure you don’t need me to tell you that investment markets around the world have been experiencing challenging times over the past year. Shares, bonds, and property, everything is down and there’s been few places to hide.
So this week I wanted to consider what we could learn from past market declines. What can we take away to help us not only get through this current period, but perhaps even take advantage of the opportunities that might present.
When I think of market corrections there are three that spring to mind. Most recently we had the COVID correction of 2020. In 2008 we had the GFC, and it’s a while back now, but there was black Friday, the 1987 crash. For US investors, the Tech Wreck of the early 2000’s would no doubt also be on the list, but this wasn’t especially significant for us here in Australia.
Of these three, I think it is the GFC experience that provides us with the most insight for today, not because we are in danger of another financial crisis, but because this episode was drawn out, with 15 months elapsing between the market top and eventual bottom. In contrast, both the 1987 and COVID falls were short and sharp, which thus far at least has not been our experience in 2022.
The GFC period was really formative for me as a financial planner. In 2006 I had resigned from my role has an employed financial planner and started my own business. When starting out, I had been placed under the wings of another advisor, and unbeknownst to me at the time, he was thinking of retiring. That led to discussions in 2007 with us shaking hands on a deal in November of that year, the plan being that I would take over 1 July 2008.
As it turned out, share markets hit their peak in November of 2007, just as we were agreeing to our deal. By the time I was handed the reins, the Australian sharemarket was down around 30%. At the time I took some heart in this, as 30% was the average decline seen in bear markets. I hoped that the worst was behind us, and an upswing was just around the corner. This turned out to be kind of correct, however markets didn’t bottom until early 2009, and by that point our market had fallen over 50%. It was a brutal time to take over a financial planning business, but there’s no substitute for being in the trenches and fighting through to the eventual recovery. I’m a better advisor to my clients today, as a result of working through that period.
Declines can be long
The first thing then to take away from that GFC experience is that declining markets can persist for longer than you would think. That doesn’t mean the overarching narrative of market cycles is broken, just that you have to ensure your plans are calibrated to weather even the worst of storms.
As mentioned, markets bottomed in early 2009. What was notable about that low point was that absolutely nothing notable happened. It wasn’t like we knew at the time that we hit the bottom, it was only 6 or 12 months down the track, where we looked back and realised, oh hang on, that was the turning point. The same happened in 2020. Markets bottomed in March, but it wasn’t like COVID had suddenly vanished. For whatever reason pessimism gave way to optimism, and buyers outweighed sellers, bidding up prices.
This reality in part explains why those trying to time markets persistently fail. To be successful at timing markets you not only need to be correct in when to get out, but also when to get back in, and that getting back in in my experience is the harder of the two. The GFC demonstrated that other than by pure luck, buying at the bottom is an impossibility.
Market correction does not equal recession
Right now markets are declining on fears of a global recession in 2023. It’s interesting to note then that in none of the market corrections we are considering, were they accompanied by a recession. Our last fully agreed upon recession happened in the early 1990’s. Now perhaps this was a lagged effect from the 1987 market crash, but that is up for debate.
Australia managed to sidestep recessions experienced by much of the world in 2008 because demand for our resources, particularly from China, boosted our trade balance.
There are some who would say we experienced a technical recession during COVID, however most economists consider a rise in the unemployment rate to be an essential ingredient of a recession, and we didn’t see that in 2020.
- Australia need not necessarily experience a recession just because other developed countries do.
- The link between share market declines and Australian recessions is very weak.
One of Warren Buffet’s most famous quotes is “Be fearful when others are greedy and greedy when others are fearful”. Successful contrarians make a lot of money. None of us know what the future holds. We don’t know when markets will bottom, and we don’t know how quickly they will recover. But I think we can be quite confident cycles will continue. Humans will oscillate between being too optimistic, and then too pessimistic. It’s happened for hundreds, if not thousands of years, and there’s no reason to think anything has changed in 2022. Certainly, a learning from past market corrections is that those able to buy through these periods set themselves up for great outcomes down the road.
Central Banks still have our back
Ben Bernake, chair of the Federal Reserve during the GFC, recently received a Noble Prize for his academic work on bank failures and the importance of central banks in providing a financial safety net. Perhaps emboldened by the success of their actions through the GFC period, when COVID struck, central banks around the world showed the extent to which they could protect citizens and their financial security. Right now much of the market pullbacks are in response to the unwinding of this COVID stimulus, however that doesn’t deny the reality that should we experience a global recession in 2023, central banks around the world can quickly switch from their current contractionary policies, to expansionary policies with enormous impact. It might not feel like it right now, but the RBA and the Fed have still got our back.
One of the worst things to deal with during the 2008 market fall were margin calls. Margin calls happen when you use a particular loan product that was popular at the time called a margin loan, to buy shares or managed funds. These loans take the shares or managed funds as security, so they are particularly attractive for those with no home equity to offer up.
A margin call occurs when the value of the shares you are using as security drop to the point where the lender becomes uncomfortable. When this happens they issue a margin call. You, as the borrower, must come up with cash to bring the debt down. Back then you had 24 hours to get it done. Today it is 1 week. If you can’t tip cash in, the lender will sell your shares. Now, the margin call has only been triggered because your shares have dropped sharply in value. So selling them at this time is the worst possible thing. But coming up with the cash at such short notice is not always easy either. And it can be tough psychologically because you can feel like you’re pouring good money after bad.
Most of our margin lending clients in 2008 were able to come up with some cash to keep the lender happy, but there were some who either couldn’t come up with the cash, or just didn’t want to, and locked in losses when their investments were sold on their behalf.
Certainly, a lesson I took from this episode is to be very wary of margin loans. Today we use different solutions to gear into the equity market, and a key consideration is to ensure the solution does not hold the potential for margin calls.
Another learning from the GFC correction in particular is that diversification is not something just for the text books, it does matter. Australian property trusts declined by 79% in the GFC as the extent of their leverage was exposed. Thus far this time around the surprise has been bonds, where declines have been greater than shares. This for an asset class that it supposed to be the capital secure, defensive portion of your portfolio.
We never know which asset class will have the unexpected return, so be humble and diversify.
Our franking credit system results in Australian businesses being generous dividend payers. In good times, dividends can sometimes be ignored, but another learning I took from the GFC period was how stable dividend income tended to be. Dividend income is also “real” in the sense that you receive the actual money in your bank account for you to spend. This compares with the capital decline you are seeing in your portfolio balances, which is only reflecting the value you would receive if you sold your investments. You haven’t lost anything until you sell, so it’s information only.
Beware the short term noise
We all know that when we invest, whether it is buying shares or property, we are intending to be in it for the long term. The necessity of a long term time horizon is because our economy operates in cycles, with down periods all part of the deal.
Yet despite knowing this, I’ve observed that it can be hard to maintain this long-term thinking in the midst of market turmoil. There is so much noise from commentators telling you that this time is different, this time markets won’t recover, and you feel like you must need to do something. But of course, in almost all cases, doing nothing is precisely what’s called for.
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