Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
January 2023The Dow Jones Industrial Average Since 1900
ne of the tools used by Wall Street’s so-called “technicians” involves the study of short-term price charts, looking for patterns that will help them divine the future movement of a stock or the markets (a practice panned as “hocus-pocus” by serious investors). We, on the other hand, have always found it truly useful to ponder a long-term graph of a market index such as the Dow Jones or S&P-not to predict the future, but to see where we’ve been and what obstacles had to be overcome to get here. It is also instructive simply to see the kinds of things that happen over decades of market history. The longer the time period the better-a century is good, since the further back you go the more unreliable the data becomes. One hundred years also provides a good picture of practically all possible market events (at least in the U.S.), from catastrophic plunges in the early 1930s, or brief crashes (as in 1987), to raging bull markets (as in the 1950s or 1980s, and more recently in the 2010s). Each episode of this history had its own story, which led to subsequent segments of the long-term drama.
There are important lessons to be learned from such a high-altitude view of the flow of events, the first and most important being that the economic life reflected in the financial markets goes on, despite interruptions and challenges along the way. The major market collapses that have occurred periodically over the decades were temporary setbacks in a long march to higher heights; even the Financial Crisis of fifteen years ago, the event still in living memory for the larger segment of market participants, is gradually receding into the past. On the other side, we find that the most powerful bull markets come to an end as the flow of money into securities exhausts itself, for whatever reason; “trees don't grow to the sky,” is an old Wall Street aphorism. Of course, experiencing these periods firsthand is very different from reading about them or viewing charts in hindsight. During a market slump (and the economic difficulty that often accompanies it) it is difficult for people to see beyond their current challenges, and they often wonder whether prosperity will ever return. During a lengthy rise, the opposite occurs: enthralled by optimism, market participants tend to project the present onto the future, and warnings of excess are mocked as the envious whining of old fuddy-duddies. The fact that we have always recovered from bad times brings little comfort to those struggling through them; that trees have never “grown to the sky” does not discourage those caught up in the speculative frenzy of bull markets. Yet, through all events, the markets have made their way and eventually marched higher, so far at least.
Our long-term overview also reduces the tendency to think in terms of discreet time periods of short duration. Humans are perhaps naturally inclined to focus on short-term needs. Finance reinforces that bias through mechanisms such as corporate planning and financial reporting schedules, and by the investment industry's overwhelming concentration on quarterly and annual results. If one believes what one sees on the internet, it appears that many find even daily “performance” figures to be valuable. But the real world doesn't operate this way; nature, including human activity, is always in flux. Viewing a period in time without its long-term context misses the gestation of ideas, the transitions and development that form the whole of experience. The best businesses invest for long-term payoffs that may be many short-term cycles away, as do the most astute investors. Another Wall Street aphorism — “being early and being wrong look the same” — reflects this insight. Those who focus on the immediate present will never know which is truly the case.
This leads us to a third lesson, which is that concentrating on a fleeting moment creates bad incentives that lead to faulty decision-making. A person caught up in the throes of a downturn who fails to understand that such occurrences are part of the normal sequence of events may choose to sell out and flee the market, thereby losing both their initial investment and future opportunity. Another, enthralled by a long market advance, sees no end to the riches to be made, and buys at ever-higher prices, only to suffer in the inevitable setback to come. The parties in each case do the opposite of what would be wise, selling when they could be buying at low prices, and buying when, if anything, they should be selling or avoiding risk. Seeing beyond the exigencies of the moment doesn't always prevent mistakes or losses, but it does improve the odds.
A final thought on the interpretation of our long-term graph: in a century of history, markets have always recovered from downturns, but nothing guarantees that the future will unfold in the same manner as the past. Nevertheless, market history is the best guide that we have to inform our expectations and decisions as investors, the ultimate outcome of which will be determined by unknowable future events.
There were few places to escape 2022’s financial market rout which wiped about $30 trillion of value from securities worldwide. In the U.S. the popular stock market indexes all declined, from about 7% for the Dow Jones Industrials, to nearly 33% for the NASDAQ index, which includes many big technology companies whose shares fell sharply last year. Other gauges fell somewhere in between. Only a few sectors — such as energy and pharmaceuticals — offered positive returns. Fixed-income — normally expected to add “ballast” to a portfolio, off-setting the volatility of equity — was not spared, with indexes down about 15%. The Financial Times reported that long-term U.S. bonds had suffered their worst decline since 1788. Not surprisingly, this market action wreaked havoc on traditional asset allocation models (such as 60/40), which had not done as poorly during the last 90 years. Retail investors, many of whom during the pandemic had embraced stock trading, saw $15 trillion of stock value evaporate, and assets fled equity funds at a record pace.
Worldwide interest rate increases in response to elevated inflation were generally understood to be at the root of the market turmoil last year (though “more sellers than buyers” seems as useful an explanation as any). Market value losses drew most of the attention. However, a more in-depth analysis reveals the extensive damage that has been inflicted on parts of the financial markets, some of which are normally hidden from public view. One notably public blow-up was in crypto, which saw price collapses in even the most widely traded “tokens,” and the bankruptcy of one prominent exchange (proving that when times get tough people go for real cash, not the trendy blockchain stuff). Additionally, many low-rated companies and nations that had taken advantage of low rates and high demand for “yield” to raise funds in the “high yield” markets are suddenly facing the prospect of paying truly high yields as they re-finance their debts (look out for restructurings and bankruptcies to come). “Collateralized loan obligations” underlain by high-risk loans from junk-rated companies also face refinancing risk (shades of the Financial Crisis). The operation of the U.S. treasury bond market usually draws scant attention, but a problem with liquidity (the ease of buying and selling) has raised alarm in some quarters, as treasury securities serve as a benchmark for other financial transactions; the ability of the government to fund itself could also be affected. Finally, the crisis in UK pension systems in Fall 2022 reminds us that squeezing markets to get a required return that is not readily available on reasonable terms just forestalls trouble for a future rainy day, which is the opposite of what retirement plans are supposed to do.
Numerous warning signs in recent years — from overly easy access to credit by risky borrowers to run-amok speculation in crypto currencies, dodgy stocks, and “SPACs” — indicated that markets were on dangerous ground. It took the unexpected catalysts of high inflation and a dramatic rise in interest rates to deflate the bubble, creating havoc in global finance. 2022 ended with market participants in a pessimistic mood. Some expected inflation to remain “stubborn,” while others even saw a risk of hyperinflation. A few central banks fled to gold. Investors who were “ditching stocks at record pace,” as the Financial Times reported, were indicative of the bleak outlook.
As investors we are once again faced with a question that is fundamental to our craft: does the selloff in asset prices that has already taken place sufficiently discount the expectations of what is to come, especially for assets that are genuinely deserving of investment interest? An end-of-year news-service headline drew our attention: “80% of Americans think U.S. will experience great economic difficulty in 2023.” If true, this suggests that quite a bit of discounting has occurred to date, but since opinions are a thin reed on which to base an investment case, let's return to the traditional “60/40” asset allocation model — whose failure was emphasized so much last year — to see where we stand at the present time. The 60% part — equities — has seen prices drop by about 20% on average, and much more in some cases. The bond segment, 40%, has dramatically changed over the past year: safe government bond yields have risen from near 0% to over 4% for some shorter-term issues, and non-sovereign issuers now offer returns more appropriate to their added risk. One prominent observer, an active participant in the bond markets, maintained that bonds are “investable again” for the first time in years. So, it seems once again that even the simple 60/40 program offers investors a better opportunity for positive results than has been seen during most of the period since the Financial Crisis.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field since 1983 and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at <www.businessforum.com/cscc.html>.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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