I have a confession. The Escape Artist was not always the know-it-all smarty pants that he may seem today. Along the way, The Escape Artist has made plenty of mistakes, including the occasional cluster-fuck. This post tells the story of how I screwed up in one bear market and applied the lessons to make money in the next.
It is in market crashes that fortunes are lost by forced sellers and made by those with the mental and financial resources to buy. In bull markets people become complacent, use leverage and reach for yield. Its in the unforgiving environment of the bear market when the tide goes out and we see who has been swimming naked.
The Escape Artist has been around long enough to have seen a couple of full scale bear markets up close. In 2000 – 03, the FTSE All Share fell approximately 49% and then by some 45% between 2007 – 09, peak to trough. I learnt a lot about risk, investing and my own character from those two episodes.
Bear market #1 : 2000 – 03
The equity markets in the US and UK peaked around the turn of 2000 amid the champagne corks of millennial celebrations. At its peak, the US market traded on a Shiller PE of about 44x versus its long run average of about 16x, implying it was approximately 2.75x overvalued.
Those were dangerous times. I remember the Sunday Times introduced a column “Diary of a Day Trader” which told the story of an insurance middle-manager who had quit his cubicle job to day-trade stocks. That guy was not financially independent and had no edge other than he felt lucky, like the punk in a Dirty Harry film. As always with day-trading, it did not end well.
I mostly avoided being sucked into the bubble in tech company shares of the time. Lastminute.com, COLT Telecom, Freeserve and ARM were some of the highest profile in the UK at the time. I remember my elderly godmother, not normally given to gambling, telling me that I couldn’t afford NOT to have some ARM shares as they headed for the sky. If this isn’t a sell sign, I don’t know what is.
There is nothing more disconcerting than seeing people around you getting rich doing dumb things. Fortunately my financial conservatism kept me clear of the worst offenders although I confess to having some (ill-fated) Marconi shares and some Celltech shares (later taken over at a healthy profit) at the time.
In 2001, early in the bear market, I had a lightbulb moment. If a stock was never going to pay a dividend, then it wasn’t worth anything to me. Yes, I know that some valuable stocks (eg Berkshire Hathaway) choose not to pay a dividend. But that is very different from a company that is never going to pay a dividend because it can’t generate the surplus cash to do so.
I learnt from textbooks that the value of a share (P) is equal to the present value of the future dividend stream accruing to the shareholder. The formula is this:
P = __________
r – g
Where: div t+1 is the next annual dividend
r = the required rate of return or discount rate
g = the assumed rate of future dividend growth
Whilst I don’t use this formula to value stocks (it requires making long term forecasts which are unreliable), it reminds us that value results from cash generation and dividends paid out by companies.
My lightbulb moment came when I looked at the stocks in my portfolio and realised that a couple of them I never expected them to pay dividends in the foreseeable future. I was holding them in the hope that someone would come along and take them off my hands at a higher price. This is known as Greater Fool Theory.
I immediately sold everything that did not pay a dividend. With this simple rule, I avoided the worst of the tech carnage. This became known as the 99% club as these stocks lost almost all their value. But the losses were not confined to tech. As 2001 rolled into 2002 and 2003, the whole market kept grinding lower.
Some personal context is relevant here. In 2000 our first child had arrived and we lost the second income. We still had a mortgage then. In 2002, I changed jobs. Whilst it looked like a step up, I quickly realised that I didn’t like the new job. This was where the benefits of FI became glaringly apparent to me. What should just have been a career hiccup became a personal financial crisis.
My investment portfolio had previously exceeded the value of the mortgage, which I had been focussed on paying down. During the bear market, the value of my portfolio ground lower. I tracked its value versus the amount of my mortgage. Psychologically, this was agony to watch. I couldn’t avert my gaze, like watching a train crash play out in slow motion. What made it intolerable was the thought of losing my dream of clearing the mortgage and living debt free. With hindsight, I should have just stopped watching the screen.
The Iraq war was approaching. The world looked scary. There is no polite way to say this – I was crapping myself. I finally capitulated in March 2003. I sold every stock I owned. I took the proceeds and cleared the mortgage. At the time, it felt like the prudent course of action. In retrospect, it seems like treating a finger cut by chopping your arm off.
Timing is everything in market cycles. My timing was impeccably bad. I sold everything within a couple of weeks of the market trough. I then got to watch many of “my” stocks recover over the next 2 years. Unfortunately, I watched this from the sidelines, sick as the proverbial parrot.
I had allowed myself to become a forced seller. Firstly I was leveraged (the mortgage). Secondly, I allowed an arbitrary portfolio value to become a stop loss level. The problem with stop losses is that market volatility has an annoying habit of stopping you out, even when your position was sound. Thirdly, I ended up selling without a rational comparison of price versus value.
Bear market #2 : 2007 – 09
2000 – 03 had been about correcting overvaluation in the market. At no point was the capitalist system itself in danger. In contrast, 2007 – 09 was a systemic crisis. As George Dubya said: “this sukka could go down”.
After Northern Rock failed, being a contrarian with a fertile imagination, I didn’t find it too hard to imagine a doomsday scenario in which the entire banking system was pulled down by an old-fashioned series of runs on the banks.
Months went by and my nightmare scenario seemed to be playing out. The day after Lehman went down I remember the eerie feeling of walking around London wondering why more people were not panicking. I started to hear rumours of deposit withdrawals from even the largest banks. Why were all the leveraged hyper-consumers not flipping out? Did they not realise that Judgement Day was coming?
The equity market plunged. For a brief period, the greatest bargains in the equity market were the liquid, high quality names. Desperate funds had to sell to raise cash and the only stuff finding a bid was high quality stocks.
I sold all my small cap stocks. Ironically, in the early stages of the panic it was possible to get out of these without too much pain. It was as if in the mayhem the market-makers were more focussed on the trading action in large caps. I sold small cap risk and added large cap quality aggressively. I bought the highest quality, large cap companies that would be the last ones standing after a possible Great Depression. Meanwhile, I directed my pension contributions 100% to equities via a low cost global equity index tracker fund. It was scary but I held my nerve and added equity exposure all through the autumn and winter of 2008.
Buying more equities seemed a one-way bet at that point, akin to Pascal’s Wager. Either the whole capitalist system would implode and equities would be worthless (along with bonds or cash) or it would survive and I would ride the recovery. In an end of capitalism scenario, there would be no point holding any financial assets anyway, only shotguns and tinned beans would be worth having. The system did what it has always done and scraped through.
The key difference between the 2 episodes was mental. In 2008 I was debt free, held better quality assets and was prepared to ride out the storm. I had learnt my lesson from 2002 – 03. As the market recovered in the years after 2009, my portfolio did very well.
Bear markets are the friend of the long term investor. If your supermarket temporarily marked everything down by 50% you’d respond by stocking up the cellar with non-perishables. Why should stocks be any different? I don’t know when, but another bear market will be here before too long. Logically, I know this will be a great opportunity, even though it will feel scary. We will just have to keep our heads.