GOOD ENOUGH
A SOLUTION FOR A COMPLICATED SITUATION
Two Sundays ago, long-time 60 Minutes correspondent Bill Whitaker interviewed Todd Semonite, the Commanding General of the U.S. Army Corps of Engineers. Whitaker asked the general how his units were responding to the COVID-19 threat in New York City. Semonite’s response was direct and stark.
“We don’t have enough time to do this the normal way. This is an unbelievably complicated situation. It’s a catastrophe. We can’t have a complicated solution. What we need is a very simplistic concept, what I call the ‘good enough design’. If we try to do any more than good enough, we will miss the window.”
This has meant turning the Javits Center into a hospital, setting up temporary medical facilities in Central Park, and docking the USNS Comfort in Manhattan. The concept isn’t perfect, but given how rapidly the situation is unfolding, it has been the most effective option. Investors are facing a similar situation and would be wise to adopt an equally similar solution.
THE BACKDROP
After falling nearly 35% by the middle of March, this selloff has been the fastest on record (as of March 31st, the market was down ~25%).
Peel back the onion a bit more and the situation is even more extreme:
- ~30% of the stocks in the S&P 500 index fell more than 40%
- ~15% of the index fell 50%
- ~10% fell close to 70%.
Thar carnage was far from limited to the S&P 500:
- Small cap stocks fell close to 40% with small cap value falling 45%
- Oil fell nearly 70% and the energy sector fell more than 50% off an already low based
- Sub sectors like travel and leisure have been decimated.
Has this selloff been unprecedented? In speed, yes. But in magnitude, actually not.
As the chart below shows, this has been the 12th correction of more than 30% since 1928.
Undoubtedly, a dire picture on a backward looking basis. On a go-forward basis though, a very different picture emerges. This chart holds the key for most investors.
In each of the eleven past cases, the recovery after eventually reaching a bottom was incredibly strong. On average, the market returned +52% in the first year, +89% in three years, and +132% over five years. Just as importantly, the minimum total return over the five year period was +85%.
So, what are the chances that the low point hit in mid-March will mark this bear market’s bottom? The fact is, no one knows. So instead of wasting time with fruitless forecasts, focus on the knowable -- what future returns would look like if the market were to return to February’s all-time highs.
A Path to Recovery
The chart below maps out potential recoveries from various market declines assuming it takes between one and five years to reach those prior highs. For example, from today’s levels (down ~25%), if the markets fully recover a year from now, the S&P 500 would return 33%. If it takes two years for the market to recover, this would equate to a +16% annual return. Three years? A 10% annual return, and so on.
So where does that leave us? The good news is that if we model a conservative base case scenario of a three-to-four year recovery for the S&P 500, a dollar invested today would compound at ~9% annually. The better news is that even if the markets continue to fall from current levels, our odds of even stronger future returns will improve meaningfully. Look no further than the fact that a three-to-four year recovery from a 40% selloff would equate to an annual return of ~16% and a 50% selloff would equate to a 22-23% annual return. Said another way, despite the enormous challenges that continue to lie ahead, the backdrop for equities is actually quite favorable, especially if you apply a “Good Enough” approach.
GOOD ENOUGH
In order to understand the value of a “Good Enough” approach, it is helpful to first understand the challenges with a more complicated approach.
For years, investors have been led to believe that private market funds (namely private equity and venture capital) would be perfectly suited for this type of scenario. After all, with the economy in distress, shouldn’t this be the perfect opportunity to deploy all that “dry powder” raised in recent years? Not exactly. Private market investing is simply too complex. Its illiquidity, dependence on available credit, intricate deal structures, and reliance on willing sellers make deploying capital in these moments incredibly difficult.
On the flip side, unlike private markets, public markets have endless liquidity, are not dependent on available credit, and can handle endless transactions. Most importantly (and ironically), when private market sellers are most unwilling to sell (i.e. during downturns when the valuations attached to their companies fall), public market sellers are often most eager (i.e. panicked selling). In this case, the key to taking advantage of these moments is by understanding the odds.
Understanding the Odds
Understanding the odds starts with establishing reasonable upside and downside cases. As mentioned earlier, let’s assume the upside for the S&P 500 today is a return to the February highs (3,400). For the downside, let’s assume a selloff that mirrors the decline during the Great Financial Crisis “GFC” (roughly 55% or 1,530), which is reasonable as opposed to a Great Depression-type scenario given the dramatic response taken by both the Fed and Congress.
So how would this upside/downside scenario look? As illustrated in the chart below, the upside from today’s levels (currently -25%) would be +33% vs. a downside of -40%. If the market finds itself down 35% from the highs, the upside is +54%, while the downside is -31%. If it’s off 50%, the ratio becomes 100% to the upside and 10% to the downside.
The key here is that like the virus, the growth to the upside is more exponential than linear the further the market declines.
Approach in Action
So how should this affect an investor’s approach? Much like the Army Corps of Engineers, the key is to implement an approach that is “good enough” -- one grounded in a combination of thresholds, funding sources, and investments.
Timing and Selloff Thresholds
History provides some guidance as to when markets bottom, but it’s far from decisive. This said, timing can be mitigated by simply staggering investments based on timing and selloff thresholds. In other words, something akin to a “public market capital call” schedule tied to a few rules.
- Determine how much capital you can deploy -- this will be different for everyone, but at minimum it should be enough to impact portfolio performance.
- Set a fixed schedule of investments, be it weekly, bi-weekly, monthly, etc. on which to commit to investing a portion of your capital
- Establish specific percentage decline thresholds that will force an acceleration of the schedule (i.e. if the market drops a specific percentage, deploy more capital than is scheduled).
Nick Magiulli and Ben Carlson of Ritholtz Management illustrated how the most simplistic “public market capital call” approach would have looked during the Financial Crisis by showing the effect that investing $100 each month starting at the peak in 2007 would have had. If they had incorporated a percentage threshold and invested more than $100 during the periods of most distress (and when the odds tilted more in their favor), it would have only magnified the effect.
Sources
For obvious reasons, the first source of capital would ideally be cash and fixed income. To date, it has been the only asset that has held up this year across the board. The next will be assets that have held up better than others (i.e. select hedge funds or sectors like consumer staples and utilities).
Targeted Investments
The most important action at these times is to add equity exposure (beta) during downturns. In its simplest form, this would mean investing in the S&P 500 on a regular schedule. However, a good enough approach can certainly be more targeted and granular. Just note that while doing so can increase an investor’s upside profile, it also adds a layer of additional risk and lack of reversion to the mean clarity. Examples could include moving capital from large caps to small/mid caps, growth to value,and passive to active managers. It could also mean shifting capital into asset classes that have suffered the brunt of the sell off (energy, financials, industrials) and even into individual companies given the fact that there are hundreds of stocks that are down 60-70% or more.
The bottom line is these are the times that separate the “wheat from the chaff” among investors. From my experience, despite many claiming to do so, only a select group of investors lean in despite the sell off having shifted the odds in their favor.