“Everyone I know that has accumulated wealth, whether it’s Warren Buffett, Ken Langone, Mario Gabelli, made their fortunes out of buying weakness and selling strength… You buy weakness and you sell strength. That’s the way to make money in the market.” – Leon Cooperman

Every market decline is surprising when it happens. Despite repeated calls for the end of the constant bull market of the last decade, the most recent decline feels shocking, even to the very people who say they were expecting it. At Ensemble, we firmly believe that short term moves in the market are driven by so many complex factors that they are completely unpredictable. This is conventional wisdom for many investors, but we would go even further to argue that short term moves in the market are not just unpredictable, but cannot even be explained fully in retrospect.

Let’s look at the current market correction as an example. Why is the market down 20% in the last three months? According to most observers, the prime suspects are 1) The Federal Reserve raising interest rates and using other tools to make financial conditions more restrictive, 2) increasing odds of a recession in 2019, 3) the increasing intensity of the trade fight with China, 4) Trump, 5) Algorithms, hedge fund liquidation, selling of index funds, etc. The fact is these are likely all part of the mix but so are other drivers. The only unambiguously correct answer is that there are more people wanting to sell stocks than buy stocks and so market prices are adjusting downward to a new equilibrium price that balances supply and demand. But let’s look at some of the prime suspects nonetheless.

The Fed
There is no doubt that the Federal Reserve’s decision to increase rates and reduce their holdings of bonds is one of the drivers of market returns. However, the Federal Reserve’s policy is not new. Everything they have done this year is consistent with what they’ve been saying they would do all year long. So it isn’t credible to say that the market was rising earlier in the year but is falling now due to the Fed even as Fed policy is unchanged. We wrote about our view on Fed policy and how it is interacting with market expectations back in October.

Recession Risk
Fears about a 2019 recession have skyrocketed recently. However, real economic indicators have remained strong. We wrote about potentially rising recession risks in November. While there are few real economy signs of a coming recession, we know they are very difficult to predict. But most of the warning signs are coming from the financial markets themselves rather than the real economy, so it is more accurate to say that the falling stock market is indicating a recession might occur in 2019 rather than that the market is falling because a recession might occur. Investor economic expectations are changing due to the market rather than the other way round.

China
There’s nothing new about the potential for a trade war with China. Everything that has happened so far has been well communicated as US policy since Trump became president. Even if you disagree with this policy, it does appear that to date China has suffered more from the tariffs in place so far compared to the US and thus it may be that the US is “winning” the trade war. It is true that a March 2nd deadline has been announced for either a resolution or much heavier tariffs to be introduced. But none of this is a big surprise to anyone following the news for the past two years and the deadline is actually an extension of what was previously a deadline of December 31st.

Trump
For some investors, simply Donald Trump being president is enough of an explanation for the market decline. But if that was really a major driver, it is difficult to explain why the market had done so well for the two years after he was elected. We do think that the rumors that Trump might try to fire Fed chairman Jerome Powell is a clear negative for the stock market regardless of your partisan leanings. Central banks make their fair share of mistakes, but it is very clear that almost all strong economies have independent central banks and generally only weak and failing economies have central banks that fall under the control of politicians. But Trump’s threats on this matter only emerged over the last week and so don’t explain the large majority of the market decline. In fact, like with recession risks, Trump’s threats are more an outcome of the market decline rather than then driver of the decline.

Algorithms, hedge fund liquidations, and index fund selling
Have you ever noticed that no one ever blames a rising market on technical issues like algorithmic trading, hedge funds levering up or index fund investors putting more cash to work? These only get blamed for downside moves in the market. There certainly may be some hedge fund liquidations going on and relatively new phenomenons like algorithmic high speed trading and a much larger share of stocks being held in index funds might be leading to higher short term volatility. But hedge fund liquidations and selling by index fund investors are being triggered by the market decline, rather than being the driver of the decline. The only real example of technical factors such as these being a major factor in a large and persistent market decline is the 1987 crash. Conventional wisdom holds that “portfolio insurance”, a then popular risk mitigation strategy created a cascade of selling as too many people tried to rush out of the exits at the same time. But even in retrospect it isn’t clear that was the primary reason for the decline and instead was just one of the contributing factors.

It is hard enough to come to terms with the fact that you can’t predict short term moves in the market. It is even harder to come to terms with the fact you can’t explain short term moves in the stock market even in retrospect. But releasing the human need to cram everything in life into a neat, explanatory narrative is a critical part of freeing yourself to focus on the long term trends that can and should be analyzed and acted on.

What we can do however, is understand how markets behave so that rather than being surprised by every large move up or down, we instead can understand when something truly unusual is happening and have a frame of reference for what might happen in the medium to long term.

Here’s a handy guide to the frequency and depths of market declines

• 5% declines: About three times a year
• 10% declines: About once a year
• 20% declines: About once every four years

These sorts of declines as well as the more severe declines that occur much less frequently, have occurred within the context of the market generating average returns of about 9%-10% per year. While volatility has been lower than average in recent years, it was back in January that we had our last 10% decline (ie about a year ago). While technically the market decline in 2011 was just a hair under 20%, it was 19% and change. So the duration since the last 20% decline has been longer than normal making this decline completely consistent with long term market behavior.

Of course what we all really want to know is what will happen next. Our urge to explain the past in a neat narrative is really about our desire to be able to predict the future. But while we can’t predict the future, we can look to the past to see what has generally happened after the market declines 20%.

Ben Carlson has a useful analysis of past declines like we’ve seen this quarter which you can read in full here. But the punch line is that declines like the one we’ve seen this quarter have seen the market rally by about 25% in the following year, by 50% over the next three years and come very close to doubling over the next five years. Outside of the Great Depression, market returns have never been negative over the twelve months following a quarter as weak as we are currently seeing.

So while we can’t forecast the short term with enough accuracy to act on it and we can’t even explain the short term very well even after it happens, we can recognize that historically market returns have been much stronger than average after periods like the one we are in. The evidence of the past suggests investors should be much more optimistic about stock returns over the next couple of years than they were three months ago. But of course, it feels like exactly the opposite.

One of the main reasons it is important to not latch on to any one explanation of the market decline is because doing so can cause you to incorrectly believe that the reversing of that factor is the only way the market rebounds. If you believe the problem is Fed policy, you think only the Fed cutting rates will cause the market to bounce back. If you think it is Trump, you may have missed the rally of the past two years and decide you have to sit out until a new president is elected. If you think it is China, you might be waiting a very, very long time as we expect the US and China to engage in vigorous trade policy competition for the foreseeable future. But the eventual market rally may come for entirely unexpected reasons.

The bottom line is that the market is wrestling with a wide range of different inputs. When the market declines, we tend to focus on negative items, such as the list at the top of this post. If the market was strong this quarter, we’d likely be pointing to the strong corporate earnings, strong consumer spending, lower mortgage interest rates, continued job creation and the range of other positive news items that have been reported this quarter. The good data and the bad data are all inputs to market prices. But looking at the preponderance of evidence, it seems to us that while there is always a chance that market returns over the next couple of years are disappointing or even negative, investors are best served by staying invested in high quality companies, trading at a discount to their intrinsic value. This approach will not protect you from short term market declines, but then neither will any investment approach that offers the potential to meet or exceed the 9%-10% long term annual returns that the market offers to investors willing to accept the unpredictability of short term market moves.

If you’d like to hear more about our views on the market, the economy and some of our portfolio holdings, we encourage you to register to listen to our next conference call on January 8th at 1pm pacific time.

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