With the Labour day weekend in the rear view mirror and the unofficial end to summer upon us, it is worth mentioning that the ‘sell in May and go away’ seasonal trend has not played out so far. Typically, this seasonal trend from May 6th to October 27th results in an unfavorable six month period for the markets. Oftentimes, that means heightened volatility to day-to-day news, less liquidity in smaller cap issuers and sideways markets, at best. This year, the TSX Composite Index is up 8.63% since May 6, the S&P 500 Index is up 17.8% and the Nasdaq Composite Index has returned 23.7% during that period. While we still have six weeks to go until the end of the period, it is a sign of strength that markets have performed well in what is usually a seasonally weaker period.
We do still have the weakest months of the year, September and October, to contend with before we can put a stamp on this year’s ‘Sell in May’ period, and a pullback occurring during the third quarter of election years is quite common. The average Q3 correction since 1980 in the S&P 500 is 8.02% (not including 2008, which saw an outsized selloff of 43.08% during the financial crisis). As of the close of September 8, the S&P 500 is down 4.6% over the first week of the third quarter and the Nasdaq Composite Index is already in correction territory with a drop of 10.1% from its recent high - just three sessions after setting a record close on Wednesday. That is the fastest-ever such decline.
While we have more access to information than ever, much of the information available has made it more challenging for investors to focus on their long term investment plan with a deluge of daily news items and the battle for readers’ attention. I often think the majority of news is NOT helpful to investors and can safely be ignored, or at least placed in the ‘unactionable’ file. We often hear from strategists or analysts with strong opinions. But what is their track record? Are they a perma-bull, perma-bear or just someone selling a subscription? I’m of the view that it would be much more helpful when reading one’s opinion that they have a disclaimer on their recent predictions. More transparency is a good thing, although it could lead to fewer publicly shared opinions.
That said, it is difficult to ignore the headlines, especially because of our ongoing quest to learn and gather new information. The key for investors is not to adjust their portfolios and focus too much on the quarter-to-quarter, or even a year-by-year, returns. But it’s often not easy to look at shorter term periods of performance or hearing about the hot stock of the day, week or month. (Tesla already has this ‘award’ sewn up for 2020!). Investors should be singularly focused on time in the markets and compound returns.
I recently heard a story which surprised me - that Berkshire Hathaway’s Warren Buffett and Charlie Munger had a third partner, Rick Guerin. He was a Berkshire partner in the 1960’s. Even back then, Warren Buffett and Charlie Munger were confident they would be wealthy in time but they were not in a rush, preferring to let compound returns take their time. However, Guerin wanted to get rich faster and was buying Berkshire stock on margin. When the markets had a big selloff in the mid 70’s, he was forced to sell his Berkshire shares, and in fact, Buffett bought out Guerin’s shares to help him out. Meanwhile, Buffett only became a billionaire in 1985. In fact, 96% of Buffett’s net worth came after his 50th birthday! It was a combination of good returns along with time in the markets. Buffett was not an overnight success by any measure, but this is a great lesson of investor patience.
There’s been a lot of discussion that the S&P 500 index gains have come from a small group of companies. However, this has been the case throughout much of the last 50 years. In 1965, the top 10 holdings were 34% of the S&P 500. Warren Buffett has said he’s owned over 500 stocks in his investment career. However, he has said the majority of gains have come from just 10 stocks, similar to an index where the majority of gains comes from a smaller number of companies. An example is the Russell 3000 index - over the last 30 years, 40% of the companies went out of business, and just 7% of the components have accounted for virtually all of the gains of the index!
Here's a look at the top 10 stocks in the S&P 500 over the last 40 years:
One of the things that jumps out from this list is how high the turnover at the top can be. Every decade there were at least five to six new names at the top of the list. While technology firms dominate the top slots today, in the early-1980s it was energy companies. There have also been some massive corrections in a number of the stocks that populated the top 10 lists of the past. General Electric is down more than 75% in total since it held the top spot in the year 2000. Citigroup and AIG also populated the list of biggest stocks at the turn of the century. They are down 78% and 96%, respectively, since then. Exxon was the largest stock in the S&P 500 in 2010. Since then the stock has underperformed the index by nearly 230% and recently was booted from the Dow Jones Industrial Average Index.
While the 25% concentration in the top 10 names today feels high, it is at the same level where it was in 1980. As mentioned, the market was even more concentrated if we look further back in time. In 1965, AT&T made up nearly 8% of the index. General Motors was another 7%. In the early 1960s, at one point the top 10 holdings of the S&P Index were over 50%!
A big change is the longevity of a company in the S&P Index. In the 1960s, it was around 60 years and today that number is closer to 20 years. This comes from a combination of mergers, disruption and companies going out of business. Concentration has always been part of the stock market’s structure. Today is no different than the past in that respect. The biggest surprise would be if today’s top 10 remains unchanged by 2030.
A topic of great interest when discussing investing, is just how people think about greed, fear, opportunity and scarcity. The headlines these days tend to talk about more ‘risks’, such as overvalued stock markets, a tech bubble, day traders, the path of an economic recovery and the U.S. election. But are any of those things as important as the headlines make them out to be? Are they items that one should be worried about or does the mere fact that it is already headline news suggest that it’s less likely to be what causes the next selloff?
Everyone wants to know when that next big event will happen. But as this year has shown, nobody predicted a pandemic that would shut down the global economy and cause the worst economic crisis since the Great Depression. Yet during that period, Tesla stock is going to be up 300%. No one would have predicted that. So, the fact that it was unforeseeable is what it made it risky. Knowing this, we can conclude that the biggest risks are often what nobody is talking about because it’s not ‘priced into markets’. Looking back throughout the years, we can see the ‘surprise’ events that were enough to shake up the markets in the short term.
So, all those things that people tend to worry about – the Bank of Canada’s interest rate policy; the impact of elections; stimulus packages; trade war – it’s not that these things are not risky. It’s just that they are well known, they’re well publicized and we are talking about them all the time so we can prepare for a range of different outcomes with a diversified portfolio. What really moves the needle over time are the things that just come out of nowhere, that few are talking about, and since they’re not talking about it, they’re not prepared for it, either in actual terms, such as one’s personal finances, or perhaps more importantly, in psychological terms.
The general idea that the biggest risk is what no one is talking about furthers the view that we should take market forecasts and economic projections with a grain of salt. It’s not that they are going to be wrong or that they are not without risk. It’s that in any given year, the biggest news story is something that is often completely unforeseen before it happens, whether it is COVID-19 or an unexpected election result, or interest rates going the opposite direction to the majority of forecasts. The biggest news story is more often than note something that is unknown ahead of time.
Another headline story of late is the role of a traditional balanced portfolio with a 60% equity and 40% fixed income allocation. Having a cash and fixed income allocation may not provide much in the way of returns going forward, with low interest rates. But it does allow having room for error in your finances. Selloffs, whether as extreme as this past March, or a 10-15% correction, will occur again and it’s in those times that people realize exactly why they have cash and/or fixed income in their portfolios. Cash and bonds are often associated with conservatism, not wanting to take a lot of risk, not wanting to be subject to a lot of risk. What they do is allow the stocks that you do own to be left untouched, uninterrupted so they can compound over time.
A great quote from Charlie Munger is, “The first rule of compounding is to never interrupt it unnecessarily” and when you think about it in those terms, you realize that the low returns from cash and bonds during tough times in the equity markets are inconsequential. They provide peace of mind, if once per decade, that cash and bond allocations can prevent you from being forced to sell stocks at an inopportune time, which allows them time to compound over a longer period of time.