According to Mighty History, “maybe one of the Navy’s finest moments came at the 1864 Battle of Mobile Bay, where Adm. David Farragut forced his way through a Confederate minefield and fought the Confederate Navy to a standstill. His victory over the last port on the Mississippi River completely cut the South off from moving cargo that could be sold abroad or importing critical weapons and supplies. It also helped secure an election victory for President Lincoln, ensuring the war would continue until the Federals won.”
Maybe what we are going through is not as dramatic, but the current decline in the stock market has lasted longer than any other since The Great Recession over 14 years ago. Since then, all downturns have been relatively short with the market rebounding swiftly.
Let’s recap how we got here, then discuss my favorite investment strategy to bear through until the market returns.
The cause of the downturn is rooted in several factors. The first is the repercussions from the lockdown due to COVID-19 and the government's response, which was to provide substantial government support in the form of cash that was created out of thin air. As with all things, the more you have of something, the less it is worth. With the slowdown in manufacturing output which resulted in fewer products for all that cash to be spent on, we now have inflation.
This inflation affects the return that investors demand on their investments. For instance, before inflation you may have found a total return of 5% on your investments acceptable, which after 2% inflation netted you a real return of 3%. However, if inflation is now 4%, with a real return of 3%, you would now demand a total return of 7% to stay even.
Therefore, if you owned a stock that had $5 in net cash flow each year, and you were okay with a total return of 5%, you would have been okay to pay $100 to own it. ($5/$100 = 5%) However, if all other things are equal, and due to inflation, you now demand 7% return, you would not want to pay the same amount as before. You would only be willing to pay $70 for it. ($5/$70 = 7%)
Is this good or bad? Well, in the short term, it’s tough not to think, “I lost $30.” But in reality, you are no better or worse off if you don’t sell. Why? Because you are now earning 7% on your investment.
Yes, you could have sold beforehand and now bought lower, but that is a 50/50 game, as it could have just as easily gone the other way. And over time, the market tends to go up, so chance is not in your favor.
Also keep in mind, we assume that the $5 net cash flow is fixed. In reality, history shows us that in inflationary times, companies raise their prices, and even though their costs increase, their net cash flow can increase proportionately. For example, if inflation is 4% and companies increase prices to match inflation, instead of $5 the new net cash flow is $5.20. In the end, you are making more than your original 5% to help cover the costs of inflation and eventually this higher cash flow will result in a higher stock price.
According to this economic theory, though it’s never smooth, linear or timely, and is oftentimes ugly, eventually... as inflation increases, profits increase, then the value of the stock increases.
So, when asked, “Do we invest in a down market?” I always think back to my favorite sayings by Admiral Farragut, “damn the torpedoes, full speed ahead” and let’s move on to the next thing!