Enrich Your Future 34: Embrace the Bear: Why Market Crashes Are Your Silent Ally

Andrew Stotz 00:02
fellow risk takers. This is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story at episode 645, now Larry stands out because he bridges both the academic research world and practical investing. Today we're diving into a chapter from his recent book, enrich your future the keys to successful investing, and that is CHAPTER 34 bear markets and on unnecessary evil. And just to highlight Larry just wrote on his sub stack. If you're not subscribed, make sure you are Larry's sub stack, he wrote, with the sharp drop in US equities investors have experienced and the questions I've been getting about the drop, I thought I would update a piece I wrote back in 2008 explaining why bear markets are a necessary evil. Larry, take it away. Yeah.

Larry Swedroe 00:55
So we could define a necessary evil as something that maybe isn't pleasant, but is needed. And the most common thing I think people can relate to are taxes. You want to live in a country and have police and schools and, you know, Social Security and Medicare in the US? Well, we got to pay taxes to support that, as well as defense. So that's a good example of a necessary evil. And I wrote it that way because bear markets really are a necessary evil, or investors should think about it that way, because if stocks didn't experience the kind of bear markets that we have, investors would actually be very unhappy. So let's think about why that's the case. The most common, most important, the most basic principle of finance, is the relationship between risk and expected, but not, of course, guaranteed return. Right? So the more risk, the higher the expected return, which means, if risk is high, which means that there have been risk of big losses, then investors apply a bigger risk premium, which leads to the denominator in the formula of a Net Present Value. The numerator is the expected earnings. The denominator is the risk free rate plus the risk premium. Well, the bigger the losses have been, historically than that. People would think of equities as being more risky. So I point out in my article that the US has experienced, you know, four periods where the losses were greater than the 34% that we experienced in the US during the COVID crisis, which lasted just a month and four Days, from February 19 to march, 23 from January, 29 through December, 32 the market lost 64% from January, 73 through September, 74 it lost 43% from April, 2000 through September, 2002 it lost 44% and from november 2007 to February, 2009 it lost 51% now imagine for the moment that US equities The worst loss that ever had experienced was 10% clearly, investors would view equities as a lot less risky than it was even in the post war period. We've experienced nothing like the Great Depression, and so that's one of the reasons that the equity risk premium has come down, people are willing to pay more because they believe the Federal Reserve has learned from the mistakes of the 1930s when it tightened monetary policy in the middle of a Great Depression. We now have much better accounting regulations. We have an SEC which we didn't have before, and we have much better regulatory rules guiding the actions of corporate executives, much more severe penalties for breaking the law. So there's investors believe it's safer. So if you go back to the 1970s or so, the average PE may have been just 15, so maybe it gets to the 20 in a good period and goes much lower in a bad period. For the last 25 years in the US, the average PE has been over 20. And so people believing markets are less risky because the economic cycle risk has gone down. We haven't had a really severe recession, except for 2008 in the last, you know, 40 years. Okay, so think about if the worst recession caused the market to only drop 10% maybe investors would be willing to pay 30 times earnings instead of 20 times earnings. That would mean the discount rate would go down, the net present value would go up, so the price of equities would be higher. You don't change the earnings of those companies, just the discount rate. And therefore, instead of stocks returning, say, 10% historically, maybe they would have returned 5% and what if the worst loss had only been 5% well, maybe the price would have PE would go to 40 on average, right? So the point being that bear markets really are necessities to create the large equity risk premium that has been called the equity risk premium puzzle. Why have stock returns been so high when corporate earnings are nowhere near as volatile as stock prices. And the reason is, investors hate big losses. They don't like the risk that that creates, and therefore they demand the big risk premium. So the right way to think about bear markets is they're really good, especially when you're young and accumulating assets, and as long as you don't get fired from your job, you get to buy at much lower prices and get higher expected returns. They're bad when you're retired because you're withdrawing from your portfolio and you can't recover money that's already been spent, those assets are gone, okay? So the right way to think about bear markets is they are a necessary evil in order to create the large equity risk premium we have enjoyed in the last 100 years, okay? And therefore you have to make sure you don't take more risk than as we've discussed many times, you have the ability, willingness or need, to take risk, and as you age, your ability and willingness to take risk is probably going down, and therefore you should be lowering your exposure to the that economic cycle risk. And if you're young and you have a stable job, well, then you can take that risk. But if you're in an industry that is highly correlated with economic cycle risk, saying, home, building, construction, autos, etc, then maybe you should have a little lower equity allocation, or certainly a reserve of a significant number of maybe years two or three, at least, that you don't wouldn't be forced to sell equities at a time when they're in distress, and that's Actually the time you want to be a buyer, when everyone else is panic selling, because expected returns are now highest.

Andrew Stotz 08:27
Yeah. In fact, while you were speaking, I went on to Schiller's website to download his data and look at that. And I just, you know, went back to 1900 and made this chart. But here you can see, and of course, it gets a little meaningless when you look backwards, because the numbers were so small, maybe if I put on a logarithmic scale, it would look have a different meaning. But the point is here we can see in 2000 2000 the.com bubble crashed, and then we can see the 2008 bubble crashed, and then we saw the COVID crash, and now we're seeing a recent crash. So bear markets, ultimately, as you say, are a necessary evil.

Larry Swedroe 09:10
Yeah, they restore a larger equity risk premium. You know, the worst thing that happened to young investors was the bull market we really experienced from 2009 through 2024 because that drove the PE ratios way up and expected returns down just when you're investing. It was the best thing that happened to retirees, because their assets continued to grow, and as they withdrew, they weren't suffering because those assets kept appreciated. So you know, you really have to consider the stage you're in as well when you think about your asset allocation and

Andrew Stotz 09:54
the the although the economy in the stock market don't correlate. Um. So it is interesting to think about the bubble and the boom and the bust. I know Peter Schiff. I listened to him recently, and he said something that maybe came from someone else, but the point is that the recession is the cure. And what his point was, and I think it's very true is that when good times are here, all kinds of people enter every industry, until eventually very high returns get competed away, and then you have oversupply, and then you have the peak of a economic bubble. And then eventually what happens is the weak players get knocked out. And I would argue the reason why we haven't had a sustained recession for a long time is because the COVID period was like a flash recession that just instantly knocked out maybe 500,000 businesses in America and maybe 10 million businesses around the world boom, the weakest ones that may have had to die slowly were put to death. How do we think about the economy and the cycles in the economy versus the cycles in the bear markets, in the market?

Larry Swedroe 11:11
Well, yeah, you have to be careful about your comment that the economy and the stock market are uncorrelated. I think you would find that they are with a lag, because the stock market is forward looking. So it tends to go down before we get a recession, and it tends to recover when we get a recession right, maybe in the middle of it, because the market looks ahead and says, gee, the government is likely to enact fiscal stimulatory policies that will help recovery. The Federal Reserve is going to lower interest rates and ease monetary policy, and that will stimulate the economy. So the market actually tends to go up once we get through the early stages, possibly, of a recession. It tends to go down ahead of the recession because it's anticipating it, and anticipating, for example, that their excesses in the Federal Reserve is going to have to tighten monetary policy, etc. In this case, what we're seeing, just to discuss what's going on now, the market concerned about the uncertainty by a self imposed recession because of the uncertainty of Trump's war on, you know, on trade policy. In the other cases, all of the other instances were exogenous events. So we had the events of 73, four. We had an oil embargo. We had 2001 we had the terrorist attack. 2008 we had a global financial crisis. 2020, we had COVID. This is a policy induced one, which leads me to believe, if rational people, and I don't know how rational President Trump is, everyone will have to make their own decisions if the markets start to crash, that alone can induce a recession because of the wealth effect. All the uncertainty he's created has driven consumer confidence way down. That means they're likely to spend less. We don't see it right away. In fact, we're seeing the reverse, because people spent more in the fourth quarter, in the first quarter, to buy things before tariffs went into effect, and so they front loaded things. So the next quarters could be weak corporate executors, their confidence level is way down, so cap x is down. No one's going to build a plant in the US, because they don't know if the tariffs will be there or not. So until they know, right and the wealth effect with the market going down is another problem, because people will spend less and all the doge cuts, it's not just the jobs lost there, which is probably a very good thing get rid of bloated government, but there are probably two to three jobs in the private sector supporting every single job in the government sector. Just think about the hotels and the restaurants and the airfares, and, you know, the you know, cell phones that you know, and all that stuff, and the consultants and and everything else. So you're talking about hundreds of 1000s of jobs just seeing a bunch of the consulting firms, well known firms, have already agreed to slash billions of dollars, right? That's gotta slow the economy to some degree. Now, it may also help the budget deficits, which in the long term, would be a positive so

Andrew Stotz 14:50
in theory, the stock market is telling us we're in for, potentially in for a weaker economy. Well,

Larry Swedroe 14:58
the market is up more. Are uncertain, so the risk premium goes up. Whether we get the recession or not depends upon, you know, sort of read the tea leaves, and you can make your own judgment about this. My assumption is as follows, but I have to admit, I'm always humble, as you know, by making forecasts, I always tell people my crystal ball is cloudy. I don't change my investment policies strategies based on them, because I know I can't forecast any better than anyone else. And I tell people, despite how much you want to believe, that there's somebody out there who can predict the future, there's only one person who knows what will happen, and you and I will never get to talk to him or her while we're on this planet. Therefore, ignore forecast. But here's what I think is likely, or at least you know, better than a 5050 chance. I believe that the President watches the stock market as the gage of his performance, and he knows he's got a big election coming up, not that far in the future. And if you get a recession come the third or fourth quarters, that's going to run right into the election, the primaries and everything else. He's got such a thin majority he cannot risk it. So what he's likely to do is the following, I believe, announce very quickly major agreements on basic tariff trade policy, but he can't announce deals because it takes, historically, nine to 18 months to negotiate very complex deals which have much more to do than just tariffs but regulatory rules, safety rules and all kinds of barriers governments Throw up to protect domestic industries. But he could announce India and the US, or Taiwan and the US have announced a general agreement that we're going to go to zero tariffs on manufactured goods, and we're going to work on these five other things, and Taiwan has agreed to invest a trillion dollars in US manufacturing. And then when you get one deal, a lot of other people will rush, because they will want to not be excluded, and that'll set the stage. And people, then the market, will think ahead, and we will avoid the recession. If I'm wrong and Trump doesn't use the common sense that he should have, and this drags on, then you could see a recession, which means earnings in the average recession go down about 10% and PES could easily drop from 20 to 15. So you would get an earnings, maybe of 230 bucks or something like that for the S P, and put it just a 15 P, that's not a bear market even. And you're about 4000 on the S P, so I don't rule out at all a drop that could be another 20% from here or so. So a portfolio has to be able to withstand, you know, both the good and the bad outcomes, because we don't know which outcome is likely. I had

Andrew Stotz 18:35
a couple questions in the chapter. These are kind of, let's say quick ones, but you mentioned one thing where you said, from 1926 through 2022 the S P has provided an annual compound risk premium over one month treasury bills of 8.2% and an annualized premium of 6.9 so Let's say equity risk premium about 7% Yeah. Okay,

Larry Swedroe 19:02
that's because, by the way, the average PE over the 100 years was about 17, 1617, invert that, and guess what, you got an earnings yield of six to seven, which equates to about what the real return to stocks was. Andrew, you put up the current Cape 10. You want to show people what that is, and then we can invert that for them.

Andrew Stotz 19:29
Hold on, I let me get that second.

Larry Swedroe 19:37
It's come down some because the market has dropped, you know, close to 20% and it's rebounded a bit the last couple of days. Yep, I think peak to trop was down 20%

Andrew Stotz 19:55
give me a second, yeah,

Larry Swedroe 19:56
all I can tell you this while you're pulling it up the current. Forward estimate of earnings, which I think the earnings estimates are likely too high, especially if we get a recession, is about 20. So that would be an earnings yield of 5% so that would tell you the expected real return to stocks is 5% now not seven, but you still have a wide dispersion of possible outcomes around that cape 10 is not a good predictor of returns in the next 123, years. It's a reasonably good one over the longer term, like 10 years, right? It's about as good as we have.

Andrew Stotz 20:38
Okay, so let me pull that up one second. Put me to the test here. Larry had to calculate that one. Okay,

Larry Swedroe 20:51
there you go.

Andrew Stotz 20:53
So what we're seeing, for the people that are listening, we're seeing that the PE ratio looks like about 33 there. Maybe, yeah. So let's just say the recent peak was about 37 let's say and it's come down to about 33

Larry Swedroe 21:12
so 33 would be a 3% real return. You know that that's, I don't know how many people would take the risk of investing in stocks for a 3% real return when you can buy tips guaranteeing a 2% or so real return, right?

Andrew Stotz 21:30
Let's and let's just look at that from a, let's say, just a long term average, which we can see here?

Larry Swedroe 21:41
Yeah, I'd be careful. The long term average is about 17 now, but that's misleading, because of the reasons I mentioned earlier. In much of that period, there was no Federal Reserve, there was no sec, we didn't have gap accounting rules. We didn't have Sarbanes Oxley, all of these things which made equities less risky. So I think, you know, a more normal number might be the last, you know, 40 or 50 years, maybe, or last 25 and now you're looking at a cape 10, much lower. So I think, you know, still obviously 33 would be way above, say, 20 or or so. So we're still way above that. So

Andrew Stotz 22:35
let's just take

Larry Swedroe 22:36
P, the current P is much more in line with the last 25 years, or even a bit longer. So

Andrew Stotz 22:44
let's take the period of 1980 maybe, yeah, that's a reasonable one. Could say that with 1980 we definitely had the Fed, you know, being a much more active player. So now let's look at that chart again, and we can see that even, even if we did that, that's going to shift it up from about 17 times to about, what do we say 23 times, right? But still, yes, we're way above it, not as above as we were in the.com bubble. And one of the things about the.com boom or bubble was that we had a huge, you know, very small earnings and zero earnings for many of the largest tech companies. Whereas now those companies, even though they may suffer a bit, they're still super profitable. That's

Larry Swedroe 23:31
why you're not seeing the P the cape 10 at 45 you're seeing at 33 and if we got to remember, yep, you know, if you get that recession, which would be a self imposed one, because of President Trump's the uncertainties created, their earnings are going to come down, and then the risk premium will also go up, and that's how you get big bear markets. And so it wouldn't shock me. I'm not making that as a prediction at all, but wouldn't shock me if we sat here in six months and the S, P was 4200 because we had a recession induced by a failure to get trade deals done. And I would add, there are other things that are certainly possible. You know, there is tremendous geopolitical risk around the world, certainly Russia and Ukraine, certainly Iran. We could see the US, if US and Israel don't get Iran to agree to abandon nuclear weapons with a verifiable testing I believe there's a 98% chance or more that Israel and the US, or even Israel on their own, will launch a strike to destroy their nuclear facility. Who knows what that could trigger and Taiwan? On, given China's problems, if the US persists in this trade war, China could decide their economy could get into a serious recession, and they could be concerned even about being overthrown politically. They want to distract their population and launch an attack on to try to take over Taiwan. I mean, I'm not predicting any of these things, but I don't think anyone could say the chances of those things happening are zero. Yep,

Andrew Stotz 25:33
the last thing I want to ask you about what's in the chapter. It made me think about, when we talk about small cap, you know, we talk, sometimes we talk about small cap premium and small cap companies having a big loss relative to large cap companies and all that. I kind of realized that we need to differentiate when people, when we listen to people talking about small caps performance, we need to differentiate between just small cap return relative to, let's say, the overall market, or relative to large cap versus long, small cap short, large cap premium, right? That we're talking about the factor premium. How should we think about those two things, and what generally has been the difference. And can we really capture that long, short premium in small cap, or should we be thinking about just the premium of, you know, small cap performer? How do we think about that? Well,

Larry Swedroe 26:33
gee, we need a whole hour to answer that one, Andrew, but let's see if we can make it short. First of all, the small cap premium is really polluted, if you will, because of investor at the retail level behavior, retail investors have a weird preference. It's not financially rational. It may be psychologically rational to buy the stocks of small cap growth companies with high levels of investment and low profitability. They are hoping to hit the lottery, if you will, and find the next Microsoft. It turns out that stocks with those characteristics have underperformed treasury bills over the long term Cliff Asness and the team at AQR wrote a paper saving, I forgot the exact name, but saving the size premium by getting rid of junk. And once you do that, the size premium, all of a sudden is restored. We haven't seen a size premium basically since it was written about in the 1980s by Ralph bands. And it's polluted. Once you look at small companies that are more profitable, low their value stocks that are profitable, then there is a size premium, but you have to get rid of the junk stocks. Another example are stocks and bankruptcy. There have penny stocks. Do you know? Take a guess what percentage of these stocks, even though they trade, they are still in indices, you know, and stuff. So an index fund that's pure replicating would buy it. So a stock like hertz that declares bankruptcy, let's say it's traded. Take a guess what percentage of them ever return one penny to shareholders, is it 50% 80% 20%

Andrew Stotz 28:46
Yeah, I would say 40% return and

Larry Swedroe 28:51
60 times too high. It's 1% 1% and yet, people love this, right? Okay, so when you look at the small cap premium, people say there's no small cap premium. It's because you have this junk. And once you get rid of that, the small cap premium is restored, and it's been something on the order of two, two and a half percent per annum. And then you get a profitability premium on top of that, if you stick with the, you know, those companies, and you know, in general, there is that size, that profitability premium, so the it's very hard to capture it long short, because the worst performance guess what is in the short side. So you have to go short, and it's very expensive to borrow those stocks, because the risk of going short, like with hertz, who went way up, or GameStop, you know, the you can get squeezed by these crazy people at Reddit who want to go after hedge funds and stuff and so. That's what's called limits to arbitrage that allow these stocks to persist as overvalued. The way to access the premium, if you will, is to buy small cap stocks that are higher in quality, profitable and cheap, and go long them. And over the long term, you should have higher expected returns for very you know, because they are risky or smaller, less liquid, you know, companies right? And you'll outperform the junk as well.

Andrew Stotz 30:32
And just to show that, here's a chart I just made on let's see. This was something I did before, where I looked at a 10 year stock market moving average to smooth out the ups and downs and just to understand, but here you can see that the blue line is the small cap premium. That's the long, short premium

Larry Swedroe 30:56
ended right around 83 when Ralph bands published this paper, yeah.

Andrew Stotz 31:02
And so we had a underperformance, then outperformance and underperformance, which tells you, it's pretty much been destroyed and that

Larry Swedroe 31:11
Well, you gotta remember, much of this has occurred in the last 10 years, when the price what you have to analyze. Andrew, be very careful here you have to ask, Why did large caps outperform? Did they out earn? Which, in case, you could say, all right, that should persist. The small cap premium is gone, or did the PE ratios go way up? And much of that outperformance, perhaps all of it, is due to the spread widening. Small cap stocks are trading maybe 10 times earnings, and large cap trading at 30, so you get an average market of 20. I'm just making examples, and it's because the spreads have widened dramatically. That's certainly been the case in value stocks, and it's also been the case of US stocks outperforming international until this year, 80% almost of us outperformance over the last 17 years has been PE expansion, not earnings expansion, and much of the earnings expansion was due to interest expenses coming down when the Fed adopted a zerp policy. So that's going away now, yeah, and as those refinances come due, maybe people borrow 10 year money back in 2018, or 19, and you know, few more years, then they'll have to pay again market rates.

Andrew Stotz 32:44
Okay, so in wrapping up, let me just also mention that the paper you're talking about is called size matters, if you control your junk. Yeah, the latest green paper, yeah. Latest version came out in 2018 it's on SSRN, and as you said, Clifford Asness, Cliff so it and just to read the abstract, just briefly, the size premium has been challenged along many fronts. It has a weak historical records very significantly over time, in particular, weakening after its discovery in the early 80s, and it's concentrated among micro craft stocks predominantly resides in January and is not present for measures of size that do not rely on market prices, is weak internationally and is subsumed by proxies for illiquidity. We find, however, that these challenges are dismantled when controlling for the quality or the inverse of junk of a firm. Interesting, that's a great paper. Okay, I look forward to it. Well, let's wrap it up there. Larry, I want to thank you for this great discussion, and I'm looking forward to the next chapter. And the next chapter is chapter number 35 Mad Money. Now I don't watch TV, but I hear there's a guy named Jim Cramer we're going to talk about. So I'm looking forward to that.

Larry Swedroe 33:56
Yeah, it's an interesting discussion. It amazes me, given he's been exposed that he adds no value. He's been around for, I don't know, 30 years, and he can people still tune into his show when the academic research shows he knows nothing. Well.

Andrew Stotz 34:13
He may not add any value in his in our stock market performance, but apparently he adds some kind of entertainment

Larry Swedroe 34:18
value. Yeah, that he's certainly an entertainer, if you like, you know, clowns. Okay, well,

Andrew Stotz 34:25
we're looking forward. That's gonna be a fun one. So for listeners out there who want to keep up with all that Larry's doing, you can follow him on x and Larry swedro, you can follow him on LinkedIn, and maybe Larry you can tell us, what are you doing with sub stack,

Larry Swedroe 34:36
yeah. So I decided now that I have left Buckingham, I've semi retired, I still do some consulting to now eight firms part time, so I still want to write, and I have a lot more time to give back and help people learn about markets. So I write for. Four other websites, wealth management, financial advisor, Morningstar and alpha architect. So you could follow me there, or simply follow me on X Twitter or sub stack. So I'm writing more than the others are have the capacity to take so I decided, all right, I could publish on sub stack. It's free, you know, at least for now, and it allows me to add commentary like I added today about the bear markets are necessary evil. Rather than writing, most of my stuff is writing about the academic literature, reviewing what the researchers looked at, what they found, and the implications and takeaways for investors. This allows me to comment more on investor behavior and how they should be thinking about things in the marketplace. So I would urge all your listeners to check it out, and if you just subscribe and tell your friends, and hopefully that'll make you a better investor.

Andrew Stotz 36:04
Fantastic. And the great thing about sub stack is that you get a notification when a new piece comes out, where you may miss that on Twitter, you may miss that on LinkedIn, so that's great. Well, this is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.