Stock markets rallied sharply in July and have continued to climb in August in response to the cooling of record levels of inflation. Investors expect the Federal Reserve to ease back the frequency and magnitude of interest rate hikes in response, an apparent bullish case for stocks. According to Wednesday’s edition of The Wall Street Journal, the bear market in the NASDAQ Composite is over since the index has risen more than 20% from the low reached in mid-June. We may in fact have seen the lows in equity markets this year, but we will only know for certain well in hindsight.
Investing is a challenging endeavor as decisions must be made in the present, looking to the future, with imperfect and incomplete information. Fundamentals drive asset prices, yet human emotion exacerbates the trajectory, especially during bear markets and times of crisis. The stock market spends most of its time in an uptrend where most stocks are rising. However, bear markets occur as natural processes of capitalism as over the course of each economic cycle; debt builds, investor confidence turns into euphoria, capital is misallocated, and investors forget the pain endured during the last bear market. Businesses fail, capital is destroyed, and the foundation is laid for the next cycle and a new group of companies to emerge and thrive.
As systematic investors, we believe that building robust processes to determine when the odds favor a sustainable market advance are critical for success and managing risk. When probabilities favor a new uptrend, we broadly expose the portfolio to the strongest stocks (‘new leadership’) as the odds of experiencing positive returns is high. The tradeoff to this process is that we will never buy at the lows or sell at the highs, as these levels can only be ascertained after the fact. We are content to capture much of the return between the extremes of the cycle and avoid the catastrophic drawdowns that destroy wealth. Even with the current 20%+ return off the bottom in the NASDAQ Composite, the index remains more than 20% below the high reached in November 2021. Investment returns are asymmetrical in that a 30% loss requires a 42%+ gain just to get back to break even. Our exposure to stocks remains limited as the equity market has yet to prove that full exposure is warranted. Most stocks remain in a downtrend and little in the way of new leadership has emerged. Are we in a new bull market? We’ll only know in hindsight.