Wealth Can Be Created On The Way Down In The Stock Market. It’s Just Not Obvious. Here’s How.

The front page of the Brooklyn Daily Eagle newspaper with the headline ‘Wall St. In Panic As Stocks … [+] Crash’, published on the day of the initial Wall Street Crash of ‘Black Thursday’, 24th October 1929. (Photo by FPG/Hulton Archive/Getty Images)

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Warren Buffett’s lesser known right hand man Charlie Munger once said, “If you’re going to invest in stocks for the longer term, there are going to be periods when there’s a lot of agony. I think you just have to learn to live through them.”

The Pump & Dump

The last ten months have been very rough to say the least if you are a stock investor. The S&P 500 Index is down 22 percent year to date, but that isn’t representative of the base of the 24 million new investors that have come to the market in the last two years.

Many popular held stocks are down a great deal more and the technology sector has been decimated. Investors have been heavily selling off growth businesses on the theory that the companies that performed best during boom times will be disproportionately affected by the rising interest rates and inflation we are now enduring. The NASDAQ is down 30 percent year to date. We are having a very serious correction where the economy was pumped with trillions of dollars of stimulus checks and other monetary aid. The “stimmies” were responsible for opening up a host of brand new Robinhood trading accounts from mainly furloughed individuals who were unable to bet elsewhere (such as sports), which in turn propelled the stock market to all-time highs and pushing the S&P 500 to a huge 27 percent gain in 2021. Sadly, the rally is looking like it had as much substance as cotton candy, and is now disappearing from sight.

So the fun times are over. Those days of watching stocks go up with quick profits are gone for the foreseeable future it appears. With some of the most darling popular (Meme) companies at the time losing between 50-70 percent, and in some cases, like Peloton Interactive, Inc. (PTON) losing over 90 percent of its value, it has forced some investors to either throw the towel in or turn into unwilling “long-term investors” with companies that may never see the light of day again. Refer to the fallout from the 2000 collapse.

Historical Perspective

So what should you do now? Before we get there, let’s look at what is going on and try to put a little perspective behind it. A good index full of quality companies will go up over time because quality companies simply grow. The trouble is that it’s not always in a straight line. I’ve been around nearly 35 years in this space and if you are a novice, you’ll soon learn that quality equity indices are likely to maintain a long-term rising trend with just small breaks between the larger cycles. Let’s assume we are speaking about the S&P 500, a stock market index tracking the performances of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices with some of the best companies in the world as constituents.

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According to what we are hearing from the media, the world economy is in a mess. You may be hearing all the bad news at the moment and wondering why are you even invested in stocks. I would tend to agree with you. Losing money is extremely hard to justify in any scenario, but hold on a minute. The chart below shows the performance of the index since the infamous 1929 crash. There were plenty of “bad” events during the journey up until now, but on a longer term scale, they really didn’t even register and buying every dip resulted in some great gains if you had the stomach to act upon it. As an investor, you must be also be aware that the market will occasionally decline. You shouldn’t own stocks if you’re not prepared for this. And when it occurs, it’s a positive.

As the great investor John Templeton once said, “There will be bear markets about twice every 10 years and recessions about twice every 10 or 12 years, but nobody has been able to predict them reliably. So the best thing to do is to buy when shares are thoroughly depressed and that means when other people are selling.” He’s been correct and there is no reason to think any differently going forward. The trick is to take out the emotion when the media (and sometimes your close friends) are full of doom and gloom. Easier said than done, I know.

S&P 500 Vs Inflation with historical events.

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Let’s look at another metric that puts the pullback of the market into perspective. The Price to Earnings Ratio of the S&P 500. A P/E is calculated by dividing the stock’s current price by its latest earnings per share. A high P/E ratio on a company suggests that investors see it as a growth stock. It may also mean that the stock is overvalued. From an index perspective, we look to be somewhere in the middle of the range judging by the last 20 years. Things may seem bad at the moment and perpetual bears would try to convince you the world is ending, but expecting every bad market to result in the Great Depression would be absurd. It would also be equally wrong to expect that a fall from overvalued to more fairly valued couldn’t badly overshoot on the downside.

The below chart indicates that the market is not exactly cheap, but the large froth made up of stimulus money has seemingly been taken out of it.

S&P Large Cap Price Earnings Ratio

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I’m not a huge fan of macro data on the whole because it is usually unactionable and very subjective, but the recent pump and dump was a global phenomenon. The fallout is persistent inflation, hawkish governments, lower GDP, and slowing economies. We have the odd situation that the whole world is suffering from the same scenario due to the pandemic. With this overshadowing everything, you can bet that it will take a long while to unwind the mess and the turnaround could be ‘another while’ after that. Ask yourself, what will change the economy and move the market back up? The U.S. stock market did not fully recover from the fall 2008 stock market meltdown until mid-2013. To put the move in perspective, it should be noted that the S&P 500 needed over 12 years to break and maintain the highs reached during the tech boom in 2000.

How To Position Yourself

I often say, “buy companies, not markets,” and I truly believe you can perform by buying good quality businesses and investing like an owner without having to think about what the stock market is doing. Predicting markets is a fool’s game and the direction will play on your emotion. Every commentator at the moment is full of bad news, and never forget that bad news sells. It can be very challenging to think differently when the audience is essentially universal and unified in its sentiments and decisions. Think contrarian when the overwhelming feeling is going one way. Predicting wider markets will also whip you around all over the place. To be honest, your stock picks shouldn’t really depend on the market direction if you are a true long term value investor. The likelihood that you will make a poor decision increases as you make more decisions with investments. Do your homework. Be very selective, be small and ready to average in a volatile market, and always start by analyzing the risk FIRST. You’ll be part of the elite if you are doing this.

The stock market was set up to fool you, not to make you money. Start with this statement every time you analyze an investment and it will help enormously with discounting the emotional element that can so often be attributed to losses.

Three Things To Help You Increase Your Future Wealth

So let’s assume that market prices are “fair” (debatable, I know). Let’s also assume that the economy will take a while to turn around. What can you do to take advantage of the situation and boost your wealth down the line?

First, always examine and outline what you are looking to achieve from investing. It is crucial for an investor to question, “What is my objective?” before buying any stocks when designing an investing program. In my experience, people generally want a retirement program, and also look for good quality companies to invest in along the way to keep it interesting; but ensure you discuss this with your financial advisor before you act and never invest more than you are prepared to lose.

Second, invest in a good quality index. The practice of investing a set dollar amount on a regular basis (usually monthly), independent of the index price, is known as dollar cost averaging. It’s a terrific method to form a disciplined investing habit, increase your investment efficiency, and possibly reduce your stress, as well as your expenses. Never underestimate the ability to have a good night’s sleep. The rub of this strategy, particularly at the current time, is that you may wait a long while for returns to come through, sometimes you may see a reduction in wealth before it increases, and you may become agitated and bored. If you stick to the playbook, longer term should see substantial gains. No one predicts the market with any sort of consistency, but this way you don’t need a view. You are betting on the longer term trend, which we have seen performs.

Thirdly, invest in companies that have a catalyst event that will potentially move the price to value. As an individual investor or even a private investor, I am amazed that I still see people over-analyze the same old stocks. As we have seen, stocks can stay cheap for years and, in my experience, great opportunities are to be found in the places that have been neglected and where other people are not looking. Especially in these sorts of markets where the most popular companies are under so much scrutiny. Where is your edge above and beyond the wider market in your chosen investment? Everything is “cheap,” but what will move it? Don’t only seek out and find stocks, but find stocks with a catalyst (or situation) to propel it to a higher value. Seek out events that are not widely advertised. Spinoffs, Split-offs, Reverse Morris Trusts, Squeeze Outs, Deep Discounted Rights Offerings, Change of Management, Insider Buying by good management, Restructurings, and companies emerging from Bankruptcy. This is the pond that you should cast your net and be fishing. These “special situations” are proven areas of success if analyzed correctly. For example, Spinoffs have been proven to outperform the market by 10 percent each year for the last 20 years. We at The Edge look specifically at these catalyst events and help investors large and small find and analyze the best opportunities from a value creation perspective.

Value investing is practically alone among techniques that provide you exposure to the upside with minimal downside risk, so in a bear market that discipline becomes very crucial. Add in a catalyst event and you are set up for an extremely powerful potential return if you have carried out your homework correctly. If you’re investing with a long time horizon, having an equity bias makes sense; stocks go up in the long run.

Buy companies when they’re on sale or display price anomalies in the confusion over an event. Your future will thank you. A lot.

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