Thursday, July 18, 2024

Stock market fall and long-term investors

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Having just plugged “portfolios for long-term investors” again, I really should opine on its message about the recent stock market decline. If you didn’t see this coming and get out ahead of time, or if it was perfectly obvious to you that this was coming but you didn’t get off your butt and do anything about it, preferring to pontificate at the dinner table, just how bad should you feel about it? 

Not as bad as you might think. 

For once, one can make a plausible case what drove the market down: Investors figured out that the Fed is going to finally raise interest rates to do something about inflation. Prices being somewhat sticky, higher nominal interest rates will mean a higher real interest rate, a higher real discount factor, and, with no change in the risk premium for stocks, a higher expected return for stocks. So, the lower price today is matched by higher returns going forward, just as a bond price decline is matched by higher yields. The lower price does not, in this argument, signal lower earnings or dividends. 

If that is the case, then a long-term investor really has not suffered any decline in long-run purchasing power. If your plan was to hold stocks for a long time, and effectively live off the dividends (including all cash flows), then nothing has changed. Sure, it would be better if you had gotten off your butt and sold ahead of the decline. But effectively market timing is difficult as a consistent strategy. Maybe inflation was all “transitory” “supply shocks” and the Fed would not have to do anything. 

Likewise, should you sell now? Well, has the market priced in all the likely interest-rate rises coming either from the Fed or from markets whether the Fed likes it or not? Maybe the Fed’s forecasts are right that inflation will largely die out this year. Maybe not. Place your bets. Also, if you sell, you have to have the courage to jump back in just when it looks bleakest. Effectively market timing is difficult as a consistent strategy. 

Is this story right? Interest rates are rising, but are they rising enough? Here are three rates, 10 and 30 year Treasurys and 10 year indexed TIPS. The rise is evident, but not shattering, and still smaller than the rise earlier this year. Hauling out the back of the envelope, the S&P500 is down about 10% from its peak. Bond yields are up about 0.5%, implying a roughly 5% decline in value for the 10 year and 15% decline in value for the 30 year bonds. So we are roughly in the ballpark. 

Of course, not everything else is always constant. Higher interest rates might reduce those cashflows. Or higher interest rates might fight inflation, which raises real cashflows. Now we’re back to betting. 

The point today is just to bring to life a simple possibility: When real interest rates rise, other things held constant, stock prices fall, but (by definition since I said other things held constant) expected dividends and earnings do not fall. A long-term investor is not hurt. The value you get from selling all your stocks declines, but the cost of reestablishing the portfolio and living on it just declined too. Similarly, if the value of all houses falls, you really do not care to first order, since the value of the house you want to buy fell just as much as the value of the house you want to sell. Indeed, you save on property and capital gains taxes.  

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