In the Bible, the book of Ecclesiastes contains a quote that seems made for the herd psychology-fuelled cycles of financial markets:
“The thing that hath been, it is that which shall be; and that which is done is that which shall be done: and there is no new thing under the sun.”
The sentiment is that nothing we might experience, collectively or as individuals, is truly unique. Everything that happens to us will have happened to us before. A new set of circumstances might come in a slightly different guise but will almost always exhibit many of the same underlying qualities and catalysts as previous experiences. And anything which hasn’t happened to us personally will have happened to someone else.
The trick is being able to recognise things that might initially seem new as repeats. If we do, we can draw on our own or the recorded experience of others to engineer better outcomes. Practice makes perfect and we have collective practice of most things.
Financial markets, powered by predictable herd psychology, are especially known for their cyclical nature and endlessly repeating patterns and outcomes. So for investors, it is particularly valuable to draw lessons from previous experience and bank them for future reference.
Previous experience, our own or drawn from others, means we know not to panic and sell off all our assets when markets drop. We’re confident a bear market will always eventually become a bull market again as it always has. But we also know each new bull market cycle will bring changes. Different companies will become the largest, fastest growing and most profitable.
We know the dollar usually strengthens when fear stalks markets, so can take advantage of that. We know expensive-looking growth stocks tend to fall hardest when the economic cycle turns. And that the cycle will always turn because markets always become overly optimistic or too negative.
Getting the timing right is tricky and so is guessing which companies will perform best in their sectors. But the big picture is usually relatively predictable. Unfortunately, or fortunately for some, the majority of investors still get caught up in and fall victim to these repeating cycles. Those who can see the big picture and refuse to get caught up in the moment have a huge advantage.
Was 2022 a unique year for investors? Yes and no.
Despite the fact we’ve just said market cycles are almost always influenced by a combination of factors that have been seen before in different combinations, in many ways, 2022 was a unique year for investors. We’ve never had a global pandemic of the severity of Covid-19 during the modern era of globalisation and critical supply chains that snake across the world. Nor, arguably more importantly, have we seen the kind of state intervention that was the response to the pandemic across much of the world.
In 2021, financial markets were heavily influenced by first the panic that followed the pandemic’s outbreak and then the lockdowns and massive state intervention in the form of financial support and fiscal easing. Cash flooded the system and a stock market plunge turned into a surge, pushing valuations to record highs, with digital economy companies leading the way.
But while we haven’t had a global pandemic comparable to Covid-19 in the modern era, economies have before experienced intense quantitative easing and economic stimulus. The traditional result of excessive stimulus is high levels of inflation. Which is what we saw last year.
Many economists did predict heightened inflation last year but few expected it to reach the levels it did or for so long. What was already a dangerous set of circumstances for inflation was put on steroids by Russia’s invasion of Ukraine, which sent energy, food and many industrial commodity prices soaring. That pushed up the prices of fuel, food and many other unavoidable costs every business and household has.
China’s recently abandoned zero-Covid policy, based on strict, widespread local lockdowns further snarled up supply chains creating a perfect storm. We’ve had wars and geopolitical flashpoints that have driven up energy prices before. However, they’ve not also involved major agricultural and industrial commodity producers before. They’ve also not coincided with a global economy still trying to shake off a pandemic.
The perfect storm of so many inflation-boosting factors coinciding meant that 2022 was as close as it gets to a unique set of circumstances for markets and investors to grapple with.
Investment lessons from 2022
The uniqueness of the 2022 environment does, however, mean that it was a particularly educational year for investors, exposing them to new lessons. Those that learn them should be in a stronger position over the years and decades ahead. So, what were the investment lessons we should learn from the past 12 months?
- Bull markets always come to an end
That a bull market inevitably ends with over-exuberance and investors ignoring normal market rules and fundamentals to drive valuations to nosebleed highs, followed by a painful correct, is by no means a new lesson. However, the past year has been a refresher course for a whole generation of investors who have never experienced a prolonged and painful bear market.
The bull market that ended this year was the longest in history. Other than a sharp but brief correction in late 2018 and a short-lived slump at the outset of the pandemic, markets have been on an upwards trajectory since 2009. Over a decade of strong growth saw many investors, especially younger generations, forget the lessons of the past.
Last year, which saw the Nasdaq lose 30% and the S&P 500 20% (London’s FTSE 100 benchmark index closed the year almost flat thanks to its heavy weighting towards energy companies and miners), while bitcoin and the wider crypto market crashed spectacularly, was a reminder that every bull market ends and that when enough valuations look unrealistically high, that end is nigh.
- Be wary when markets attach huge valuations to companies not yet making any money
2021 saw markets value a large number of companies yet to record a profit, many weren’t even generating meaningful revenues, at billions of dollars. Almost all of these companies were in the tech sector in hot spaces like electric vehicles, ecommerce and the digital economy more broadly.
The last time we saw a cohort of companies that didn’t yet have demonstrably sustainable and profitable business models valued so highly was in the run-up to the bursting of the dotcom bubble. 2022 had roughly the same result – the valuations of scores of unprofitable companies recently worth billions were wiped out.
If you see history repeating itself in 5, 10 or 20 years from now, you should be prepared for what comes next – a stock market crash.
- Build a portfolio for the long term and around high quality assets
While most sectors had a bad 2022, the companies hit hardest were those whose valuations were built almost entirely on optimism for the future. If 2022 has taught us anything it is that investors should limit their exposure to moonshots.
High-quality equities with a focus on strong free cash flow and margin resilience have suffered the least and should also recover quickly when market sentiment turns. Investors chasing stellar returns by jumping on the bandwagon of “the next big thing” tech stocks, before they’ve proven themselves, should have learned a valuable lesson last year.
Don’t take the magic beans, keep the cow. Especially if it provides plenty of metaphorical milk in the form of consistent dividends. It might not be hugely exciting but it will probably pay off in the long term.
- Keep enough cash on hand to ride out a prolonged bear market
2022 was another reminder to investors of how important it is to keep cash on hand. A bear market is only a problem for an investment portfolio built around high quality assets if they have to be sold while their valuations are depressed. Good investments should bounce back when the broader market does and anyone who wasn’t forced into selling should recover losses.
Especially if you are in or approaching retirement, it’s important to keep enough liquidity to see you through a bear market without having to sell investments that will recover at a loss. If you can keep enough cash to buy up bargains during a bear market, even better.
- Diversification is key
A large number of retail investors made the mistake of putting a majority, or even all, of their capital into growth stocks over the past decade. Successful tech companies, especially Big Tech like Apple, Amazon, Facebook, Alphabet, Microsoft and Netflix, were showing such phenomenal rates of growth that they were hard to resist.
While investors who bought into these stocks early enough will still be very nicely up despite the carnage of the past year, those who bought later and concentrated investments on growth stocks will have been burnt badly. Last year energy stocks soared thanks to elevated energy commodity prices, especially oil and gas and consumer staples and brands with strong pricing power also did well thanks to being able to absorb inflation. Financials also had a good year as interest rates were steadily hiked.
As a result, losses suffered by well-diversified portfolios will have been far lower than those concentrated on growth stocks, chasing the stellar gains the sector has returned in recent years. Over the long term, lower volatility boosts returns and diversification reduces volatility. 2022 was a reminder that no one sector will ever remain top dog for returns forever and if diversification can subdue returns in the short term, over 10, 15, or 20 years it tends to pay off.
