Anatomy of a Bear Market: Violent Volatility

A Quick Review of Equity Market Declines Post Bubble Peaks

Brutal end to Q1 for investors who buy cheap stocks, quality stocks, or some mix of the two. Quick review.

The Wall Street Journal’s James Mackintosh recently penned an outstanding article explaining the violent rally in low-quality growth between March 14th and March 31st. A former writer/editor of the Financial Times’ Short View, Mr. Macintosh has a background in philosophy and psychology and is a like-minded individual. He explains how investor sentiment drove the recent snapback despite the continued deterioration in fundamentals.

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A very popular narrative over the last few years has been that fundamentals no longer work. That’s always the story at market peaks. Our bear traders post is worth a quick visit to remember the carnage that follows such nonsense. For long-term investors interested in compounding their capital with some margin of safety, markets like today challenge us to stay disciplined.

A recently famous fund manager claimed that “innovation was on sale.” We hope our piece last week on speculative growth investing puts such nonsense to rest. Amidst a gale of people selling arithmetically impossible exponential growth narratives, KCR has insisted on stating the obvious: a cash-consuming stock with an unviable business model and no economic barrier to entry is likely to be cheap only when its price hits zero.

As we explained in market cap vs revenues, that a stock falling from 40x to 20x price to sales is “cheap,” defies the lessons of history. Great buying opportunities in innovative companies are somewhere in the future. Likely after a great bear market in the speculative fury we are coming out of. In the meantime….

Let’s keep our emotions at bay. Let’s stop trying to pick bear market bottoms in speculative stocks. Let’s stop making the simple discipline of proven investment processes complicated.

The top chart below shows the rolling 10-day performance spreads between the Russell 1000 Growth Index minus the Russell 1000 Value Index.

1. The dashed red line shows you the 95th percentile of observations (when growth crushes value)
2. The dashed green line shows the 5th percentile (when value crushes growth)
3. You can see on the far right that the violence of back-and-forth swings between growth and value have hit these levels in the manic run through today in a way last seen in the internet bubble

The chart above takes that ending stretch from January 2020 through today and expands it to make it easier to see. Look at the violent horse-trading between growth and value. Lots of 10 day stretches where growth beats value by 6% or more and value beats growth by 6% or more.

This behavior is not consistent with price patterns we see at the bottom of a bear market. Look at the top chart again. The market bottoms in 2003 and 2009 were characterized by much less “warfare” between the two groups.

KCR believes looking backward is the best way to think about the future. The chart below examines the last period where Value and Growth consistently traded 6% blows every 10 days. 1998 – 2001. The top chart shows:

• Everything to the left of the vertical dashed line is the period into the peak of the dot.com bubble
• Everything to the right of the dashed line is from the peak of the dot.com bubble through the end of 2001, at which point growth and value stopped their bitter warfare
• The key takeaway is that INTO and OUT OF bubbles, growth and value are at WAR with one another, creating incredible performance spreads every 10 days

The chart above shows the absolute returns to Growth and Value into and out of the dot.com peak.

• In the ~2 years into the dot.com peak, growth ran an incredible 104% while value stocks rose only 24%
• Post the peak, growth stocks fell a staggering -44% through the end of 2001 while value rose 1%
• Incredibly, over the entire period from 1998 – 2001, value beat growth
• Also, worth remembering that growth continued to plummet after 2001, by the time the S&P 500 troughed in October of 2002, growth would fall a staggering -62%
• Even worse, over that same period, the Nasdaq, which resembled in 2000 what the more speculative funds today look like, fell an incredible -83% before building one of the great bottoms for tech investors

So, what is the key takeaway? Don’t lose your discipline. Play the batting averages. Las Vegas was built on a 1% edge.

Consistency, patience, and a willingness to suffer moments of discomfort are key to long-term capital preservation. In a recent rant about private equity returns, we led out with a chart built on the wisdom of Seth Klarman showing how nominal losses after a big run can wipe out capital. We also discussed how Private Equity firms were racing to take themselves public.

That’s a sentiment flag similar to Blackstone’s IPO in 2007, immediately prior to the mortgage crisis. Those folks are smart. Watch what they do and not what they say is our way of reading them. In our view, with Buffett’s Market Cap to GDP ratio still above the peak of the internet mania we suspect there will be many more occasions when US equities will be cheaper in the days ahead.