It Always Comes Back. But…

By Brad Thomason, CPA

 

One of the implications of the recent all-time-high in the stock market is that everyone who has ever said in the face of a decline, “Don’t worry, it will come back up,” was right.

This is a familiar refrain among asset sellers who tout the notion that their favored asset always goes up.  To the extent that the asset is traded on an exchange, this is sure to be a 100% undefendable position (for in fact, there are not any exchange traded assets which ALWAYS go up).  So during the periods of time that these sure-to-rise assets are falling, there is reference made to the long-term and the idea that they should (eventually) return to their former value.

Interestingly, this phenomenon is not restricted just to stocks.  About 13 months ago I was speaking at a conference for international investors where several of the other presenters were talking about gold.  One guy was saying gold is the greatest thing ever: put 50% of your money into it.  Another guy was saying gold was overvalued at the moment (Pratik Sharma from Atyant Capital, who was discussing some analysis prepared by his partner Vedant “VK” Mimani) and that gold buyers should be careful.  Since that time gold has fallen from $1700 an ounce to less than $1400 today.  I would bet you just about anything that guy #1 has been on the phone with his clients this week talking up the it-will-come-back message.  And you know, I guess it probably will some day.

So if the price comes back and the asset is worth as much as it was before the temporary downturn, everything’s cool, right?  No blood, no foul, and all of that?

Actually, no.  Those years waiting for the price to come back are years when the capital involved is essentially earning nothing.  If you factor in inflation it’s actually earning even less.  But the simple example will suffice to make the point.

Consider the following situation.  If we start a 20 year span with $100 and we watch it grow by 7% every year during the period, we’ll have about $390 at the end.  But let’s look at what happens if we have a few years in there where the return is 0% instead (which again, is essentially what happens during periods when we are waiting for a price to climb back to a previous high).  The last time the US stock market was in the neighborhood of current prices was 5 years ago.  So if we cut off 5 years of growth from our progression we no longer have an ending value of $390: now it’s $275.  Recalling that we started with $100, that means that 40% of the potential growth for the period was lost ($175 instead of $290).  To state the impact in terms of overall average yield, that would be like moving from 7% to down around 5%, for the entire 20 years!  Take note of the fact that I could have made that disparity even bigger by choosing a higher rate of return or a longer time frame, or both.  But as I said, the simple example suffices.

The point is that when you have to sit on the sidelines for an asset to “come back” you actually have to have a new price that is much higher than the old one if you are going to keep your growth curve intact.  New highs are rare enough; substantial runs past new highs are even more rare.  So understanding this dynamic is pretty important.  The cost of idle capital is very real: just because it’s not an actual cash flow doesn’t mean that it can’t hurt you.  A lot.

Taking solace in the presumption that asset prices always come back ignores a part of the story that really matters.  If your capital needs to earn a return every year, it cannot be seen as OK when it fails to do so in any year.  Even more so when it fails to do so for many years.  Coming back is a consolation prize at best; it’s not something to aspire to.

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