The Mathematics Of Down Markets

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One of the hallmarks of value investing is that its practitioners cultivate a state of mind where their attitude is the inverse of the market’s. As bull markets advance and valuations deteriorate, we become increasingly gloomy and negative. When volatility strikes, we cheer up fast.

Q3 hedge fund letters, conference, scoops etc

Down Markets
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The stock market is a deception machine, so cultivating this state of mind is not easy. For example, the latest highs in the U.S. market happened on September 21, only three months ago. But look how different the noise around the market is today compared to then! Mr Market went from euphoria to despondency very quickly.

One tool I use to develop a contrarian spirit is a simple thought experiment. Let’s say the latest high on the S&P 500 Index was the high for this market cycle. (I’m not saying it was.)

I then ask myself: five years from now, if the S&P 500 is still only back to its September 21 high, what would my return be?

In this case, there would have been a roughly 4% compound price appreciation plus a 2.5% dividend for a total return of about 6.5%. That is at the low end of long-term equity returns, but it isn’t terrible by any means. And I don’t know of anything that would do better.

The good thing about this kind of thinking is that it concentrates on the improving longer-term opportunities as prices fall. Should the Index fall by as much again as it already has (and I’m not saying it will) the return opportunity just to recover lost ground from the September highs would be more than 10% compound returns over the next five years.

None of us likes the lump of coal that the market put in our collective Christmas stocking this year. It is uncomfortable, to say the least, that our investments of the past two years are now flat or down. And things may get worse before they get better. If they do, you can rely on Burgundy’s Investment Team to feel increasingly good about it.

We encourage you to use this simple thought experiment as a guide to rational behaviour in dealing with a volatile stock market. It’s not easy but it maintains an appropriately long-term approach to equity investing. And it can help prevent expensive mistakes.

Wishing you the best of the season and 2019.

Article by Richard Rooney, Burgundy Asset Management

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