We hosted a special episode to pass along a rational reminder when it comes to COVID-19 and the recent market volatility.
Read the Transcript:
Ben Felix: This is The Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision making for Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore.
Cameron Passmore: So welcome to a special release. We've had lots of requests to get some information out, and Ben has done a ton of work on getting data available. I think this is a very timely and interesting and fact filled episode. We thank you very much for joining us. We recorded it on Sunday the 15th. Ben and I were in separate offices because our friend Wyatt has implemented a work from home policy effective on Friday the 13th. We are behaving well.
Ben Felix: Yeah, we are. We try to keep the same format as we always do with current content, the listener question, the investing topic, and the planning topic. We did not do bad advice, and I just realized I had some from the economist I think his name's Rosenberg. Is that the right name?
Cameron Passmore: Yes.
Ben Felix: He's a permabear and he's always saying that markets are going to crash. Is that the old joke that he's called 900 of the last two bear markets or whatever. He had a piece where he was quoted a lot in, I think in the Financial Post, saying how this time is going to be different. And as you hear the episode, you'll hear why we think that's not very good advice to listen to. I mean, maybe it will be different but what we're worrying about that is, I don't think the right approach. Anyway, that would have been the bad advice topic, but I'm mentioning it now instead.
Cameron Passmore: Anyways, a message for our clients, as I mentioned, we are all working from home, but we're all available. We have technology, we have had for a long time in our firm that enables us to work from home and work very effectively. Teamwide, we have full backup in every position, so every single role has dual participants in it so if someone did become sick. And as of right now, everybody is healthy and everyone's family is healthy.
Ben Felix: I mean, work from home capabilities, I don't know when we made the move to put everybody on a laptop, but we did that a while ago, so this hasn't been a huge adjustment. I think the only change was that we gave people on the team a bit of a budget to pick out monitors. Most of us have dual screens at the office.
Cameron Passmore: We're all using Microsoft Teams and the video and audio capability, which is incredible. It seems like most people I know are going on Teams. We also use an app called Fellow that enables us to continue our meetings and track agenda items and action items, which is an amazing tool, for those of you who aren't familiar with Fellow.
Ben Felix: We've been on Zoom for... I mean, I calculated it earlier this year, roughly half of our clients live outside of Ottawa and the surrounding suburbs.
Cameron Passmore: We're getting proficient at Zoom meetings.
Ben Felix: Yeah, I believe we do a ton of meetings on Zoom. I haven't looked at my own calendar to see what the day will look it, but I would bet that more than half of my meetings with clients are over Zoom, so we are already pretty efficient at that. I mean, we're on Zoom right now. Cameron and I, are on Zoom right now to record the podcast episode, just like we would be doing with a remote guest, but we're switching what would have been in person meetings with people in Ottawa to Zoom video meetings so far has been pretty seamless.
Cameron Passmore: Yeah. We can do financial planning online at multi points, so we could be in different offices and share the planning software and the portfolio. It works very, very well.
Ben Felix: We'll see how the next couple of weeks ago, but as of now, I mean, we don't have that much data either, Friday was our first full day with everybody working from home. But Friday with that one data point, it felt totally normal. I don't think anybody missed a beat.
Cameron Passmore: It's interesting comparing this experience to past crises, which in the episode, we talk a fair amount about the rational observations of these events, but the client interaction is different to me. I mean the level of care and concern for all of our health, like us, our families, our team members, that by and large is the main concern from clients that are reaching out. Yes, there have been some questions about the portfolio, but by and large health is trumping everything this time.
Ben Felix: I've had the same experience. And I mean, that speaks to this event too. Like you look at the financial crisis and it wasn't about health. We'll talk more about this time is different, but this time is different from the perspective of this being a global health crisis, where it is a real concern for everybody. One thing just on the portfolio piece that I... We mentioned this two episodes ago, about how people were not getting in touch about wanting to sell and panic about the portfolio. We were having more people getting in touch wanting to get more aggressive with their investments. That's changed a little bit.
I think a few more people are a little bit wanting to talk a little bit more about just make sure everything's okay, which is one of the reasons we're doing this podcast episode, but that idea of changing your asset allocation to be more aggressive now I wanted to mention this during the episode, but it didn't get to it. A crisis is not a reason to change your asset allocation, but we did mention this part during the episode. It might teach you a lot about yourself. So if you all of a sudden markets crash, stock prices decline a lot quickly. If you don't feel stressed, maybe even feel excited, that's a new data point.
You truly now know how you would react in a crisis type situation from a financial perspective. And that's a data point that you can use in the future to change your asset allocation, but from a market timing type perspective, I don't think that a decline in stock prices is a reason to change your asset allocation, but it might teach you a lot about yourself, which can inform future decision.
Cameron Passmore: Exactly. Anyways, we did not rush this conversation. Ben you did a ton of research, which I and I'm sure the listeners will appreciate. And there's a lot of very good data and reflection in this episode. So with that, we'll let you listen to episode 90 and thanks for listening. Wow. What a week? Lots of phenomenal podcasts and information out there to learn about this pandemic. I'm sure you'd agree.
Ben Felix: Forget about the podcast. What a week this has been, not unprecedented and we're going to talk more about that but I think in at least my lifetime unprecedented.
Cameron Passmore: Certainly is. And one of the positives out of this is, there is so much good information in so many different formats. And so many people being creative about who they reach out to and bring back really good information about what is going on. So I found that to be one of the bright spots of a pretty dire situation obviously.
Ben Felix: Yeah, absolutely. I think you and I have listened to a lot of the same podcast covering what's going on from an epidemiological perspective, not from an economic perspective. I think one of the challenges is that not everybody's listening to that information, which is one of the problems that's causing this to continue to get worse.
Cameron Passmore: So as you mentioned the top, we're going to try to have a normal structure to this, even though it is a special episode. And I thought one of the most interesting podcasts I listened to this past week came from Shane Parrish that actually came out this morning. So we're recording this on Sunday, the 15th. And he interviewed Balaji Sreenivasan, who is a molecular bioinformatics expert from California, incredible background. And he talked about, and I know you haven't listened to this yet, but I think you've listened to another podcast with similar topics. We talked about some silver linings that could come from this pandemic.
One of the things he talked about, this could be an incredible accelerant for biomedicine, and he likened it to the impact that the internet had on programming. And he also talked about how the day will be coming, where we are going to have... You can believe it real-time personal testing that will feed to your smartphone, all the things that people are being tested for now at some point could be in real-time available to you. And it could even be rolled up at a societal level. So they would know different areas might be having certain pandemic type issues happening.
It's absolutely incredible what he is saying will happen. He didn't say when, but he's not minimizing the crisis that's happening, but humans have this ability to keep creatively finding solutions to problems.
Ben Felix: And that's one of the keys and themes that will continue to come up as we talk more about what's going on and what the impact might be. There was also a really good podcast episode from Joe Rogan. He had Michael Osterholm on who is an expert in infectious disease and he talked about what's going on and what you can be doing to prepare, what the potential impacts might be. Sam Harris had a couple of people on to talk with the same types of things. Silver linings are, yeah, that's good stuff to know about it. I think listening to these experts talk about what's going on and what we should probably be doing about it I think that's something that's important for people to do in my opinion.
I mean, I felt much more informed after listening to those people as opposed to all of the disperse information coming from all the different sources that you see on Twitter and LinkedIn and stuff like that.
Cameron Passmore: Yeah. That's what I thought Shane did a great job. It was in plain English and he went through, how did this start? What is a pandemic? How did it spread? And it was very simple to understand from obviously really smart guy. Before we get into all the meat of what I know you've done a ton of research on the past few days, I thought there was a great blog post that came out from 10% Happier this weekend from gretchenrubin.com. And as we mentioned at the top, we've implemented a work from home policy firm-wide and they came out with 11 tips for staying calm during the time of the coronavirus.
So I started running through these 11 tips very quickly. Number one, take care of your body, get enough sleep, watch alcohol and keep a routine. Number two, keep moving, go to the gym, keep active. Don't go to the gym actually-
Ben Felix: Yeah, don't go to the gym.
Cameron Passmore: Said don't go the gym, keep moving, do not go to the gym. Keep active. There's lots of videos on YouTube, do yoga at home. And I recently got a Peloton bike. So shout out to that. Number three, be aware of information overload, don't get overwhelmed and they suggest maybe setting specific times for the news updates as opposed to just watching your favorite newscast all day.
Number four, prepare. We're certainly living that in our city. People lining up at different grocery stores for items. I mean, I went yesterday morning, as I know you did. It's surreal to go into a grocery store these days.
Ben Felix: Well, I went Friday night actually. And it was quiet. It was the quietest I've ever seen, Costco Friday night 8:00 PM. I was thinking Saturday and Sunday are going to be crazy, I'm going to go now. And I think I made the right call.
Cameron Passmore: I kind of feel bad for manufacturers whose products are left on the shelves. It's pretty striking what people are not buying even in a time of crisis.
Ben Felix: Well, I mentioned earlier, there was a funny picture I saw on Twitter, who knows how real this is, or if it was just staged or whatever. But there was a picture of a meat section in a grocery store. The beef side empty, the chicken side empty. And in the middle, there was beyond meat full kind of funny.
Cameron Passmore: But again, is it true or not? Who knows?
Ben Felix: Yeah, you are right.
Cameron Passmore: Now, our next one tidy up. Order gives people a sense of inner calm, which we can all use now. The visual improvement of order has a large impact. Next one, help others. One of the best ways to make ourselves happier is to help others. And we've talked about happiness often on this podcast. Help to make people safe, calm, and feel better, prepare, do what you can to look out for others. Next one, connect with friends and family reach out to who might feel isolated, strong social relationships are certainly a key to happiness.
Next one, I've heard a lot of people talk about, make use of this opportunity to declutter, to spring clean or do other things like I'm going to practice more guitar, which is one of my goals. I've got a new cookbook I want to work on with the kids is a great time to meditate or even organize your photos, organize your various cloud accounts.
Next one, catch up in books and movies. I can only imagine the Netflix volume downloaded bonus going to be coming up. Create comforting rituals, such as, find pleasant patterns like your favorite tea or reading stories with your kids. And the last one, reach out with love. And remember that we're all connected in a common human hope for good health and prosperity. So I think that's a good note to finish on.
Ben Felix: Interesting.
Cameron Passmore: And the article ends with a quote be patient and tough one day this pain will be useful to you. I think that's a great segue to all the research you've done kind of looking at past pandemics and crisis moments in the markets and whatnot.
Ben Felix: Yeah, I'm going to take this to a not as nice note to finish on. Sorry. Yours was very nice, but one of the biggest takeaways that I've had from the podcast that I listened to talking about the implications of what's going on or at least one of the things that is allowing this to spread so quickly is that if you get the virus, you won't have symptoms for 10 days a week, two weeks, or whatever, a period of time. And the whole idea of social isolation, it's not just if you feel sick because by the time you feel sick, it's already too late.
My family were staying home a lot. You and I came to the office to record this, but we're in separate offices and we're going to stay far away from each other. But yeah, that's the biggest thing is even if you don't feel sick, you could be spreading the virus. You'll find out a week later that you had it and then all the people you were in contact in the in-term you potentially put at risk.
Cameron Passmore: You can even be tested negative, I believe and still be infected because of the amount of time it takes to be able to be found in a test.
Ben Felix: So that's like, I'm obviously not an expert in disease or epidemiology or whatever, but the biggest takeaway for me so far, is that the whole idea of social isolation it's not that you feel sick. It's not if someone you know feel sick, it's just you don't know what you've been exposed to and you won't know if you're sick from symptoms for a while after you've already been being contagious. One of the best things that I've seen, just in terms of how to think about how we as a population should react to this was that if we look back on this in a year or six months or 10 years or whatever, if we look back in this period of time and think, wow, we really overreacted, that's one of the best outcomes that we can have.
Cameron Passmore: Absolutely. That is without doubt.
Ben Felix: Anyway, this has been a lot of non-investing talk, but-
Cameron Passmore: Let's jump to listen to a question that was posted on the Rational Reminder website. So here it is, I think a lot of us listeners, many of whom are probably do it yourselfers would really benefit from a short little emergency pep-talk episode. I'm staying the course of the regular contributions and sticking with my factor tilt, but it's been rough seeing small cap and value get hammered so hard.
Ben Felix: And they have gotten hammered hard. The tracking error has been meaningfully negative if you own small cap in value. Small cap value, and market-wide value have taken a bigger hit than the market, which is, I mean, normal, that is what happens in downturns. And that's part of the risk of investing that way. And we'll talk more in general investing during times like this, we have a whole bunch of material on that, but I think, well, to answer the listener question and also because we talk about factors so much, I think it's worth talking about how factors tend to do in downturns and when the premiums tend to show up, when we're not predicting in the next month, small cap and value are going to come back.
That's not the kind of prediction that we would ever make. But it is worth having historical context for what things have looked like leading up to crashes and after crashes.
Cameron Passmore: Pretty crazy episodes in the past. I mean, it was unreal for you to dig through this.
Ben Felix: Yeah. It was pretty eye opening, especially, we'll talk more about it, but especially just with how value's done, people are saying values underperformed for the last 10 years and its value is dead and this time it's different and all that stuff. It's not, there've been periods like this in the past, anyway. So in September 1929, which as people may recognize is right before the big stock market crash that kicked off the great depression. I just looked at the trailing three year returns, annualized for value premium and small value premium. So these numbers are relative to the market. So value had trailed the market by 4.1% per year on average for the three years leading up to 1929.
Cameron Passmore: So this is before the slide of the market?
Ben Felix: Yeah. October was when the big slide happened at the end of October. So value had trailed by 4.1% small value had trailed by 9.6 3% per year for the past three years.
Cameron Passmore: Wow.
Ben Felix: When you think about that, your stock market's going crazy, everything's going up, valuations are going up and up and up. Now, obviously we know how that ended and when we can look back at the data, but at that time living through it in September 1929 it didn't seem like it was going to stop. And then we know that it did, but anyway, if now people probably weren't doing this back then, but if you had a tilt toward small cap and value stocks in September 1929, it was painful. 9.63% per year trailing the market in small cap value.
Cameron Passmore: Leading up to the market fall. That's what's incredible about that.
Ben Felix: Yeah. Now in October 1929, and this is a case where value actually didn't have as much of a drawdown, value did have a positive premium. So value was above the market by 8% in October 1929. After that one month, the value premium became slightly positive, in that one big month, small value is still trailed in terms of three-year return. And then falling October, things turned around again, value and small value started to have negative premiums and the three-year, I don't know why I'm using three or I just thought it was an easy number to think about. I'll talk about different time periods later, too. But anyway, three year from now.
So following October, the three-year value in size premiums became negative again and they stayed negative until May 1933. So again, you think about that, think about living through that as a factor tilt investor, which didn't exist back then. But if you are leading up to the crash, things looked awful. Like, why am I doing this? And then you get the crash. You got one good month where value looks pretty good. And then following that for another four years or so, it's just ugliness. But then in 1933, things did turn around.
Now, like I just mentioned to get to 1933 you had to hold on, which wasn't easy. We're talking about most months had meaningfully negative premiums relative to the market. Now, here's the other interesting piece. And this speaks to how the factors perform in downturns. So the max drawdown. Now, this is from the previous peak to the lowest point, which obviously is easy for us to look at in the past data. We don't know in the future when the lowest point is going to be. But if we look at the US market, so during the 1929 and following crash, the lowest point was in June 1932. So peak to trough. So I guess September 1929 to June 1932. Now listen to drawdown.
Cameron Passmore: It's a long time.
Ben Felix: Yeah. Well, things were ugly for a while. I guess, that's why it's the great depression. When the great depression, I think officially went to 1933, but it was bad, things were really, really turbulent until sort of 1941. But anyway-
Cameron Passmore: Give us the data and give us the numbers.
Ben Felix: Yeah. So the biggest drawdown, US market from peak to trough was down 83.7%. So if you bought in September 1929, the biggest drawdown was 83.7%. Now, again, as we know, if you held on long enough that came back, just market, forget about factors. That did come back eventually, but at the lowest point, you're down 83.7%. US value over the same period was down 87.5% biggest drawdown and small value was down 88.7%. That's almost 90%. Can you even imagine?
Cameron Passmore: No.
Ben Felix: Neither can I, hopefully we don't have to see that again. Yeah. But anyway, so we do see that bigger drawdown from small value, which is maybe what we're seeing some of now where you are taking that additional hit. And then starting in 1932, we start to see some big positive monthly premiums for small in value.
Cameron Passmore: Well, I would hope so after that.
Ben Felix: Yeah. And it's that story of where the market, you see the bottom in hindsight, we can see the bottom and after the bottom, when things start to come back, as they tend to do, which we'll talk more about in a different section today, but the premiums in this case delivered substantial premiums. So then if we look in June 1933, the one-year value premium, I double triple checked this because I couldn't believe that it was real. In June 1933, this is in US dollars. All of this so far has been in US dollars. In June 1933, the one-year value premium was 177%.
Cameron Passmore: So this is not the return. This is the premium. So we'll be clear on this.
Ben Felix: Yeah, we'll talk about the actual return in a sec just to give a little bit more context, but the small value premium was 234% for a 12-month return.
Cameron Passmore: This not calendar year, right? This is mid-year to mid-year to 12-month period.
Ben Felix: Yeah. I guess July 1932 to June 1933.
Cameron Passmore: Exactly.
Ben Felix: So I mentioned we started to see those big positive, monthly premiums. They were big. So over that time period, just to clarify, like you mentioned, Cameron, the market return over that period was 157.5%. Which is, I mean, can't even imagine, although I also couldn't imagine the 90% drawdown. But anyway, the value in that year returned 334% and small value in the US this is all US, I don't know if I mentioned that small value returned 392%.
Cameron Passmore: That slows the absolute returns and the premiums for the Delta return.
Ben Felix: That is correct.
Cameron Passmore: Unbelievable numbers.
Ben Felix: Yeah. Well, just like I couldn't imagine living through that drawdown I also couldn't imagine living through those big positive returns. Now, because people talk about value underperforming for a decade. And that seems to be something that people anchor on. I thought it would also be interesting to look at 10 year annualized historical returns over different time periods.
Cameron Passmore: Okay. So the first part was about in and around 1929 and the massive premiums coming out of that.
Ben Felix: And how you had to hang ours for a lot of serious ugliness to get there.
Cameron Passmore: Right. Okay. So park that, let's go on to 10-year returns now.
Ben Felix: Now, obviously this is all looking back in hindsight, we can find the worst and best 10-year periods. So for the decade ending June 1936, which is where the data really start, because the first data points that I have for market small value and value in the US starts in July, and I think 36. June ending 36.
Cameron Passmore: 10 year later to get the 10 years of data.
Ben Felix: Exactly. So the decade ending June, 1936, where the data start value had trailed the market by 72 basis points per year on average, which is interesting because they want to hear about that period of value under performance. A small value over the same period had beaten the market by 71 basis points per year on average.
Cameron Passmore: Isn't that interesting?
Ben Felix: Yeah. I guess a small value and value portfolio mix would have roughly matched the market return. Do I make sense over the same time period?
Cameron Passmore: Yep.
Ben Felix: There have been 155 months. Now, this is confusing, so I'll make sure we're extra clear. There've been 155 months historically, where in that month, looking back, there was a 10-year negative annualized value premium. So in 155 months, if you looked at what were my 10-year returns, 155 of all of the historical months, you would have looked back and seen a negative 10-year period.
Cameron Passmore: Yeah. We've talked about that phenomenon in the past, the value premium is not at always happening.
Ben Felix: Right. And that's 155 months out of I don't know how many, a lot.
Cameron Passmore: Yup.
Ben Felix: And then for US small value, there've been 101 months like that, where you look back and said, how are my 10-year returns and that was a negative premium over the market. Now, it's also interesting to see that those periods come in clusters. So I looked at value and most of those trailing decades happened between 1937 and 1943, big cluster. Any month within that time period, you look back what were my 10 year historical returns? You were trailing the market as a value investor. They also happened in 1999 to 2000, which I think people can probably relate to better because it's more recent. And we kind of know the story.
Cameron Passmore: Yeah. And in that period, it doesn't mean negative returns just means negative premiums. You didn't keep up with it growth.
Ben Felix: Correct. And then 2011 to 2012, there was another period. And then there was a bit of a gap where value premium was positive. And then 2013 to now, we've had this long stretch of... Long but not necessarily unprecedented. I mean, 1937 to 1943, pretty long stretch too. Anyway, small value has been mostly similar, but there have been some periods where a small value had a negative premium and value didn't. And there've been some periods where value had a negative premium and small value did not. Now, if we look back at the first period that I mentioned, the 1937 to 1943, the worst month was in December 1939.
If you looked at what were my trailing 10 year returns in December 1939, you had a negative 3% annualized tracking error for value, which interestingly is about the same as the worst month in the current period. And we'll talk more about that in a sec. Small value over the same time period was positive 2.03%. So you can see how they don't perfectly match up, which speaks to the diversification of having multiple factors. But anyway, so after that, you look back, man, I've lost 3% relative to the market for the last 10 years as of December 1939. Following that, both value and small value delivered big positive premiums.
And that wasn't necessarily after a crash. I mean, maybe that was near the end of the great depression, but one of the things that we'll mention later on, I guess I'll mention now too, is that you can't time this. Like in 1929 one seems obvious. Okay. Well, if you get into the bottom, you're going to kill it with the factor exposure. They don't necessarily come right to the bottom of a crash. You can't time it. So if we move forward in time, if you look back at the decade of returns ending December 1945. So remember previously we had a negative 3% tracking error in 1939, and we're thinking, man, value investing sucks. December 1945, you look back at the previous decade and there's obviously overlap here, which is interesting too.
Cameron Passmore: I was just going to say that's an overlapping period here. So you're going to suggest that things change quickly I'm guessing.
Ben Felix: Well, that's part of it. Absolutely. So December, 1945, we look back now, the annualized premium was 5.48% for value. You beat the market by 5.48% per year on average for the decade ending December 1945.
Cameron Passmore: For the overlapping decades, which is incredible.
Ben Felix: It is incredible. And small value over the same period, 11.28% premium. Crazy.
Cameron Passmore: But you had to be in your seat to get it.
Ben Felix: Right. And the whole time I'm doing this research and writing, and I'm thinking about like, yeah, value sucks right now. But I mean, it sucked in the past too. And to get the premium, you had to be there. In February 2000 value had trailed growth by 1.76% per year on average and small value had a small premium of 14 basis points. That's more recent.
Cameron Passmore: That's the decade ending February 2000?
Ben Felix: Yeah, sorry, decade. Yeah.
Cameron Passmore: Wow. I would have thought I'd been larger than that, but interesting.
Ben Felix: Yep. Well decade, right. I mean, if you looked at shorter period premiums.
Cameron Passmore: Yup. And then as we talked about in the past a year later or so the premiums jumped dramatically.
Ben Felix: Well, this one's crazy. You jump forward a one year. So instead of looking at February 2000 where the value premium had been substantially negative for the decade, you move forward in time one year and the whole ten-year premium flips to plus 4.92%.
Cameron Passmore: I remember that period, value's dead, it's all about growth stocks, pets.com, et cetera. And the whole thing flipped on its head a year later.
Ben Felix: The small value premium over that same time period jumped to 6.05%. Now, in the recent period, we mentioned there are those different clusters of value under performance. Now the most recent period, the worst decade end of July 2016, where there's a 3.15% annualized negative premium. Small value is negative 1.56% over the same time period. So both have done poorly or did poorly over that decade. Now, remember in that first decade in 1939 the 10 year premium was negative 3%. So this recent one it's on par with that.
Now, as we mentioned earlier in the decline, when stuff drops in general, except for in October 1929, this didn't happen. But in general, a small value take a bigger hit than the market.
Cameron Passmore: And on the flip side they tend to come back with big positive premiums and quickly. They tend to.
Ben Felix: Yeah. And now one of the things that I noted is that these things aren't called risk premiums for no reason. They're risky. The drawdowns are bigger, the volatility is higher and the premium show up unexpectedly. But if we look at history after crashes or on rebounds, when things start doing well, small value in value have tended to do pretty well. Now, one of the ways that AQR thinks about this, as opposed to thinking about it in terms of after a decline happens in the market, they look at the value spread. So the value spread is the difference in valuation between value and growth. When that valuation is really wide, it means growth stocks are priced much higher than value stocks.
And when the value spread is narrow, it means growth stocks have come and down in price or value stocks have come up in price, I guess. And when that spread is the biggest is when someone like Robert Shiller would say that the market's overvalued, irrational, exuberance has bid the prices up too high. And when that value spread gets really wide, the factor premiums tend to show up. Which sounds like, oh, hey, I can time the market. But just like when you think about using Shiller price earnings to time the market, the same kind of thing applies with factor investing. You can't time factor premiums using the value spread. And AQR looked at this specifically in a paper in 2017 that they called Contrarian Factor Timing is Deceptively Hard.
I had a quote from the paper, "Tactical value timing can reduce diversification and detract from the performance of a multistyle strategy that already includes value." And we talked to Cliff Asness about this specifically. He was a guest in episode 93, which you'll hear in a few weeks, Cliff wrote about the value spread in a November, 2019 blog posts on the AQR site that he called, the post was titled, It's Time for a Venial Value-Timing Sin. They had a paper a while ago called Market Timing: Sin a Little, and they say, market timing is a sin, but sometimes it makes sense to do, depending on what things look like.
So he said in November 2019 that the value spread was wide enough that in their opinion, and they did this in their portfolios, it's time to increase your exposure to value. Now, we didn't do that. We don't do that. We keep the same value tilt all the time. But cliff was saying it's time to increase exposure or maybe add exposure if he didn't have it. Now, what's interesting is in February 2020, he followed up with that piece with another blog post that he titled Never Has a Venial Sin Been Punished This Quickly and Violently!
Cameron Passmore: Exactly.
Ben Felix: And he's speaking to the fact that value got crushed in February and worst probably now. I don't have month end data from March yet, but yeah, it'll be ugly I'm sure. And so he wrote in that blog post another quote, we only send a little again while we know such tilts are rarely if ever instantly rewarded, it's also rare for them to be instantly incredibly punished. Well, welcome to 2020. And there's another quote from that post that I mean, he says it so well. So I'm going to quote him again. He said, and this is about value being painful right now.
Cameron Passmore: So this is Cliff?
Ben Felix: Cliff. So he said, "We've seen this movie before a few times, and we know how but definitely not when it ends. We believe that sticking with the process is the only way to achieve the long-term gains we seek. We also know that sticking with something that's good through its occasional very bad times, and even acting as a contrarian when others are finding newly created reasons to throw in the towel." And he's referring there to the whole idea that this time, growth is different, companies are different, whatever, whatever. "When others are finding newly created reasons to throw in the towel is very difficult, but this very difficulty is a large part of why we believe it's long-term rewarded and much harder to arbitrage away than some seem to think, as they say, if something were easy, everyone would do it."
Ben Felix: And so that speaks to that. I mean, the listener question was about small value and value or painful right now. And it's like, yes, yes they are. And that is one of the reasons that we expect a long-term premium. And we also have to remember, why did we make this decision? We made it because the very long-term data, not just in the US but all around the world, everywhere that we can possibly study the relationship between relative price and expected returns, all of the data show that there has been a positive premium. And it's not just that though, from a theoretical perspective, from an asset pricing theory perspective, you should expect a positive premium.
We had a guest episode that we recorded recently, and I'm not going to say who it is because we're keeping it a secret until the episode is released. But one of the questions we asked them was, how much you can learn about an asset classes expected returns from a decade of data? Actually, I think we might've said five years of data, but same kind of idea. And the answer is basically, and this is one of the foremost experts in asset pricing. They said, nothing or at least very little. And so when we're looking back on a decade of under-performance and sitting through pain, more pain, now that doesn't change our expectations about returns for that asset class.
Cameron Passmore: Yeah. And then he went on to say, focus on the decision process that you followed and not the outcome.
Ben Felix: And one of the things that I know that you loved I love to do, but we chatted about how great this line was afterwards. He said that your return is a combination of your expected return and your unexpected return. And the unexpected return you can't control, the expected return you can't control. I think the spread between those two gets tighter the longer we go out. But over 10 years, there can be a huge component of unexpected.
Cameron Passmore: And it's your behavior that can often be triggered by the unexpected part, because it was unexpected that will have possibly the greatest impact on your long-term returns because the unexpected will trigger behavior that could ruin those returns.
Ben Felix: Right. Now, we'll talk more about this and then in the next section too, but it's worth mentioning in terms of factor exposure. If tracking error is painful for you, if you're holding onto that factor portfolio and it's really causing you discomfort and people, I think we can say that, three weeks ago, when people would say yeah, pain, sure. But today people probably get pain a little bit more. It's physically uncomfortable to see asset values drop and to see big negative tracking error numbers. So if the pain of being in value in small value is too much, you may have learned something about yourself and-
Cameron Passmore: That's a valuable data point.
Ben Felix: And that can be, I'm not saying you should go change your asset allocation but that can be a lesson for his first people to say, "Hey, I can't handle this tracking error." That's not rational, that's fine. But if people can't handle the tracking error relative to the market, you may have learned something about yourself and maybe you shouldn't be in factors.
Cameron Passmore: So it's interesting. I talked to Dr. Moira Somers this week, and one of the things she was telling me was take advantage of times like these to actually journal your reaction to things and pull those quotes out in the future when things happen because often people's risk tolerance will shift based on the recent experience and the data point now is that you can't tolerate this. When things get back to normal, you revisit your asset mix remember and keep that quote for future consideration.
Ben Felix: Yeah. And we'll talk more about asset allocation, just risk, non-risk asset allocation, as opposed to factor allocation in the next section. Okay. Are we good on listener question factors in a downturn?
Cameron Passmore: I think so, great data. So let's go into the investment topic, investing through crises. So this clearly is first and foremost, a human tragedy that's certainly been all my communication with clients lately has been about that more so than the portfolio, but clearly it's having a huge impact on markets. The DFA global equity portfolio as you looked up is down 22%. This is an all-equity portfolio down 22% as of close on Friday, March 13th which will be the most memorable birthday for me ever, or certainly so far. And then VEQT, which is the Vanguard all equity ETF down 16% so far this year.
Ben Felix: So negative tracking error for the factor tilt to portfolio, which would expect the geographic allocations for these two are the same, which is why I use VEQT as opposed to XEQT which has a little bit less in Canada, but we're seeing 6% tracking error. And that's partially, I ballpark roughly 50% from small cap and value exposure and roughly 50% from the partial currency hedge that DFA does in the global equity portfolio. VEQT is completely unhedged. All this stuff happening with the coronavirus, but then we also have the oil price shock that we had which tends to affect Canadian currency. Anyway.
Cameron Passmore: Just think of all the things that market participants have to figure out, the crisis itself, the oil shock, trade, supply chain. I mean, I was reading articles about how this is a supply side, not a demand side economic event because of supply chains and different countries having their supply chains effecting the supply of products to North America. Now it's arguably moving on to the demand side with France and Spain basically shutting down their economies over the past couple of days. And it looks like that could be coming to North America certainly with sports teams and any public events, public venues. So the efficiency of markets, some people say the markets are not efficient, but it has a lot to figure out here.
Ben Felix: Well, people say because of volatility, well, if the market was efficient, why would it drop so much in such a short period of time? Which as an aside, this has been in terms of getting to a 20% drawdown, this has been the fastest drop in history, which is interesting. Not the deepest drop in history, but to the drop that we've gotten to, this is the fastest that we've ever gotten there. But yeah, like you said, this does not mean the market is not efficient. It means that there's a lot of uncertainty. And how does the market treat uncertainty? Well it treats it as risk. There's also a lot of uncertainty about like, you mentioned that the real economic impact.
I mean, how is the stock priced? It's the discounted value of expected future earnings, if expected future earnings become lower. I guess that the expectations decrease based on the economic concerns that decreases asset prices. But also uncertainty increases risk, which increases the discount rate, which again decreases asset prices.
Cameron Passmore: Because there is a buyer and every side of that trade. And it's a smart buyers. They're doing that same calculation.
Ben Felix: But things are changing quickly, which is why we're seeing so much volatility. Like Friday closed up quite a bit.
Cameron Passmore: So far the number one question we get is, so what should we do? Number one, try not to worry. Yes, we're all going to feel stressed, but every equity investor should expect something like this every 10, 15, 20 years. If it happens with the market regularity, we go out of a way to highlight that to people.
Ben Felix: Remarkable regularity. And we'll talk more about how remarkable that regularity is in a sec, we have some interesting-
Cameron Passmore: The other regularity is that the story that goes along with it changes. The story in my experience, if it was just the numbers, I don't think would be nearly as dramatic the impact.
Ben Felix: Yeah. You said that-
Cameron Passmore: As soon as you touch the story to the numbers.
Ben Felix: You said that a couple of weeks ago and we'll talk more about the paper in a bit. There's a paper from Robert Shiller that basically says exactly that. So you're very wise.
Cameron Passmore: The next thing you should do is avoid making drastic changes. When you're under stress, it can be pretty tough to make good long-term decisions. If you've made a plan, stick to the plan.
Ben Felix: That's the thing, you made a plan in calmer times, probably I mean, unless I guess you're doing your planning now, or if you did it in '08 or '09 or something. But most times are calmer than they are right now. And most planning is therefore done in calmer times. And just because things are getting weird as the prices are going crazy, even correlations have been weird. Bonds dropped with stocks, Gold's been dropping with stocks.
Cameron Passmore: So did Bitcoin.
Ben Felix: Bitcoin. Yeah. That's a whole other story. Crazy. Not such a hedge, I guess, anyway.
Cameron Passmore: No.
Ben Felix: I don't need to make that jab, but I did.
Cameron Passmore: I think we should remain optimistic, certainly it can get worse but you cannot predict how this is going to play out. But I mean, I know, I believe that lots of good will come from all of this pain and humans have an amazing ability to figure things out and make things better.
Ben Felix: It's both. I mean, it's both of those things. Remain optimistic, absolutely, understand that this could get a lot worse. It's both. And they're not mutually exclusive. We can remain optimistic in the long-term and understand that things in the short-term could get worse, a lot worse. I mean, we talked about the drawdowns in 1929 to 1932, and we're nowhere near. I hope we don't get there, but we're nowhere near that.
Cameron Passmore: And if you're not in asset allocation portfolio ETF where the rebalancing is happening right away, now might be a good time to be rebalancing your portfolios. And we'll talk about later on in the planning section, could be a good time to tax loss harvest.
Ben Felix: We talk about payment, if you're in an ETF portfolio and the market has dropped every day for the last week, you still need to rebalance.
Cameron Passmore: For sure.
Ben Felix: Which can be scary because the market might drop the next day as well. But that's part of your job as if you're doing this yourself, a part of managing the portfolio is really balancing.
Cameron Passmore: And lastly, keep a long-term view. Just imagine what the world will look like. Just imagine six months out if we all stay at home, this thing could hopefully will go away.
Ben Felix: Yeah. And if we take a longer-term view, the world's seen a lot of stuff. Asset prices have seen a lot of stuff. Financial markets have been around for a long time, longer than most people appreciate. And a lot of stuff has happened. We'll talk more about that. So I think like you mentioned Cameron, the story one of the most, and this speaks to the idea of keeping a long-term view, but one of the most important things for people to do is separate the facts from the narrative. You mentioned the supply side demand side, what's the impact. That's all narrative.
We don't have facts. We don't know what the impact are going to be if we step back and I think that one of the best ways to process what's happening is to look at historical situations where we've been in similar circumstances and see what has happened. Those are facts. We know exactly what happened when stuff like this happened in the past. Everything else is narrative. Now, narratives in general are important because they help humans understand stuff and narrative don't change facts, but narratives do change the way that people respond to facts.
Cameron Passmore: Absolutely.
Ben Felix: If we look at the 1920, the 1921 US recession as an example, and this example comes from Robert Shiller's paper called Narrative Economics, that recession was surrounded by the end of World War I, I think 14 months prior. The 1918 influenza pandemic, which we'll talk more about in a second, there was a growing fear of communism within the US public. I think they were having problems with race riots across the country. And so you look at all this stuff together and there was a really unsettling, I mean, you can you imagine the situation.
Cameron Passmore: Can you imagine? You can't even imagine all that.
Ben Felix: A lot of economic uncertainty. And then on top of that, there was an oil price shock where oil prices jumped 50%. And there was a narrative surrounding that too. The narrative was that the demand or the uptake, the use of automobiles was growing way too fast for the nation's oil supply and people were predicting that oil was going to run out in the US in 18 years. This is in 1919, that prediction was made. Obviously that didn't happen because of global trade and the US finding more oil reserves. But at that time, oil prices jumped 50% and people are saying we're going to run out of oil.
You can see how that would have a meaningful economic impact through the narrative. It wasn't a fact. It wasn't a fact that the demand for automobiles was outstripping supply and that everything was going to collapse. That was a narrative, but that narrative had a real economic impact because people start to worry about it. Now, because of what's going on right now, I think that the 1918 pandemic is interesting to talk about. One of those experts I think the one that was on the Sam Harris podcast said that this probably isn't the 1918 pandemic, it's probably more like the 1957 one, who knows, I guess. He probably knows better than me so I'm sure there was a good reason for him to say that, but we're going to talk about the 1918 pandemic for a second.
So it's ballpark estimated to have killed 675,000 people in the US and 40 million people around the world from the spring of 1918 through the spring of 1919.
Cameron Passmore: Unbelievable.
Ben Felix: And it did continue until I think 1920, or maybe even a little bit later, but the peak was from 1918 to 1919. And in that case, which is different from what we're seeing with the coronavirus so far, the hardest hit portion of the population was males aged 18 to 40. And I don't think that we fully understand why that is, but one of the hypotheses is that, that virus caused the human immune system to basically turn on itself. And so the people with the strongest immune systems were the ones that had the highest mortality rate. Now we don't have-
Cameron Passmore: The impact of that in society.
Ben Felix: Yeah, we don't have really good data because this is 1918, 1919, but between the economic data that we do have newspaper clippings from the time, and this came from a paper, St. Louis Fed, I think, a paper in 2008, I think on this but the main estimates were that there was a big reduction labor supply, as you can imagine with males age 18 to 40 being hit the hardest, which resulted in a higher cost of labor. And there was a short term, which is important, but substantial, which is also important, revenue reduction for businesses, particularly in retail and entertainment. Which you can obviously see that expectation for our current situation it wouldn't be unrealistic for the same thing to materialize. It's probably already materializing. I think airlines are saying, they're shutting down a lot of their flights and stuff like that. And I don't think you can book a cruise right now.
Cameron Passmore: No.
Ben Felix: No. And so we had that pandemic and then there was a recession. Now we can't say with certainty, I mentioned all the other narratives that were going on at the time and the war had just ended. So we can't say that the pandemic caused the recession, but they did happen pretty close together. But what we do know, just empirically looking at the data, the S&P 500 cyclically adjusted price earnings ratio dropped to its lowest level in history, the Shiller PE at the time, I don't have the data point, but it was like four or something and it's 30 or maybe 25 now.
Cameron Passmore: Wow. Really?
Ben Felix: Asset prices just tanked. And we talked, well, I know we didn't talk about this early. We talked about 1929. Now, following that drop. So from that bottom where the PE ratio is the lowest it's ever been in history, asset prices, I mean, they went crazy. But this is, I think the theory behind what happened there was increasing global trade. The narrative, I guess, is that the US helped rebuild Europe, which caused US asset prices just skyrocket. And then maybe there was some I don't believe in bubbles, but whatever, maybe there was some asset bubbles going on because people were just getting irrational and bidding up stocks and using leverage to borrow stocks, which is one of the reasons 1929 was as bad as it was. But anyway, that's all narrative can prove it.
So after that big drop, asset prices screamed up like crazy, must be one of the biggest bull runs ever followed by the 1929 drop. But even after that, as we talked about earlier after the 1929 drop, it was a bit slower this time, but there was a recovery. Now, this is empirically not unexpected after big drops in asset prices historically, there've been big rebounds. And you can say that's survivorship bias, because we only have data from markets that have survived, but we'll talk more about a very broad data set that shows this to be true, going back many hundreds of years and across any market that we can possibly study.
I found a paper that looked at that. But before we get there, I think it's also worth mentioning the 1957 Asian flu. And so Nicholas Christakis, who's the guy that was on the Sam Harris podcast that I mentioned. He had a Twitter thread where he said that he doesn't think 1918 is the right comparison, 1957 is probably better to compare to COVID-19. So that was a pandemic that again started in China, it killed 1.1 million people including 116,000 in the US. I think I saw we're at what, 150,000 cases now for COVID-19 globally?
Cameron Passmore: Yeah. Changing by the hour.
Ben Felix: Yeah, it's probably double that by now. I found an article in the journal Pathogens that explained all past pandemics involving novel influenza strains. And this was one of the important things about COVID-19 and the 1918 called the Spanish flu and 1957 Asian flu. They were all novel strains, which means that they were brand new to the human population. So they jumped from animals to humans. And at the time that they made the jump, no human had ever come in contact with before, which is one of the reasons that they're so deadly, nobody has immunity.
So I'll read a quote from the article specific to the 1957 pandemic, "The economic impact was small with the pandemic reducing industrial production by about 1.2% in Canada during the peak and reducing GDP in the United States by about 1%. Economic recovery following tapering off of the pandemic was almost immediate. Meanwhile, though hospital admissions in North America did increase during the pandemic. Hospitals were able to accommodate surges in patient demand through repurposing beds, reassigning physicians and canceling elective surgeries. This was complimented by a concerted effort to promote home care for uncomplicated cases."
Now, there was a market downturn, and I don't know if they're directly related or not. I didn't do a ton of research on what else was happening in 1957, but there was a market downturn from February 1957, which is when the first cases of the Asian flu were diagnosed in Singapore I think. So from 1957, the biggest drawdown was about 15%. After following 1957, the biggest drawdown was 15% for the US market. So there was a drawdown and then 23% for US value, 21% for small value. I mean, it was ugly. And again, I don't know if they were directly related, but there was a big market drop. But if you look at the full period from February 1957 through the end of December 1958, over the full period the US market delivered an annualized 16.93%.
Cameron Passmore: In just less than a two-year period there.
Ben Felix: And that was an annualized-on average per year. I didn't look at the size premium and the value premium over that time period. But the point is post discovery of this novel virus in 1957, there was a big market decline, but over the full period that the virus took its course market returns were positive. I'm not saying market returns are going to be positive this time, but it is just interesting to look at what happened in 1957.
Cameron Passmore: Certainly interesting data points and the people didn't know this could happen. This is sure been an information full experience.
Ben Felix: Yeah. But I think the most interesting thing is this is not, maybe it will end up being unprecedented. When we look back at that this on in two years or something, maybe this is totally unprecedented in human history, depending on how it plays out. But it's definitely not the first time that something like this has happened at this point in time, who knows how much worse it gets. I don't know.
Cameron Passmore: But this is the first time this has happened in a Twitter age though, right?
Ben Felix: Yep.
Cameron Passmore: Where the information spreads so fast. I mean, when Spain shut down yesterday, the whole world knew within minutes. That's very different certainly than from these past events.
Ben Felix: Yep. And presumably technology is better and our ability to develop vaccines is better than it was then, I don't know, I didn't do research on that, but anyway, we're all uncertain, nobody knows what the outcome is going to be. The point is, there have been pandemics in the past that have affected the global economy. And we're still here, although it was probably painful at the time and the narratives were probably very scary at the time. Now, if we step back from all of those narratives and think about what are the empirical data say about market crashes?
There was a paper, a 2017 paper titled Negative Bubbles, which is a plan on Robert Shiller's concept of bubbles. So Negative Bubbles: What Happens After a Crash by William Goetzmann and Dasol Kim. And I mentioned stock markets have been around for a long time, asset prices have been examined for a long time. And even this dataset, they corrected for survivorship bias, made sure that even markets had failed were included in the dataset. They looked at 101 global stock markets from 1692 to 2015. So way further back in the data, then the stuff that we usually talk about from an empirical perspective.
And they identified over that time period, 1032 events where a market declined by more than 50% over a 12-month period. So this is a 101 global stock markets from 1692 to 2015.
That's 323 years.
Ben Felix: It's a big data series and what they found and I guess what they were looking for was, there's a much higher probability of a large positive return. And now, I mean, I guess we can just anecdotally look at the example we talked about earlier with the 1929 crash, following a crash, there's a much higher probability of a large positive return. Now why I think this is important other than it being interesting. Why I think this is important now is that if now after a crash seems like a good time to change your strategy. Maybe you want to get more conservative or go to cash.
It might be one of the worst times to do that because after crashes, there tend to be significantly positive returns. I don't know when that's going to happen, or even if it's going to happen, but historically, over this very long data series, that is what has happened. Now, if you think back from 1692 to 2015, over 1032 crashes of 50% or more, I can't even imagine what the narratives were in each of those situations, but I bet you, they were pretty scary. I bet you didn't feel good, but we today have this paper and have this data series. We can step back and look at all the outcomes. We don't get to see the narratives.
I'd be fascinated to read about them, but we don't look at those. We're looking at the empirical data and what happens empirically after crashes, markets come back. Now, they say in the paper, even though it's called Negative Bubbles, they say, the idea that this is because of a negative bubble is really hard to test, you can't, you cant test it. Just like FAMA says you can't test whether bubbles exist or not. So same kind of idea, but they're just kind of saying maybe that's an explanation for why this is happening. We can't test it, but maybe that is an explanation. Maybe prices in panics get way too low.
Cameron Passmore: Get irrationally low.
Ben Felix: Right.
Cameron Passmore: So the opposite of irrational exuberance, irrational pessimism.
Ben Felix: Right. And now whether the rebounds are caused by that irrational pessimism or not, I don't think that really matters for our purposes. What matters is that empirically after crashes markets tend to come back.
Cameron Passmore: Just imagine 1,032 events over 12 months of more than a 50% drop in the past 323 years.
Ben Felix: I'd love to read a book about each one.
Cameron Passmore: That could be your project once your kids are older, you can write that book.
Ben Felix: I don't know. I'd rather read it.
Cameron Passmore: That's a high impact data set, the information, it normalizes what's going on. But you think of this world where we as a society over engineer portfolios to try to... I think a lot of people like to avoid this by over engineering portfolios, but you can't escape the fact that stuff like this has and will happen.
Ben Felix: And best thing that you can do is stick with it.
Cameron Passmore: Stick with it.
Ben Felix: If you get out and when do you get out? Not usually before a crash, because you don't expect the crash to happen or a decline in prices. Once it happens is when people go, "Oh, this is bad. I should get out." But you've already taken the hit.
Cameron Passmore: And I think too many people in our industry paint a picture of, don't worry, be happy and say, this is normal. I think every time this happens, it is different because it is a different narrative. But when you look at a survey or a sample, 1,032 events we've come back from every single one of them.
Ben Felix: The narrative is different, that's kind of what the point I was trying to make earlier, if we could step into every one of those events, those 1,032 events where markets declined by more than 50% historically over that data series anyway. I can't even imagine what the narratives would have been at the time. I read and we'll talk about this more in a minute, but I read a book called Our Mysterious Panics, which is about market crashes in the US and that also ended up being global recessions at the same time, from 1830 to 1930. It's by a guy named C.A Coleman, Our Mysterious Panics. The English is well older, so it's kind of funny to read but it's fascinating just the narratives that he talks about in each of those situations were things that you can absolutely see applied to today.
Prices are irrationally high, people were too greedy, there was corruption in the financial system. There's too much government debt. All of these things, none of that's new, maybe the combination of factors is new. Anyway, I mean-
Cameron Passmore: Interesting experiment would be to instead of having live pricing, because we all enjoyed it as the market's roared up earlier this year, instead of having live pricing, imagining having your portfolio priced every month. Or every six months if you could run that as an AB test would be fascinating to see if those highs would have happened, if these lows would have happened.
Ben Felix: Yeah. That would be.
Cameron Passmore: Because so much of the drop it's the arguably irrational exuberance earlier this year that's been taken away.
Ben Felix: If that were a possible experiment to run, that would be a way I think, to test the negative bubble idea. Anyway.
Cameron Passmore: On Twitter, that's one of the greatest reasons why people do so so well with their houses. You don't see a statement arriving all the time. They don't just go and sell it because market happens to be down.
Ben Felix: So I think from that dataset, we can take away that getting out after a drop is probably the worst time to get out because there's historically, generally been large positive returns after a drop. And just for fun, I don't know if you call it fun but just to see, I had fun. I looked at the S&P 500 data going back in 1926 through the end of February 2020, as an example, the full period return annualized was 10.08% in US dollar terms. And I just went and said, what if I took out the top 10 months? So that's 0.9% of the months and the full period. Less than-
Cameron Passmore: 94 years of data.
Ben Felix: Correct.
Cameron Passmore: Or something like that. 93, 94.
Ben Felix: So I took those 10 best months out and the annualized return dropped from 10.08% to 7.74%, 10 months, less than 1% of the months-
Cameron Passmore: Wow.
Ben Felix: ... Were the best ones. Now I just went and scraped through the data to see when those happened. And all of them were surrounded by or following meaningfully negative returns.
Cameron Passmore: Think about that. Just think about that, the behavior and the thinking that's going on and the emotions that are going on then.
Ben Felix: Exactly you step into someone's shoes who's living through that. It would seem like a good idea to get out but that increases your chances of missing that tiny percentage of the returns that drive somewhat the long-term growth of an index. I think one of the other things that is important for people to think about when we're going through times like this is, I mean, what is the main concern, I guess, is the question people should ask themselves. Because I think people get caught up in the idea that everything's going to go to zero and we're going to lose everything. Now in 1929, it was close, small cap value.
Cameron Passmore: You think about it though, if that happens, we have much bigger problems than our portfolios.
Ben Felix: Yeah.
Cameron Passmore: Obviously.
Ben Felix: You just think about what do you own when you buy an index fund? Well, you own stocks. What's a stock? Well, it's ownership of future earnings, or expected future earnings from actual real businesses that are doing stuff. Now, business can slow down for sure. Some businesses can go bankrupt. Absolutely. You pay a price for those earnings based on the riskiness of businesses. So I guess businesses that are maybe more likely to go under like that, you would pay a lower price for the same amount of earnings. Now, when stock prices drop and I talked about this earlier, it means expected future earnings have decreased, businesses have become riskier or a combination of those two factors.
Now, when we're talking about a globally diversified portfolio of index funds that owns a very close approximation of all of the businesses that exist in the world. For that to become worthless, we would have to be in a situation where nobody expects any business, because remember, how does it go to zero? Nobody will buy it from you. As long as someone will buy it from you it has value. So for no one to buy your stocks from you, the stocks and your index fund from you, we have to be in a situation where nobody expects any business to earn any profits in the future. And like you said, Cameron, if that happens, we have much, much, much bigger problems.
Cameron Passmore: But think of all those companies, all utilities that deliver services to you, yourself all in your natural gas, your grocery store, all the companies producing products there.
Ben Felix: Yeah. So I think that the more realistic consideration is that you're going to watch your portfolio decline, and it might decline a lot, hopefully not as much as small cap value in 1932, but hopefully not, but it could go down a lot. I mean, compare it now to '08, '09 and we're not there yet. That can happen, the asset prices can decline. But I think this is where narratives, both narratives and asset allocation become extremely important. Narratives will make us think this time is different and it might be different.
Cameron Passmore: It will be different.
Ben Felix: The narrative is always going to be different.
Cameron Passmore: The narrative always different. That is the point.
Ben Felix: But I think challenging and uncertain times and increasing uncertainty for whatever reason are not new. And we've talked about the empirical data around how robust markets have been historically. If we just look at this century, as an example, we've seen, we've lived through the dotcom crash. And we talked about some of the data on factor investing over that period. The 9/11 attack in the World Trade Center and those happened pretty close together, Ebola, swine flu, SARS, the global financial crisis and now we've seen the start of COVID-19. And through all of that from January 2000 to February 2020, the MSCI All Country World Index in Canadian dollar terms delivered a 6.56% annualized return.
Cameron Passmore: Wow. That's a lot of stuff going on in that time period.
Ben Felix: You just think about the narratives, all of those times, I mean, I've been alive, maybe not really paying attention to stock markets the whole time, but I've been alive for all that stuff and it's always scary. It's always uncomfortable, but why does stock investors expect positive returns? Because they're being compensated for taking risk. Uncertainty translates to risk. When we're living through uncertainty I mean, geez, that's how you earn a risk premium I think by taking risk.
Cameron Passmore: And we figure stuff out.
Ben Felix: Humans have been very good at that.
Cameron Passmore: And you never know what the solutions and what the creative outcomes will be as we talked about off the top.
Ben Felix: So we think it's important to not get caught up in the narrative, even though it's scary, we're living through it too, but not get caught up in that. And look at the much, much, much broader set of historical data on how robust markets have been, and even look at case studies of how things have played out when we've lived through stuff like this in the past, maybe they were slightly different. They definitely were slightly different, maybe even a lot different, but we can still draw analogs.
And even though things have been bad in the past, they've also come back. Now, one of the things that I've heard a couple of times, and this is again, a narrative is that there's a credit bubble and there's so much debt everywhere, which interestingly, I also read, there's a book called The Great Depression: A Diary, that I read a while ago by a guy named Benjamin Roth, who was a lawyer that worked... Had his own law practice throughout the great depression. And he kept a detailed journal. And talk about narrative, I mean, that's a first-person perspective on how people felt on what was going on.
But he talked about a lot of the same stuff, the debt bubble thing. He talks about how high the government debt was back then and how nothing good can come from that whatever. Anyway, so that's one of the things that I've heard. There was a 2008 paper from the National Bureau of Economic Research titled, This Time is Different: A panoramic View of Eight Centuries of Financial Crises. And so the hook for their paper was that they had collected this massive set of historical data on well, financial crises. And the paper is basically a summary of their findings and also a summary of how they put the data together.
But I pulled a quote from their conclusion. They said, "This panoramic quantitative overview has revealed a number of important facts. First and foremost, we illustrate the universality of episodes of serial default and high inflation in emerging markets extending to Asia, Africa and until not so long ago, Europe." They're basically saying that emerging markets almost always have a bunch of defaults before they figure stuff out. We show that the global debt crises have often radiated from the center through commodity prices, capital flows, interest rates, and shocks to investor confidence. Now, the interesting part that I took away from this is that a lot of the countries that they're talking about that have gone through serial default in the past are now countries that are global big players from an economic perspective.
And they give a lot of examples about how countries have been able to figure it out through restructuring and negotiating and all that kind of stuff. I mean, I guess Greece is maybe a very recent example.
Cameron Passmore: It's sure is. I was just thinking that.
Ben Felix: The way that countries figured this out is not always that nice. France was the most extreme example, which I thought was fascinating. France, effectively defaulted on its debt through history by executing major domestic creditors. So that's-
Cameron Passmore: Executing?
Ben Felix: ... Killing them. Yep. That's pretty extreme. The French finance minister Abbot Terray who served from 1768 to 1774 even suggested that governments should default on their debt at least once every 100 years in order to start equilibrium. Now, I don't know how good of an economist he was, but that was his suggestion. And I guess France carried that out sometimes by executing the people that they owed money to.
Now, that's not an argument that everything's going to be fine in a country that defaults, but I think it is an argument that in aggregate a globally diversified investor will come out okay. There will be defaults. There will be credit bubbles from a sovereign perspective this is something that has happened all throughout history and through restructurings and negotiations and executions, I guess, countries have been able to figure it out. And you couldn't have been a globally diversified index fund investor throughout the full period that they were looking at. But my bet is you would have done all right. And I'll talk a little bit about some US data similar to that.
Cameron Passmore: So it's almost like people hunting for narratives to explain what's going on. And the credit situation might be it, it might not be it, that's effectively what you're saying.
Ben Felix: It might it, it might not be it, even if we end up in a serious credit situation, historically, countries have figured it out. And it's not always nice, I'm sure that there's been austerity for some countries that hasn't been very nice for their citizens to live through, but here we are. So in that 1931 book that I mentioned, Our Mysterious Panics. And I was looking at US panics May 1030 to 1930. I know I already mentioned this, but there were a ton of narratives that you could apply to today. If you told one of these stories in 2020 English, you can believe it was about today. There are asset bubbles, bankruptcies, restructurings, and outright fraud like we've seen.
And I'll just mention the chapter titles in the book, there is the great inflation, the land craze, the gold stimulant, the railroad cantrivers, the gambling bankers, the trust lunacies, the merger manias and the battling bankers. Anyway, it's a funny book to read. Now, the interesting part was that, a lot of these specific assets like railroad is an easy one to talk about. There are these high yielding railroad bonds and railroad stocks that people were getting crazy buying, using leverage, all that kind of stuff. And if you're in that, especially if you're a leveraged, you blew up, you lost everything. And the same thing, they talked about land, massive land inflation, everyone's borrowing money to buy land, sounds a little bit eerily similar to today, but same kind of idea.
If you had all of your assets in leveraged landholdings and that bubble popped, yeah, you lost everything. But in aggregate over the same time period, when we had all these crazy asset bubbles and all these big losses and all this fraud, capitalism as a whole, as measured by an index did just fine. So index funds in 1830 didn't exist, obviously, I don't know.
Cameron Passmore: Let me think about how Warren Buffett would frame it. He's always so all shocks about it all like capitalism works. They'll figure it out, just be patient. And that's the message I'm taking away from all this work that you've done.
Ben Felix: Yeah.
Cameron Passmore: Bad things happen. You have to know bad things can happen, but humanity figures it out. And then as you come through it, you use that information point on perhaps future asset allocation as it makes decisions, but not to make changes during the time. Because if you think about it, as prices go down expect returns, if we all came out on the other side, expect returns increases, prices fall. But the return doesn't show up so fast and furiously, if you're not there, you can do more harm by making changes than good.
Ben Felix: Yep. Now Robert Shiller does publish S&P 500 returns going back to 1871 after which there were many panics. I think there was one in 1873, but I mean, if you read the book Our Mysterious Panics, you'll see all of the... I mean, you read the stories, read the narratives. And it's like, man, what a crazy time people must have lost so much money. The S&P 500 from 1871 to 1930 returned 5.01% per year on average. If you follow the narratives and didn't look at the index return, like you read this book, you read Our Mysterious Panics, you wouldn't be so optimistic because so many different things blew up for so many different reasons. But in aggregate the US market as measured by the S&P 500, go back to 1871, just fine. Thank you very much.
Cameron Passmore: Incredible data points. Onto the next subject.
Ben Felix: Yep. Planning topic.
Cameron Passmore: Planning topic, where we get a chance to make some lemonade out of these lemons. So we'll go through some of the ideas and some of the rules, what you can do during times like these. So number one thing that we hear often coming out of Robo advisors, especially as tax loss harvesting. So you have a portfolio in your trading accounts, so your non-registered account. You can sell and buy back another security, has to be a different security and trigger that loss. Super easy to do. We're going to be doing a lot of it I'm sure coming up.
Ben Felix: We did an in-depth discussion on this. I can't remember which episode, but we did talk about it on the podcast a while ago, and I have the loss allowed by Canada Revenue Agency. You can't buy back identical properties. They had not an opinion like whatever. They showed their position on how that works for index funds a while ago. I think it might've been even 2006 they wrote that. But anyway as long as you buy index funds that track different indexes. Even if they're investing in the same market, you can have two US indexes, like maybe one's tracking the crisp 110, one's tracking the S&P total market index, pretty much the asset. But as long as it's tracking a different index, it is a non-identical property. Two funds from different issuers tracking the same index would be an identical property.
Cameron Passmore: Like an S&P 500 from Vanguard switching over to BlackRock.
Ben Felix: That would be-
Cameron Passmore: That would be disallowed.
Ben Felix: The loss would not be allowed. But there's a problem with that is the tracking error. Right?
Cameron Passmore: Right. But in Canada's laundry out for 31 days, you can buy it back and carry on. But the nice thing about triggering the losses is you can bring it forward with you and definitely the net losses where you can pull it back the three prior years. So if you happen to have triggered capital gains in the past three years, you can bring these losses back and trigger a refund for yourself.
Ben Felix: I think like when we look at this for clients, I don't think we just trigger any loss. We generally try to find situations where people have a current year or a past three-year gain. And the reason it's not free and it's not free because you have to change your portfolio. You think about a regular index fund investor. And this is one of the things we talked about in the podcast a while ago, over 31 days, you can have meaningful tracking error between two index funds because by definition, they have to be tracking a different index. Now that's probably not such an issue. And you wouldn't expect a long-term difference in the outcome. If we're talking about total market cap weighted index funds, but anyone who's doing any sort of value tilt or small cap tilt the tracking error between those type of index funds like two index funds tracking different small cap value indexes. The tracking error can be substantial over a short period of time and over a long period of time.
So I don't think it's free. And even if we use a lot of asset allocation funds from dimensional, which is a single holding, which is great, and it is efficient and it rebalances internally, usually so far, at least using new cash inflows from new investors, which means that the rebalancing is extremely tax efficient. To get out of that, to do a tax loss sale, we have to sell that and buy back the components of that thing. So we have to sell the dimensional 60, 40 portfolio and buy maybe 60% of the equity portfolio and 40% of a fixed income portfolio that allows a loss to be claimed. But now we don't have the automatic rebalancing portfolio anymore.
And it's the same thing, if you're investing in V grow, you could sell that. And Vanguard has VEQT and they have a world bond now, I think. So you could sell that and buy 80% VEQT and 20% global fixed income from Vanguard. You get the same portfolio.
Cameron Passmore: So you got to rebalance.
Ben Felix: Now you've got to rebalance, that's the trick.
Cameron Passmore: And traits, and you're not going to be as tight on your asset mix going forward.
Ben Felix: And likewise, you could do V grow and go into X grow, but they've got meaningfully different underlying geographic allocations. The fixed income is totally different, you're going to have tracking error. Maybe that doesn't matter, but it might. Anyway, I don't think it's free. I would only do tax loss selling if you have a current year gain and a high income, a high tax bracket, or a past three-year gain.
Cameron Passmore: And probably the most important thing to do that was rebalancing now because these market moves have been significant. And if you haven't rebalanced, you are off your policy for sure.
Ben Felix: Oh yeah.
Cameron Passmore: That's a good time to buying in low. So if you're in a one decision type portfolio, that's happening every day for you automatically, but if you haven't, you're going to be out of work right now and you've got to stick to the strategy of rebalancing.
Ben Felix: Yup. I don't know. I think that's it. What do you think?
Cameron Passmore: I think that's good enough for now. Thanks everybody for listening. And we will be back with another guest next week and keep sending in questions to the Rational Reminder website.
Ben Felix: Yeah. We hope this was useful. We don't want to be like a news outlet and I don't feel like that's what this was, but we do want to help people keep perspective because we know the last couple of weeks have been turbulent, unusual and stressful for a lot of people. So hopefully, we're bringing our usual rational perspective as opposed to being another news outlet.
Cameron Passmore: Yes, agreed. And thanks for listening.
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