The pandemic is an exceptional event that has had a huge impact on the stock market. Indeed, it initially caused a 32% decline in the S&P 500 over a period of just five weeks before the fiscal and monetary policy stimulus it prompted led to the stock market reaching a new record high in recent months.
Clearly, the pandemic’s effect on the economy and stock market is unprecedented. However, it is not the first time that one or more events have led to severe stock price declines in a short span of time.
For example, the global financial crisis prompted a 52% drop in the stock market in 2007-08. It was caused by a banking crisis that was also described as being unprecedented at the time. Meanwhile, the world had arguably never seen technology companies trading on the rich multiples of the late 1990s tech bubble. Therefore, it could also be described as an unprecedented event.
As such, it could be prudent to accept that while the pandemic is an unprecedented event, it is very unlikely to be the last time the stock market declines by 20% or more. Indeed, the S&P 500 has dropped by that amount, or by an even greater percentage, on 26 occasions since 1928.
Preparing for unprecedented events
Baupost Group founder Seth Klarman (Trades, Portfolio) has previously discussed the frequent occurrence of unprecedented events. As he once said, “Unprecedented events occur with some regularity, so be prepared.”
It is impossible to foresee such events ahead of their occurrence, but, as Klarman highlights, it is possible to prepare for them. This does not mean trying to gauge when they are most likely to occur. Rather, it means aiming to ensure your portfolio is ready to overcome any event that could temporarily have a hugely negative impact on the economy and stock market.
For example, it may be prudent to ensure that all portfolio holdings have solid fundamentals. Many companies have taken advantage of low interest rates to increase debt levels in recent years. While this could improve their return on equity, it can also lead to higher risks should the economic and investment outlook deteriorate.
In addition, it may be logical to ensure that all portfolio holdings continue to trade at fair prices. Given the stock market’s recent rise to a record level, many stocks trade on generous earnings multiples compared to their historic averages. Such companies may be among the hardest hit in the next stock market downturn.
Capitalizing on unprecedented events
Of course, unprecedented events that cause a sharp decline in the stock market can provide excellent buying opportunities for long-term investors. They can prompt high-quality stocks to trade significantly below their intrinsic values, as was the case in the March 2020 crash.
As a result, it may be prudent to prepare for such events by holding at least part of a portfolio in cash. Certainly, this may lead to disappointing returns in the short run if the bull market continues. But, as Klarman noted, unprecedented events have historically taken place with some regularity. Therefore, investors who hold cash today may be in a commanding position to benefit from future one-off events that, while unpredictable, seem bound to occur.
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