Most of us have seen the classic film, “A Few Good Men,” with Jack Nicholson and Tom Cruise. It’s most quotable line occurs in a courtroom scene after Cruise, playing a Navy JAG attorney, states to Nicholson’s character, a decorated Marine Corps officer whom Cruise is cross-examining, “I want the truth!” Nicholson’s response is, “You can’t handle the truth!”
This line from Aaron Sorkin’s screenplay brilliantly captures a certain ethos that uniquely befits the U.S. Marine Corps. I know this because I was raised by a Marine Corps officer and Vietnam vet, Captain Jack Richardson. I have heard my father make many statements in this vein.
Captain Jack Richardson, Vietnam, 1967
As a result, it rang a bell when I first heard the following piece of market wisdom many years ago: the market doesn’t care what we want. There are many iterations of this wisdom. Just google “the market doesn’t care”: “The market doesn’t care what you think”; “the market doesn’t care what you paid for a stock”; “the market doesn’t care about your opinion.” This market wisdom is really an inversion of Nicholson’s line, where the market and truth are at odds with us in some important way.
Upon hearing a market maxim in this grain, my first response was, “So what? Why would the market care about what I want?” But there was more here than I initially understood.
2022 has been a year for investors in which the markets—and I mean just about all markets—have made their indifference to the desires of investors shockingly apparent. For nearly all investors, success wasn’t measured by how much was gained, but how little was lost.
With few exceptions, the best investors could do was to limit exposure to market risk. There has been no safe haven, and bonds have had their worst year since the early 1930s, even as stocks sold off from the first trading day of the year and never regained their highs. The typical 60-40 portfolio of stocks and bonds has had one of its worst years in history.
Even momentum strategies, which limit market exposure at key times, did not perform a lot better, including momentum strategies that diversify into assets other than stocks and bonds. And avoiding all market exposure presented a different form of pain: real losses, if not nominal ones, because of high inflation.
In 2022, the markets have delivered the worst news since 2008. Both 2008 and 2022 were outlier years for the markets, specifically negative outlier years. Others were 1974, 1931, and 1929. These were years in which even the most reasonable and rational goals of investors were profoundly frustrated.
How investors respond to such an outlier year is important. It’s only human to feel frustration and pain at such negative feedback from the markets, and those feelings should not be ignored. But neither should they drive investors from understanding that the markets will give us outlier years from time to time. Nor should such feelings drive investors away from executing a plan that succeeds over time despite the outliers.
This is another way of saying that investors should not place too much weight on short-term performance, even performance that lasts for a full calendar year, especially when market results deviate so strongly away from their long-term results. I saw this happen in the wake of the 2008-2009 financial crisis. Even though the stock market had bottomed in March of 2009, many traumatized investors stayed out of stocks for many years afterward, missing out on substantial gains.
Investors face the same risk today. Currently, because the Fed has been hiking the federal funds rate at the most rapid pace in history, investors are tempted to lock their funds in high-yielding fixed income instruments, swearing off market risk altogether, despite that inflation remains high. But it’s important not to fight the last war for too long because current market conditions will change, and the base rate is likely reassert itself. After the 1929-1931 period, the stock market bottomed in 1932. After 1974, it bottomed in 1976. After 2008, it bottomed in 2009. With the likely end of Fed tightening in sight, and a likely recession coming, bonds may have already bottomed. Stocks generally bottom before the end of a recession.
For these reasons, in a year when the market became shockingly indifferent to the goals of investors, investors should accept, instead of resist, the fact that the markets will give us negative outlier years from time to time, as in 2022. There is a time for feeling the pain of a negative outlier year like 2022, especially before it becomes clear that the year is in fact a negative outlier. That pain lies in the gap between reasonable investor expectations and market realities that go in a different direction. By now, however, that pain should transform into acceptance and moving on.
For investors who rely on modeling to direct their portfolios, as momentum investors do, models should not be based on on outlier years. Otherwise, the benefits of the base case are at risk. But models should be at least robust to the outlier, instead of fragile. This is a key way in which momentum investing succeeds over time, by limiting exposure when asset prices are in downtrends.
This is how investors can handle the truth of the markets—with perspective and crucial information from market history. Although 2022 was an outlier, outliers come and go.
In that spirit, I wish you all a Happy 2023.
Marilyn, Jack, and Matthew Richardson, 1970