Conflicts, Corrections, What to Do About Them (Ukrainian Edition)
As of early Thursday morning, Russia has invaded Ukraine.
Here’s a quick background on the Russian-Ukrainian conflict, if you’re not familiar with it…
The Soviet Union held effective control over Ukraine until 1991. However, despite the dissolution of the Soviet Union, the country is still perceived as being part of Russia’s “sphere of influence” and retained a… complicated relationship due to a shared history, shared language, and complicated Soviet policies.
For example, Russian President Vladimir Putin surprised then-President Bush in 2008 when he said, “You have to understand, George. Ukraine is not even a country.”
All the nuance of sovereignty was further complicated by the fact that Ukraine “inherited” nearly 3000 nuclear weapons and several nuclear power plants from its break with the Soviet Union. It was also home to Russia’s biggest warm-water naval base, Sevastopol, until that was annexed in 2014.
To sum it up: Russia perceives Ukraine as a sort of vassal state. Ukraine perceives itself as a sovereign nation.
For that reason, Ukraine and the European Union began to seek closer ties between 2011 and 2013, which was opposed by the Russian-backed president of Ukraine, Viktor Yanukovych.
In February 2014, the Ukrainian parliament voted to impeach and remove the Yanukovych.
After his impeachment, Parliament issued a warrant for Yanukovych’s arrest, accusing him of the “mass killing of civilians.” Yanukovych is now in exile in Russia.
On February 27, 2014, seemingly in response to the impeachment, Russian forces without insignias began taking control of the Crimean Peninsula in Ukraine with the support of pro-Russian Ukrainians.
The Yellow portions of the map show Ukraine, while the Red portions show the area controlled by Russia or Russian-supported insurgents as of the beginning of 2022.
But beyond minor economic sanctions against Russia, not much happened after 2014.
Russia simply continued to hold parts of Ukraine.
Until now.
In early 2021, Russia began to amass thousands of military personnel on the border of Ukraine again, moving tanks, missiles, and heavy weaponry in place.
Now, on February 24, 2022, Russia has invaded Ukraine.
According to the New York Times:
“Ukrainian forces were in ‘all-out defense mode’ on Thursday to repel a multipronged Russian assault by land, sea and air. The Ukrainian military claimed to have shot down several Russian military aircraft, and civilians lined up at recruitment offices to take up arms against President Vladimir V. Putin’s forces.”
Why is Russia doing this?
In December 2021, Russia advanced two draft treaties that contained requests that Ukraine would not join the North Atlantic Treaty Organization (NATO) as well as a reduction in NATO troops and military hardware stationed in Eastern Europe.
Basically, Russia wants Ukraine to remain within its sphere of influence.
NATO rejected Russia’s requests.
Putin has since warned the U.S. against interfering, promising “consequences you [the U.S.] have never faced in your history."
And that’s the story so far, at the time of writing.
So what does this conflict mean for the stock market and your wallet?
The concern right now seems to be whether the crisis in Ukraine will increase gasoline and oil prices.
Russia is the third-largest oil producer in the world, producing more than one-tenth of the world’s oil in 2020. However, access to the supply would be disrupted in the event of a military conflict or sanctions by the U.S. and its allies.
For that reason, oil and gasoline prices, which have been increasing due to inflationary pressures already, have surged across the U.S. to their highest level in eight years.
The higher the cost of oil and gas, the higher the cost to make and ship goods, which makes producer and consumer prices go higher.
U.S. stocks, especially tech and growth stocks, are already reeling from high inflation, so the possibility of a conflict that could increase energy costs naturally causes investors to be nervous.
However, these higher energy costs seem to be mainly driven by irrational fear rather than reality.
Reason being: the U.S. has become a net energy exporter rather than importer.
Meaning: it’s unlikely energy prices or availability in the U.S. will be affected by the Ukrainian crisis or the availability of Russian oil at all.
The U.S. has been producing and exporting more energy than it consumes or takes in since mid-2019, according to the U.S. Energy Information Administration.
You can see that in the yellow line in the charts below:
When you look at these charts, though, keep in mind this fundamental truth about the markets: The price of something has little if anything to do with reality.
Oil could be abundant… but it can also be high priced based on what people assume or speculate the price of oil might be worth in the future. (The same is true for stock prices.)
But here’s something else to consider:
We live in a world with highly interconnected economies.
And Russian exports of gas and oil accounts for more than one-third of Europe’s imports.
That’s an insane amount.
And while Germany has decided to suspend a single Russian gas pipeline that was under construction…
That doesn’t change the fact that countries are still hugely energy-dependent on Russia.
Europe needs Russian gas.
And Russia needs Europe’s money.
So while it seems like a conflict in Ukraine won’t affect oil supply in the U.S., it does seem like it will create volatility and worsening inflation (especially in energy prices) regardless.
Speaking personally, my heart goes out to the people of Ukraine.
I’m deeply saddened by the unconscionable and needless loss of life occurring there.
I have acquaintances who live there, and I am rooting for them and their nation.
When it comes to what Western nations can do, I think the best weapon in this battle is an economic one.
Economics brought down the Soviet Union. It can sufficiently punish Russia.
The question then becomes whether there’s enough political will for Western leaders to go through with it… Especially considering how dependent Europe is on Russia for energy.
For the foreseeable future, it looks like this crisis is going to add some significant negative pressure to the stock market and global economies overall.
On that note, let’s look at what’s going on in the stock market…
How to Correct a Correction
I spoke in December about how it looked like we were heading toward a market correction, and that the evidence suggested a “hidden” bear market had already begun.
Well, now the hidden bear market is no longer in hiding, with the Russell 2000 (small cap stocks), S&P 500 (large cap stocks), and the Nasdaq (tech & growth stocks) all dropping -10% to -20% this year so far.
Drawdowns in the market are all pretty similar…
They’re all primed by overvaluation and then triggered by some mix of external catalysts.
We knew the market was and still is overvalued. We just couldn’t know what the catalysts would be.
This time, the catalysts seem to be (but aren’t limited to): Inflation, the possibility of rising interest rates, and international conflict (which might contribute to further inflation).
The only unique flavor to this drawdown, that I’ve noticed, is that this is the first real correction that millennials have experienced.
And if you trawl investing forums, like I do, you know that they are flipping their $#!% about the fact that stocks do, in fact, go down.
People want to know how bad it’s going to get.
They want to know how long it’s going to last.
And they want to know if now’s a time to be buying or selling.
So let’s look at the numbers and get some answers.
First up, let’s look at every major market drawdown, focusing on the S&P 500.
There’s a great resource from Yardeni research that shows each drawdown, how deep it went, and how long it lasted.
The birth of the modern S&P 500 occurred on March 4, 1957. So let’s use that as our starting point.
I went through and pulled each drawdown and how long it lasted into this table:
We’ll call anything more than a -5% drop a pullback. Anything more than a -10% drop is a correction. Anything more than -20% is a bear market. And anything more than -40% is a crash.
All of these combined, we’ll call a “drawdown.”
In the 65 years since 1957, there have been 48 drawdowns.
To put that in perspective, we should reasonably expect a significant drawdown in the markets once every 500 days.
There were 25 corrections over these years, which means we should expect a correction every 2 to 3 years.
So the correction we’re experiencing right now?
It’s on schedule.
And it looks like it could go down a little more still from here.
Now, with 10 bear markets and crashes combined, we should reasonably expect this to occur once every 6 to 7 years. Crashes occur once every 21 years or so — basically once in a generation.
(The periods for the Nasdaq and Russell 2000 are similar, but these indices are way more volatile, with much deeper drawdowns and more crashes on average.)
All drawdowns typically last about 154 days, or 5 months.
Notably, the average over the last 10 years is about 48 days. If we go by that number alone, we should be nearing a bottom in the market drawdown we’re currently experiencing.
But talking about drawdowns is only half of the story…
Because even when the markets see a drawdown during a year, they usually finish the year positive.
Here’s the data from Calamos Investments:
“This chart shows the maximum intra-year equity market drawdowns since 1980. From this, we can see how frequently at least one double-digit decline occurs within any given calendar year. In 21 of the last 41 calendar years — more than half of the time — the S&P 500 saw a double-digit pullback within the year.
“In every year, there was a market pullback and on average the market experienced a 13% decline. In the years when the S&P did experience a double-digit decline, 13 of those 21 times — or 62% of the time — the market ended the year with a positive return.”
In plain English: Even when the market goes down, it tends to go back up within the same year.
Look…
One of the things I speak about frequently when it comes to finance and investing is mindset.
Specifically, why it’s important to be proactive and not reactive. Calm and not chaotic.
I advocate that people approach the markets with simple, calculated deliberateness.
That’s because many other investors are plagued by a psychological tendency that causes them to underperform the markets long-term or, worse, lose lots of money in their investments.
This trait is called “recency bias,” or the false belief that what’s happening right now is more urgent and pressing than the past.
Recency bias causes the primitive, emotional parts of our brain to think that what we’re experiencing right now is somehow “special” or will continue happening forever.
For that reason, I’ve been pounding the table in this newsletter on why it’s important to be a bit of a contrarian…
To see market drops not as threats but as opportunities to accumulate more assets that will help us compound our wealth.
All that being said, there’s one logical deduction to take away from the data:
Buy the dip.
Hold enough cash so that if it dips more, you can buy more.
And so long as you don’t hold junk stocks, don’t get scared.
In trader talk, I believe the rule associated with this is “Buy into weakness, sell into strength.”
On that note, in a previous blog post, I showed you how much money you could have made if you only bought the S&P 500 ($SPY) if it dropped more than -1% between the beginning and end of each month.
The results were: You beat the average annual returns of market, on average. By like… 30%. A not insignificant amount.
I haven’t run the numbers, but I’d bet the same is true for the Nasdaq and Russell 2000.
This strategy, while dummy simple, actually has some merit to it, too.
Michael Schwartz, a financial planner with Magnus Financial Group, says that, historically, people make most of their money during bear markets, or when the market sells off more than 20%.
“There’s always going to be a reason not to invest,” Schwartz says. “There’s always going to be a problem that is surfacing in the markets. Removing the emotion from your investment decision, and focusing on a thoughtful, disciplined approach, is how you create a wealth strategy.”
Simply, the people who make money are the ones who buy when others are selling.
I think another way to put all this connects with the primary rule of investing: “Buy low, sell high.”
If you ain’t buying after market prices go lower…
You’re not following the simplest rule in investing.
Simple as that.
So if you want something prescriptive, here’s what I do:
In my IRA (one of my four accounts), I try keep about 30% of my account in cash, as a reserve.
If the market drops -5%, I spread 33% of my cash (one-third) around low-cost, dividend-paying ETFs like $SCHD, $SPHQ, $DTD, $DES, and $PFF.
(If you want to know why I’m avoiding $SPY or $QQQ for now, I touch on the reason here.)
If the market drops -10%, I do the same thing again.
And if the market drops -20% or more, I do the same thing again.
Since I’m adding cash to my IRA account every month, I replenish the cash I invest, so I have additional cash to invest if the market drops below -40%.
Then I simply hold for the long term and don’t plan to sell for a few decades.
Time to pull out this meme again, I suppose:
That way you are much more likely to “Sell High,” years from now, when you’re ready to retire.
That’s it. That’s the strategy.
