TAGStone Capital – Fourth Quarter 2024 Newsletter

“Speculation is most dangerous when it looks easiest.”

—Warren E. Buffett

The markets, like the seasons, follow a familiar rhythm. Euphoria breeds excess, excess leads to reckoning, and from that reckoning emerges opportunity—though few recognize it at the time. Over the years, I have spent more ink cautioning investors about the perils of bear markets rather than celebrating bull markets because discipline is tested in tough times. However, as evidenced by today’s somewhat stretched valuations, let’s talk about the other great pitfall: the fear of missing out (FOMO).

There are two moments that shake investors to their core. The first is when a bear market reaches its final, gut-wrenching phase—when despair is so thick that even sensible people consider throwing in the towel. At that moment, the intrinsic value of attractive companies is quietly rising in relation to their falling stock prices. And yet, the temptation is to believe: This time is different. This is the end.

The second—and possibly more dangerous—moment is when markets soar, optimism is boundless, and prices defy gravity. Suddenly, trees are expected to grow to the sky, and investors forget that every great technological breakthrough, from the railroad to the internet, has followed the same trajectory: from miracle to commodity. And yet, the chorus sings: This time is different. This is a new era.

During such times, rational investors face an irrational urge to abandon a carefully constructed, broadly diversified portfolio and chase what has doubled or tripled in a year. It feels safe—after all, the crowd is doing it—but history has shown that few strategies are more reliable at destroying wealth than performance-chasing.

I have always maintained that while prices fluctuate, true value endures. I remain optimistic about the long-term prospects of our global economy. Innovation drives progress, businesses expand, and hardworking people continue to build the future. The secret isn’t to chase last year’s hottest stock; it’s to acquire a well-balanced collection of attractive businesses—whether they're large or small, from various industries and corners of the world. A diversified portfolio, maintained in proper proportions and adjusted when needed, is about as close as you can get to a reliable recipe for long-term success.

Too often, investors stray from their disciplined allocations, piling into stocks simply because their prices have been on a tear. This approach prioritizes price momentum over intrinsic value. A stock that’s risen sharply might not be a bargain if its price no longer reflects its inherent worth. While chasing rising prices might boost short-term returns, it also increases the risk of holding overvalued companies, particularly if revenues, cash flows, or earnings falter.

“The investor of today does not profit from yesterday's growth.”

—Warren E. Buffett

Consider U.S. large-cap tech stocks as an example. These companies have enjoyed an impressive 15-year run. However, history shows that overconcentration in any asset class—especially one with lofty valuations—often leads to below-average returns over the next decade. Chasing yesterday’s winners is effectively betting that past trends will continue uninterrupted. Often, investors end up paying a premium for what has already been realized.

Howard Marks of Oaktree Management highlighted a J.P. Morgan Asset Management graph that illustrates this point. The graph, covering monthly data from 1988 through late 2014, shows the forward P/E ratio on the S&P 500 at the time and the annualized return over the subsequent ten years. This data reveals some key insights:

• There is a strong relationship between starting valuations and subsequent ten-year returns. Higher starting valuations consistently lead to lower returns and vice versa.
• Today’s P/E ratio is firmly in the top decile of observations.
• During that 27-year period, when the S&P 500 was bought at P/E ratios similar to today’s multiple of 22, subsequent ten-year returns ranged from +2% to -2%.

In November, several leading banks projected ten-year returns for the S&P 500 in the low- to mid-single digits. This relationship between price and returns explains their outlook. The return on an investment is significantly influenced by the price paid for it. Therefore, investors should not ignore today’s market valuation when making decisions.

As we reflect on the solid returns of 2023 and 2024, it’s easy to think that a lower expected return for stocks might not be so bad. That’s certainly true if the market were to plateau for the next decade while earnings grow and valuations come back to earth. But before you get too comfortable with that view, consider an alternative: a sharp correction, where market multiples compress rapidly in just a year or two—something akin to the market declines of 1973-74 or 2000-02. This wouldn’t be a “benign” scenario.

Let’s revisit some key lessons from recent years:

• 2022: Inflation surged to 9%, prompting the Federal Reserve to raise interest rates sharply. The outcome? It was a devastating year for the traditional 60/40 portfolio, which posted its worst performance since 1937.
• Tech stocks in 2022: These fell by 36%, a sharp contrast to the broader market’s 25% drop.
• 2020: A global pandemic triggered a near-total shutdown of the economy, sending the market down by 34% in just 33 days.

The big takeaway? Markets rise, and markets fall, often without warning. As investors, we don’t need to predict every twist and turn; instead, we prepare for the inevitable ups and downs that come with the territory.

There’s an old saying: The stock market is designed to transfer money from the impatient to the patient. And if there’s one discipline that ensures you stay on the right side of that transfer, it’s rebalancing.

Rebalancing isn’t exciting. It won’t make headlines, and nobody brags about selling a high-flyer to buy bonds or an undervalued stock at a cocktail party. But make no mistake—it’s an effective tool that helps investors keep emotions in check and stay the course. By systematically trimming what’s soared and reinvesting in bonds or underweighted stock positions, you keep your emotions in check and resist the temptation to chase performance.

Of course, rebalancing isn’t a magic trick that guarantees success overnight. Instead, it’s the final step in a series of rational decisions made when you set up your investment plan. Those decisions were:

1. Determine your risk profile. Understand how you feel about and have reacted to price volatility. If you don’t know how you will respond in the future, any portfolio mix will work—but probably not the one you want.
2. Build a portfolio that aligns with your risk profile. Assemble a mix of stock and bond assets that match your risk profile.
3. Commit to the plan. Stick with your predetermined asset allocations throughout your investing journey (unless your goals change). Don’t let fads, crowds, or market manias steer you off course.
4. Be a long-term investor. Attractive businesses create value over years, not weeks. To avoid chasing performance, own a broadly diversified and appropriately weighted portfolio of attractive businesses and high-quality fixed income.
5. Accept that downturns are part of the deal. Build and maintain your bond positions during bull markets so you can rely on them during the occasional stock market storm. This is the price of earning long-term equity returns.
6. Tune out the noise. Media headlines and marketplace chatter will always try to make you act. Your job is to stick to your plan and let your investments do the work.
7. Rebalance when necessary. Do it not when it feels comfortable but when your disciplined approach calls for it.

Rebalancing often feels counterintuitive. Selling what’s been performing well and buying what appears to be lagging isn’t the natural impulse for most, but that’s exactly why it works.