When any one buyer meets any one seller, they become a market. More often than not, there is some balance between groups of buyers and sellers, and prices are nudged one direction or another based on which group is more eager to accept the others’ terms.
In extreme moments, one group steps away from the market while the other steps forward. When there is an imbalance between buyers and sellers, prices are driven by the buyers or sellers who remain determined to transact regardless of price. To understand how prices can either skyrocket or plummet overnight, you must recognize that it is always the most eager buyer and most desperate seller that meet in the middle and form a market. Once those two have taken care of their business, the next most eager buyer and the next most desperate seller step to the middle and see if they can reach agreement. Somebody gives in and accepts the terms of the other side. As the crowd watches, they begin to wonder if they should push to the front to either offer or accept similar terms.
It must be nerve-racking if you begin to believe “this is what my investment is worth” instead of recognizing “this is what it was worth to them.”
The best defense against losing money on similar terms as the most desperate seller is to not be forced into transacting on desperate terms. That’s why we build a buffer of cash and bonds for clients who make planned withdrawals. A year’s worth of cash, followed by three more years of bonds, all of the interest and dividends their investments produce, and then more bonds mixed into a long term portfolio can provide a very deep defense against being forced to sell to meet your expenses. This plan to source withdrawals from cash and bonds buys years and years of time to let crowds settle down.
You’ve heard us preach this first line of defense before, and by now you also know the second line of defense: Quality businesses worth owning and the real world profits they produce. It isn’t a trade-your-way-to-riches philosophy, and it focuses on your businesses, not their stock prices.
A Market for Oil…
Today’s stock market drop is driven by developments in the global oil market. On Friday, Saudi Arabia and Russia disagreed on how to adapt to softer demand for oil as travel is curtailed. Saudi Arabia favored production cuts to support oil prices, but Russia was unwilling to go along believing US shale producers would simply take market share. In a dramatic change of tactic, Saudi Arabia began offering Asian customers sharply lower prices than Russia, and promised to ramp up production as soon as quota agreements expire at the end of March. They stepped to the front of the crowd to offer the lowest price, and oil fell from about $47 a barrel a week ago to about $27 by midnight Sunday.
In the end, the Saudis need oil at $83 a barrel to balance their budget, whereas Russia and US shale producers need about $42 a barrel each to break even. Some of the weakest energy companies may leave the market, and none will be able to sustain losses indefinitely, so a market will need to form slightly above the breakeven price for those that remain. Who ultimately wins will be a function of access to capital, and ability to cut expenses.
Whether any of these fundamentally temporary shocks permanently damage the world economy depends on how long it lasts, and the purchase decisions each person, business, and government makes. Whether investors suffer permanent damage depends on the decisions they make. We intend to stick with our written approach…
- Build a buffer of cash and bonds for clients who withdraw to meet expenses
- Own quality business that can withstand temporary disruption
- Pay sensible prices
We’ll have more to say about the actions we’ve been taking and those we have planned. For now, we thought this primer on markets might provide perspective. Thank you for your trust and confidence.