What should one make of turbulent financial markets, in particular following Wednesday October 10 when the US market fell more than 3% in a single session? At the time of writing, the S&P 500, for example, is trading at a level some 7% below its all-time high which was reached three weeks ago.
Firstly, if you focus on the long term (as most investment professionals will insist they do), one should try to ignore most of the shorter term noise and volatility. Accordingly, you should try not to get worked up too much when you see drawdowns that are ultimately considered to be normal in financial markets. In this regard, two summary statistics stand out – as pointed out in separate blog posts/tweets by US financial advisors Michael Batnick and Charlie Bilello in the past couple of days:
Going back to 1900, a daily decline of as much as 4% (or more) in the US stock market has happened on average once every 82 days; and, this is the 23rd correction in the S&P 500 of 5% or more since the recent March 2009 stock market low.
Having said that, one also has to accept that the long term is the sum of the short term, hence I’d like to offer some points of commentary in the wake of this recent volatility.
Firstly, it should be borne in mind that financial markets – especially equities – have been in expensive territory for some time now; responsible investment managers will have been pointing this out to clients in an attempt to manage expectations. When a correction happens as we see playing out now, one can thus argue that it is in fact a healthy development, at least to some extent: markets end up being less over-priced as a result, enhancing the returns outlook going forward from this point onwards (especially relevant to those who may be putting “fresh” cash at work now).
In trying to offer reasons for the sell-off, it needs to be pointed out that the “good news has started turning into bad news”, specifically as far as the US market is concerned. Whether or not one is prepared to give President Trump any of the credit (most of the positive momentum started a number of years ago, i.e. during the Obama days), it has become evident in the past few months that the American economy is now healthier than practically anytime in the last two decades or more: unemployment is at all-time lows, as a result disposable income is up and consumer confidence is high. This is likely to have an accelerating impact on inflation, hence the Fed is expected to respond in the form of interest rate increases that could end up being more in number and ultimately higher in level than previously anticipated; in turn, this has started being reflected in the yield curve, with US 10-year rates now being in excess of 3% (higher than any time since the global financial crisis). Ultimately, interest rates are relevant in terms of discounting future returns from any investment, hence higher rates translate into lower capital values – which explains inter alia stock market declines.
Should one turn bearish as a result? The other side of the coin is simply to focus on the good news itself, i.e. a stronger economy should lead to increased profitability which is obviously good for share prices once all is said and done… the trick is simply to identify those sectors and companies that are likely to benefit quickest and/or most. Speaking about profitability, the same Charlie Bilello referred to earlier, also pointed out earlier this week not only that overall S&P 500 earnings are expected to increase by as much as 26% this year, but also that, if this expectation is in fact met and the index ends the year at current levels, its P/E ratio would go from 21.4 to 18.3; this would be the first year of multiple contraction since 2011.
The market dislocation has also been good news for value investors, at least as far as performance relative to the broader index is concerned. If you’re a true value investor, you would in all likelihood not have been invested in some of the sectors that have been considered to be the most overvalued, specifically the so-called Fang stocks (Facebook, Amazon, Netflix and Google) – all of these are down well into the double digit percentages from their highs in an overall market which is “only” 7% down from the top. As financial author Jonathan Tepper tweeted in tongue-in-cheek fashion on Wednesday: you can pick up bargains in this sell-off… Netflix is trading at 104x EV/Ebitda and 80x forward PE (this stock has declined even further since then, and is now trading nearly 25% lower than its all-time high a short three months ago).
Which brings me to the main question: what should investors do at a time like this? My personal advice will always be the same: on the basis that one had a diversified portfolio of good quality investments (bought at reasonable prices) to begin with, the best strategy is to ignore the volatility and to sit it out until markets recover. The worst thing to do would be to “blink at the bottom” and sell out at the worst possible time (and of course no-one knows exactly when markets will start to turn again). For those with extra cash to deploy, this may be a good time to start “nibbling” again.
Jack Bogle, founder and retired CEO of Vanguard, recently said: “I spend about half of my time wondering why I have so much in stocks, and about half wondering why I have so little.” Market participants may be nodding their heads in agreement to the first half of this quote today… but as night follows day, the time will come when you worry more about the second part again.
PS: Why do we tend to focus mostly on the US market? Simply because it is by far the biggest and most important market in the world, and still represents approximately 50% of most global benchmarks; accordingly, it also represents about half of the discretionary equity portfolios that we manage at Credo. We could have focused on alternative indices such as the MSCI World, but the main conclusions would be exactly the same.
Deon Gouws is the CEO at Credo Wealth.