The volatility in equity markets over the past week has been sufficiently opined upon by just about everyone who makes a living doing so. Whether they have been bullish (“the sell-off is overdone”) or bearish (“this is the start of something much worse”), much of their rationale has been called into question within a week of them putting a stake in the ground.
For this reason, we have resisted commenting beyond what we wrote about in our October outlook for fear of trying to draw conclusions too early. Nevertheless, in many of our portfolios, we tried to reduce risk a bit in November after earnings had concluded.
But now, after a rapid and severe December sell-off that few saw coming and a violent bounce off the bottom the day after Christmas, it seems like a good time to assess the damage and take inventory of what we believe this all means in an historical context.
Here are a few points to consider:
1. The Christmas Eve sell-off and the December 26th recovery were extremely rare events in market history. Normally at this time, much of Wall Street (and the investing public) have turned off their screens for the holidays and accepted that much of the news of the year is behind them. Therefore, the trading volume in this time period is typically extremely low, leaving prices extra sensitive to buy or sell orders of any meaningful volume. During the aforementioned moves since December 23rd, much of the volume was reported as being driven by electronic trading programs. Since these programs are driven by machines rather than humans, they pay little attention to vacation schedules and holidays. They also tend to favor and exacerbate directional trends in the market. Therefore, one can make a reasonable argument that this unprecedented volatility was driven by an unprecedented level of electronic trading (as a % of total daily volume) that tended to “pile on” to a falling market trend, only to reverse course and “pile on” to the first sign of a bounce.
2. The decline over the past year has been 100% driven by P/E multiple compression. Earnings growth over the past year has been quite robust (in excess of 25%). So, this decline has been driven by falling sentiment (fear) about the future.
3. Year to date, through December 24th, the market experienced a 26% decline in its trailing P/E ratio. This was one of the ten worst such declines in the past 92 years.
4. Whenever the market P/E has declined by this amount, it is almost certainly forecasting a recession. It is hard to argue that this is not what this decline has been all about. What is unclear is whether such a recession is expected to result from a Fed rate overshoot, a trade war, an emerging market currency crisis, political dysfunction in the US or loss of trust in the current administration due to recent cabinet departures (Mattis). Perhaps a combination of all of these is to blame.
5. Markets are not always correct in forecasting economic activity and the events that cause it. In the past when the market P/E has declined by the amount we have seen in 2018, it has fully recovered from this decline within the next year 75% of the time. So where does all this leave us? Our intent with all our equity strategies has always been to build “allweather” portfolios that can protect and grow our clients wealth through all market cycles with a focus on companies that have some combination of unique market positions, unique assets or strong and growing cash flow. Our belief is that this is the best way to remain positioned in both bull markets and bear markets when storm clouds gather.
Unlike speculative assets such as commodities and crypto-currencies, companies that generate strong earnings and cash flow and consistently deploy such cash flow into profitable assets over time should see the value of their enterprises grow steadily over time, regardless of how the market temporarily values them during times of stress and uncertainty. The challenge for all of us as investors is to adhere to this conviction when the market declines rather than getting concerned that our shorter term losses will become permanent impairments.
Eventually the market always rewards growth in earnings, assets and cash flow. Like a balloon on the ocean temporarily pulled under the surface by an occasional rogue wave, the buoyancy of the value being created by these companies will inevitably rise.
So while the current market decline raises the very real risk that we could be facing a recession in the next 12-18 months caused by one or more events that are currently not knowable, know that we are constantly re-evaluating our portfolios to be sure that we have invested in the very best collection of companies with which to weather such a storm. And if the storm gets worse, we may be presented with some incredible entry points to add to these companies in the months ahead.
We encourage all of our clients to contact us to discuss the above as well as how we currently have them positioned to ensure that such positioning is in alignment with their current risk preferences.