Recent Market Volatility Not Unusual

“While short-term changes rarely mean much, often information can be gleaned by examining the underlying market dynamics during such periods. Specifically, the recent pullback has corresponded with a sharp increase in investor fear and uncertainty. As a result, investors have flocked to so-called low volatility stocks such as consumer goods companies and utilities, which have historically been safe havens, while selling companies that historically have been more volatile such as banks, technology companies and foreign companies. The key word here, however, is “historically.” As Warren Buffett once said, “If history books were the key to riches, the Forbes 400 would consist of librarians.”

Chris Davis of Davis Advisors, recently wrote commentary that struck us as simple in its message, but extremely important as investors learn to experience market volatility again. The quote above caught our attention, as the market’s increased volatility provides the opportunity to purchase companies with durable business models at prices that become more attractive. Davis’s commentary below exemplifies this very important point.

“While the market’s recent price decline has left many investors unsettled, this increase in market volatility and stock price corrections reflect a return to normal market conditions rather than something unusual. In fact, what was truly unusual was the post financial crisis period of near zero interest rates and the market distortions they created. Although volatility and corrections are unpleasant, they are normal aspects of the stock market and, over the long term, create opportunities for investors able to look beyond the negative headlines.

In large part because of the distortions created after the financial crisis with essentially zero interest rates, quantitative easing, and government asset purchases, volatility among almost all asset classes from stocks, bonds, real estate, private equity, and venture capital investments has been extraordinarily and unsustainably low and investors have grown accustomed to only rising prices.

Based on long-term history, a double-digit market correction occurs in roughly half of all years and a 20% correction on average every 635 days. Having gone more than 2,200 days without a 20% correction, we should not be unduly alarmed or surprised by the market’s peak to trough decline of 19.4% in the second half of 2018. However, because such sudden declines can be unsettling, it is always helpful to put them in a longer term context. For example, faced with the blaring headlines that accompanied the fourth quarter market decline, investors could easily forget that over the last two years (including 2018!), the market is up more than 15%! (the market as viewed by the S&P 500 Index).  As a result, trying to invest based on timing a correction has been a loser’s game.

While we do not know if we are in the early stages of a substantial correction or whether we are simply returning to a period of more normal volatility, we do know substantial corrections are a normal part of the landscape. We also know with the media as an amplifier and the headlines blaring, investors will overreact. Here is a sample of headlines blaring just from recent weeks: “Market Rout,” “Stocks Plunge” and “Carnage Continues.” Reading such headlines, investors would hardly guess the market only declined about 5% in 2018, is up more than 15% in the last two years, 50% in the last five years and more than 200% in the last decade.

This increase in volatility may also be amplified by the increasing popularity of so-called momentum investing. In recent years, many quantitative funds have used a stock’s momentum as a key factor in determining its attractiveness as an investment. This approach suggests the more an investment goes up in price the more attractive it becomes. Conversely, the more an investment declines in price, the less attractive it becomes. The trouble with investing based on this backward-looking approach is that it flies in the face of common sense. Because a share of stock represents an ownership interest in a business and because the value of any business (or any asset for that matter) is simply the present value of all of the cash the business will generate in the future, paying a higher price will lower rather than raise future returns. To understand why, simply imagine a business that reliably earns $100,000 per year is purchased for $1 million, thus creating a 10% return on investment for the buyer. If a series of buyers are each willing to pay a successively higher and higher price for this business, the expected return for each would be lower. Although such a chain can continue for a long time with the ever-rising price attracting more attention and potential buyers to take their place at the end of the line, the ultimate return will still be determined by the relationship of the earnings generated divided by the price paid. In other words, sooner or later, the music stops, price and value converge, and the fool at the end of the line is left holding the bag. Investing in a way that is logically foolish simply because doing so has worked for some time seems like a recipe for disaster.

While the current environment may be more challenging on investor nerves, the return of greater volatility should not be feared as [we believe] it creates opportunities for long-term investors. Although such an environment creates more noise and distortions in the short term as investors overreact and flock to former safe havens, over time it creates greater differentiation.

Emphasis by Madison.

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written.  Actual economic or market events may turn out differently than as presented. © 2019 Madison Wealth Management