How to Approach Down Periods in the Markets

Last quarter, our newsletter reminded clients of the unpredictability of markets and that losses are a normal part of investing. After four years of consistent returns, we thought that investors might have been getting too comfortable.

On schedule, the S&P 500 declined 10% over five trading days in August, dropping 12% below its July peak. Q3 was the index’s first negative quarter since 2012. Concern over China made volatility we saw in previous quarters due to Greek drama, European economic woes, and Ukraine seem quaint.

The downturn impacted investors’ nerves as much as their portfolios. In the same spirit as last newsletter, we offer some countervailing thoughts to current sentiment.

Here’s how we think through periods like this:

In the short-term, markets are about Psychology

In the medium term, they are about Economics

And in the long-term, they are about Valuations

Market’s in the Short-Term: Psychology

Most investors have observed the following phenomenon: a company makes a big announcement (e.g. a new product or a sales boom), and then the stock immediately tanks. Huh?!?

In a study years ago, scientists monitored monkeys’ brains as they were fed. They found that dopamine, a chemical released when happy, ramped up when the monkey anticipated food, peaked just before receiving food, and then dropped right after acquiring food.

Similarly, investors await quarterly earnings announcements. If they expect positive news, and the announcement merely meets that expectation, there may be a letdown. Anticipation is more powerful than the result.

If disappointment can happen when expectations are met, naturally the mood swing is more dramatic if expectations are unmet. When a pattern is broken, our brains respond with alarm.

In August and September, a streak of bad news (China, commodity prices, Volkswagon) caused moods to turn dramatically sour. The sky is falling. Stocks duly plummeted.

It’s always important to consider how new information affects the big picture. However, people have a recency bias: they overweight current events and lose sight of facts on the ground.

Day-by-day and quarter-by-quarter, the story of the stock market is as much about psychology as about earnings, GDP, or the unemployment rate. During bouts of volatility, it’s important to recognize that emotions are fickle and it’s likely that perception changed more than reality.

Markets in the Mid-Term: Economics

The stock market and the economy are correlated but not as strongly as many think. Case in point, for the first six years post-recession, the stock market outperformed the economy by leaps and bounds. The U.S. stock market is collectively three times larger today than at its 2009 nadir even though GDP growth has been fairly slow.

Current negative stock returns may cause people to feel pessimistic about the economy. In reality, there are many positive signs, particularly in the U.S.

U.S. GDP growth is steady with no signs of abating. Consumer spending is strong. Unemployment is low. Inflation is low. Profit margins are high. Lower oil prices are a net positive. The most innovative companies in the world continue to emerge from the U.S. economy.

Internationally, global growth remains solidly positive. Central bank stimulus in Europe and Japan are sprouting signs of progress. Much of the world is enjoying lower oil prices. Emerging markets face challenges, but they are better positioned to endure rough patches than in previous decades.

Economists are notoriously miserable at predicting recessions. So, we can’t assume that because the economy is in good shape today that a recession tomorrow is unlikely. Regardless, there is much to like about the economy. Investors should temper their pessimism.

Markets in the Long-Term: Valuations

A company’s share price reflects the value of current and future cash flow. For example, Delta Airlines and Tesla are worth about the same amount. Delta’s profits are in the billions. Tesla loses money. But Tesla’s share price is high because investors expect our grandchildren will fly Teslas to Mars.

Similarly, the entire stock market’s share price reflects the value of the underlying companies’ current and future cash flow. The historical relationship between price and value (“valuation”) acts as a guide to whether the market today is cheap or expensive.

If anything is predictive about future stock market returns, it’s valuations. When valuations are expensive (high price vs. value), future returns will be lower. And when valuations are cheap, future returns will be higher. Valuation acts like a gravitational pull when prices drift too far from their historical equilibrium.

However, and this is a major point, the correlation between price and value only works over the long-term. There is zero correlation between valuations and 3-month returns. There is just barely above zero correlation between valuations and 1-year returns. Only when you go out to 5 years or more, are valuations meaningfully correlated with returns.

Unfortunately, investments are tracked and discussed on a day-to-day and quarter-by-quarter basis. Daily drama causes many investors to jump at shadows. In reality, the story of the stock market is a multi-year saga.

Fortunately, days or quarters are not most investors’ time frames. Our clients’ goals are always measured in years and often in decades. Over that span, we can be somewhat dismissive of what happens quarter-by-quarter and instead focus on the five-year outlook.

And the takeaway is that today that outlook isn’t bad. There are many ways to measure valuation. Most of them indicate that U.S. stocks are fairly to slightly overvalued, and international stocks are undervalued.

That’s not to say that stocks won’t drop like they did in August or worse. In any given year, the likelihood of an intra-year double-digit drop is better than 50% (20 of the last 36 years, see chart below). However, predicting when they will happen is a fool’s errand.

We put weight in what is predictive and actionable: valuations and long-term returns. In an investing world filled with speculation, valuations are a relatively reliable guide given a long enough horizon.

That’s why we emphasize financial planning. We need to know that our clients’ goals align with our long-term investment philosophy. Thus, when short-term volatility inevitably hits, we can help them look past the present. There is more peril in abandoning ship than in navigating through the storm.