Market Summary – 2nd Quarter, 2016
July 20, 2016
“UK votes to leave EU
Oil prices tumble/China’s economy stumbles
Ebola reaches epidemic proportions
U.S. faces “fiscal cliff”
Arab Spring embroils Middle East
Japanese earthquake causes tsunami, nuclear disaster
Greek debt sends Eurozone into crisis”
“If you’re going through hell, keep going.”
– Sir Winston Churchill
The headlines above are among the most prominent examples of global issues that have confronted investors since the end of the Great Recession in 2009. The latest “crisis” facing the markets can be attributed to voters in Great Britain who directed their country to “leave” the European Union (Brexit). With that outcome, the relatively solid and stable British economy, and perhaps that of all of Europe, will be transformed. The people have spoken, but would Sir Winston have approved?
The “hell” in the markets created by Brexit was initially short-lived. After two days of market upheaval driven by emotional investors and British citizens who may have realized that a revolution is not a revelation, and exacerbated by algorithm-driven funds and pessimistic media commentators, cooler heads prevailed. By July 11th, less than three weeks after the historic Brexit vote, the S&P 500 had risen beyond its pre-Brexit levels and reached an all-time high.
Brexit itself will undoubtedly be in the headlines for quite some time. Europe will have to deal with a transformational period, traveling an uncharted path that is fraught with uncertainty. Experience has taught us that markets hate uncertainty. But what can the past teach us about headline-driven volatility?
Events like Brexit often lead investors to wonder what near-term headlines mean to their long-term investment prospects. The surprising answer is that these headlines are almost always inconsequential to one’s long-term investment outcomes.
As the table below shows, the market has been able to shrug off many of these headlines to not only recover past losses rather quickly, but also to push forward to new highs. These headlines are interestingly unimportant. Yes, they make lively social conversation. However, overemphasizing these headlines at the expense of fundamental analyses on individual company valuations leads to terrible investment decisions.
Intensifying the post-Brexit decline and other headline-driven moves in recent years has been the rise of algorithmic trading. In the immediate aftermath of the shocking Brexit vote, the surge in volatility began to feed on itself. In the United States, it was estimated that a flurry of post-Brexit selling by computer-driven funds whose sell signals are tied to volatility amounted to an astonishing $300 billion1. Incredibly, these algorithmic trading strategies that dominate the market’s daily trading volume were pushing stocks sharply lower, in all likelihood without even knowing the names of the companies that they were selling! It’s a reminder that we live in different times and that we need to be prepared to accept short-term volatility caused by factors that we cannot control.
Even more important, it is a reminder that one needs to know what they own. Knee-jerk reactions to short-term price gyrations caused by an emotional market, and made worse by algorithmic traders, can sabotage investors’ outcomes. As Benjamin Graham pointed out, the day-to-day market is merely a barometer of investor sentiment, and shouldn’t be taken too seriously. These short-term price swings based on headlines that are often written by traders masquerading as journalists create the illusion of confirmation of what is a non-event. Thinking that the market “knows” something during a headline-driven sell-off can lead to poor investment decisions, such as selling a good business before it has time to realize its price potential. As the table to the left shows, these headline crises create volatility and discomfort in the short-term, but are quickly forgotten.
Silent, but deadly
The headline-driven shocks to the market may garner all of the attention, but it is overpaying for an asset that is truly the great destroyer of wealth. The increased danger of owning the popular asset du jour is often overlooked, as much of the focus is on the emotion of investors needing to own these popular assets at any price. However, this is when the risk is greatest, and the consequences of this silent accumulation of risk are ultimately more harmful to an investor than any macroeconomic or political headline.
Consider the outcome of some of the previous momentum-driven crazes that left investors severely worse-off when they eschewed risk and valuation in order to be part of what was currently working in the market:
- “Nifty Fifty” – these were the “must own” stocks of the 1960s and early 1970s. These businesses were viewed to be so magnificent that they had mastered the business cycle and were necessary to own at any price. By the early 1970s, the price of these stocks began to fall precipitously and, by and large, under-performed the broader market for the rest of the decade.
- Dot-Com boom of the 1990s – the Internet was new and a number of young companies expected to have bright futures reached astronomical valuations. The technology-dominated NASDAQ Composite Index topped the 5,000 mark in March 2000, then declined dramatically. It did not top the 5,000 level again for more than 15 years.
- Housing market – ten years ago, the conventional wisdom was that home prices never go down. People who may not even have had the wherewithal to buy their own home were buying three or four homes (with little or no money down), and were told it was a surefire winner. The housing bust followed, and the whole country found out, sometimes painfully, that home prices can go down. They dropped by 27% on a nationwide basis over a 5+ year time frame (far more dramatically in some markets). Many people lost everything in the housing market. Through April of this year (most recent data available), the price of the average home in the U.S. is still 3.2% below the peak levels reached nearly a decade ago2.
Today, these pockets of overvaluation are not limited to speculators chasing growth at any price. Sadly, it is safety seekers who have created the latest financial bubble that will in all likelihood end in a similar fashion to the previously mentioned asset bubbles.
Risk-averse investors have been aggressively bidding up the price for perceived “safe-haven” assets such as government bonds and bond-proxies, like utility stocks, for years. These well-intentioned, but misinformed, investors are likely aggressively chasing these assets because they have traditionally been labeled as conservative and low risk investments.
However, what made them safe in the past was their very low valuations. Now that their valuations are at all-time high levels3, these assets have become so popular and grossly overpriced that they are teeming with the very risk investors were seeking to avoid.
If history has taught us anything, it is that there is no such thing as a preordained “safe” asset class. Rather, it is the price that you pay for an asset that determines its risk and gives you not only safety, but also the opportunity for meaningful price appreciation.
It’s no accident that the S&P 500 has grown from just 100 less than 50 years ago, to a record 2,152 (the level it reached on July 12, 2016). It has more than tripled since the market hit bottom in the midst of the Great Recession in March 2009. Throughout these periods, there has been an endless string of unexpected news events or unfavorable economic trends. The market’s long-term upward trend is a reminder that stocks remain the greatest wealth creation vehicle of all time.
What’s important is for investors to be in the market and to patiently wait out the inevitable, short-term setbacks. Buying a good business at a bargain price is the surest way to protect your assets and stay invested, and the key to increasing your wealth over time.
1 Joseph Cioli and Anna-Louise Jackson, “Nightmare Coming True for Stock Bulls Blindsided in Brexit Shock,” Bloomberg, June 24, 2016.
2 Case Shiller U.S. National Home Price Index (Source: Federal Reserve Bank of St. Louis).
3 S&P 500 Utilities as of 6/30/16, 10-year US Treasury bonds as of 7/8/16.