ECONOMIC/MARKET REPORT
STEVEN I. DYM
ANALYTICAL CAPITAL
November 3, 2018
There’s nothing like a bout of market volatility to start reviewing your assumptions.
Is exposure to equities a wise idea at this point?
Well, corporate profits are still good. Not spectacular as the past two years have been, but healthy nonetheless. As we explained in a previous note, this is the long run driver of equity returns – but really long run. The question is whether the short-term risk, which we can think of as a cost we pay to reap the rewards of long-term investment, is acceptable.
There seem to be several possible flash points:
• The Federal Reserve hopefully doesn’t accelerate (nor raise the ultimate stopping point of) its rate increases program. Let’s be clear – interest rates should go up. A cost of capital near zero is not a sign of a fundamentally healthy economy. However, if inflation appears to accelerate, and the Fed thinks it needs to push rates up more dramatically to head it off, then this will probably spook markets.
• The trade spat (Trump against almost every trading partner) continues. We hope it’s short lived. If not, then this can cut into corporate profits and reduce equity returns.
• Market participants might be rethinking their view that technology remains on its secular growth path. If so, not only would this lower Price-Earnings ratios for the tech sector, it may carry over to the market as a whole.
Our general approach to short-term risk factors is sanguinity. Granted, it can be quite unnerving (and, typically, the strength of this panic varies inversely with investment experience), but it is, in large part, simply noise. Equity profits (indeed, all profits) do not come smoothly. However it may seem in retrospect, returns are not a 45 degree line from the bottom left to top right. In fact, the more closely we examine the equity curve, the worse it looks.
To illustrate:
A buy and hold position in the S&P 500 over the past thirty years returned about 1800% (or roughly 10.1% per year, compounded). I’m sure whoever held that investment is very happy now. But how did it look in real-time? If an investor would have looked at his profit/loss statement only once every year, he would have slept pretty well. The S&P 500 was negative in only four years out of 29, or 13% of the time. If he looked every month, it would have been a little more nerve-wracking, as 34% of months were negative. Still worse, at the weekly level, 42% were negative. And looking at daily returns, almost 46% of days were in the red!! This, despite the stellar record over the full time period. So even with this great investment, an investor would have been happy only slightly more than half the time if he paid attention to volatility.
In short, we are not overly concerned with the current market volatility, and we think equities are okay for the intermediate term. It could very well be that over the next couple of years choosing which industries, and which companies within industries, will be more important than choosing to be in or out of the market, and how much so. Furthermore, for the first time in years fixed income has become an attractive asset class. So we’re not as bullish as we were five or six months ago because the world has changed. It always does.
