Instead of a January rally, the New Year kicked off with a drop in stock prices and a jump in market volatility; the stock market’s own bomb cyclone. There are similarities in the collective response to January’s market behavior and the recent storms: they lead to considerable fear, compounded by news media, and often cause people to act in ways they otherwise would not. The discomfort the market behavior caused was persistent. Stock prices, measured by the S&P 500, fell 5.2% for the month, falling 13 of the 20 trading days and prices fell more than 1% on more than half the down days.
Volatility in a stock’s price is measured by the magnitude of the up and down swings. Maximum drawdown is a more tangible method of measuring active risk than the somewhat obscure standard deviation. According to JP Morgan Asset Management market data heeding back to 1980, intra-year price drops in excess of 10% are far more common than many investors allow themselves to believe: over the 42-year span since then, there have been 23 years in which prices fell 10% or more (55% of the time). Stocks did generate an average annual return of 9.4% over this span but smooth sailing is hard to come by with prices dropping less than 5% on only four occasions. More often than we like, extreme price volatility makes owning stocks exceedingly uncomfortable.
The primary concern stock prices are confronting is rising interest rates, the fear the Federal Reserve mismanages the transition to a more restrictive monetary policy in the hope of tempering inflation without tipping the broad economy into a recession. The Fed hasn’t actually done anything yet, other than jawbone the markets into tighter financial conditions. This may well lead the Fed to do less, i.e. execute fewer rate hikes, over time. On a positive note, the bond market (often the best measure of the health of the economy), the shape of the yield curve, and high yield spreads are not showing cause for alarm.
In response to this more-quickly-than-expected move toward tighter financial conditions, expensive stocks have fallen in price (a valuation reset) and have in many ways catalyzed the drop in the broader market. The expensive stocks are those with high prices relative to their earnings, cash flow, revenue or book value. Different types of companies are valued using different measures relevant to their specific industry or sector. The correction in stock prices, in some segments of the market, has been extreme. For instance, the Russell 2000 small cap benchmark is down 20% and the Nasdaq Comp growth benchmark is down 17%, while the average stock in these benchmarks is down 35% and 45%, respectively.
Stocks have fallen in price this year when viewed by virtually every measure (popularity with analysts, size, valuation, dividend yield). There has been far less damage to stocks with lower valuations and higher dividend yields, both typical hideaways in a challenging market. This is the general space we will continue to work in until we have further clarity on what we consider more actionable trends across the market. Business execution is critical here. Apart from valuation, the unwinding of the supply chain debacle, adept management of the demand pull-forward many businesses have experienced, and the ability to execute pricing power are all top on our list of factors to screen for.
There is a multitude of things that can go wrong and these take on a new presence when stock prices begin to fall. At the same time, owning stocks involves a defined process, and requires a long-term outlook. I believe there are numerous positives to support owning quality stocks: the virus looks to be easing, earnings are coming in nicely, the job market is robust, and I think the inflation we are seeing, with the exception of wages, will largely dissipate as we move beyond the effects of the pandemic. Owning quality stocks has a long history of being an effective way to accumulate wealth and I don’t believe a choppy January is any reason to change heart.
One of the most important parts of our work is to help you navigate the inevitable challenging times. If we have not spoken, please do not hesitate to reach out.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.