Let’s talk about October
October: [ok-toh-ber] n. from the Latin marketus volatilitus. Nope, totally made that up. Just a silly carryover from some science homework I’ve been helping my son with. Nothing to see here. But plenty to see below in this quarter’s addition of Ask a CFA with Marshall Bolden.
GW:
Marshall, put into perspective, please, the volatility we’re seeing in October.
Marshall:
There is a reason websites like Hotwire and Priceline have done so well, why retail stores are packed the day after Thanksgiving, or why ‘buy one get one free’ on certain cereals always works on me…most people enjoy feeling like they got a great bargain. I often find that this line of thinking does not carry over into investments in the stock market though. Now I certainly recognize that buying consumer products and investing have some differences, but the primary point is that, in both cases, lower prices usually means a better deal and higher satisfaction. I want to devote this update primarily to exploring this conundrum.
The Investment Update I wrote in January this year delved into market valuations – mainly the price/earnings or P/E ratio. At a basic level these valuation measures indicate the price we are paying for a stock or a group of stocks. As I noted in the January commentary, the long-term average P/E ratio of the S&P 500 index (large U.S. stocks) is around 15. So we could say the normal price is 15. If I know a pair of shoes normally sells for $75, I currently want or need those shoes, and I can buy them now for $50, I’m probably going to purchase them and feel good about doing so. And this thinking carries over to almost anything else I would purchase. But this gets a little fuzzy if we start talking stocks though.
Due to the recent pullback in the various stock markets I’m starting to hear questions about reducing risk, or reducing stock exposure. Let me be the first to say this is a question worth asking. I believe we have to explore why stocks have seen a pullback though before determining the appropriate action. If the declines are due to some fundamental factors (these are discussed further down), there may be good cause to consider reducing stock exposure. But if declines appear to be more a function of just the stock market doing its normal thing (volatility and periodic declines are normal) or of overreaction to some short-term fears or news, then we may be missing a bargain and acting contrary to what we would do on any other product. The appropriate action in this case may be to take advantage of the bargain, or to increase stock exposure.
So we need to look at the current price of the stock markets and what we believe has led to the recent declines. In evaluating various markets, it appears to me that current P/E ratios and other valuation measures have definitely improved over the last few months and are now slightly below their long-term average valuations. Sounds like there may be a sale going on. Reducing or eliminating stocks now may not be a good idea, unless we believe there is a fundamental reason or justification for stock markets to be declining.
If you listen to enough “experts” you can find hundreds of explanations for the recent declines, ranging from deflationary fears in the U.S., China’s economy slowing down, stagnant European growth, Russia’s intentions in Ukraine, ISIS in Syria and Iraq, Ebola fears, the Federal Reserve raising rates, etc. I will not address all these so that this commentary does not turn into small book. I will say that some of these issues could affect our view of the stock markets, but most of these (barring major changes) do not cause us much worry as to long-term stock market values.
I believe the important things on which to remain focused are the current and projected state of the U.S. economy, the expected growth of corporate earnings, and the current price of the stock markets. These are the fundamental issues that will primarily determine our view of stocks. I believe all three of these look favorable now. As stated above, the price (or P/E ratio) was looking a little high earlier in the year but now appears to be a little below average (or on sale). The U.S. economy has experienced growth the last several years – nothing spectacular, just consistent – and is projected to continue the trend or for the pace to even increase. Corporate earnings have also seen consistent growth for several years, and this is projected to remain the case the next couple years. So, considering these factors, we have a fairly optimistic outlook for U.S. stocks.
This is not to say the short term will not be volatile or that we won’t see any more losses. I’ve said in the last two Investment Updates that at some point stocks we would most likely see a 10% pullback or more and that volatility would increase. Markets do not rise forever in a straight line. There always has been and always will be disruptions, pullbacks, volatility, etc. This bull market had gone much longer than average without any disruption. The important things to remember are that long-term stocks have always gone up and that these more uncomfortable periods are often the best entry points, or the best times to increase risk because these are often the sales…those same sales we seek in every other area of life.
Let me draw one other real world comparison before discussing portfolio changes. Raise your hand if you rushed out to sale your house in 2008-2010 because the price of it was declining. Some people may have sold due to moving to another city, wanting more space, or some other reason, but few sold because the price was declining. That is because we know houses are long-term assets, we do not pay much attention to the value, and we expect that the price will rise in the long run. I believe it would be best to view stocks in a similar way. There are planning reasons to sell stocks when the price has dropped.
Excepting these, if we’re invested for the long term and have no changes in goals, what happens today or next week doesn’t make much of a difference; watching daily valuation changes is not important or productive. Your house is probably worth more now than it was 5 years ago. Your stock accounts (unless you sold in the 2008-2009 downturn) should easily be worth more than they were at the 2007 or 2008 peak. And I’m guessing if we hold steady through this turbulence, a few years down the road we’ll be much better off than we were when the markets peaked in the summer of 2014 and then fell from the highs.
Portfolio Update
Taking into account everything said above, it is our job to constantly evaluate what is happening in the markets and to adjust when we believe it is appropriate. This almost never means wholesale changes or jumping into cash, back into stocks, and so forth; I don’t know of any investors who have consistently succeeded at this type of market timing. Instead it means we are trying to find the values within different areas of the stock and bond markets and to take advantage of them. It also means we will make small shifts in exposure between stocks and bonds when this appears warranted.
When I see 10-15% declines, my normal course of action is to try to determine what caused this and then to determine if I can buy on sale. Both small company US stocks and MLPs have had such declines, and I’m beginning to get excited about the potential of buying on sale. International stocks are down over 15% in some cases, but I’m a little more cautious in this area because there are some fundamental issues that may justify the declines. The point here is that we look at many different areas on a case by case basis before deciding whether we think the falling values are justified or whether we think there is a chance to buy an asset on sale.
As we move forward, I think there is a good chance that we will increase our stock exposure, and that this will primarily involve increasing U.S. stock exposure with partially offsetting decreases to international stock exposure. On the bond side, we decreased risk with the changes made in July. I would anticipate keeping our bond risk about the same moving forward, but the overall bond allocations may decrease depending on how much exposure we add to U.S. stocks.
Marshall Bolden, CFA
Vice President, Chief Investment Officer
