Market Correction Comments
A comment on Equity Market Volatility
The market’s recent weakness (S&P/ASX 2001 down 10.0% from its highs in late August and in the US the S&P 500 is down 9.7% from its high in late September) has been the result of a confluence of factors, in particular, i) continued US Fed rate rises as well as rising bond yields, ii) escalating trade tensions between the US and China, iii) stretched market valuations, iv) challenges in some emerging markets and v) a turn in some global economic indicators suggesting slowing global growth. We discuss each factor in turn.
The US Fed is likely to continue to gradually raise rates for some time while US bond yields are also likely to continue to move up on inflation concerns. However, some perspective needs to be taken in response to the rise in US bond yields where, despite recent increases, bond yields are below levels that prevailed in 2011, and have just moved up from a 40-year low. With regard to trade tensions, these are likely to remain for some time, with recent indications that they may actually deteriorate. However, the actual impact of tariffs on earnings is, so far, quite small. The challenges in emerging markets will also continue as long as the US Fed raises rates and the US $ remains strong. Both these factors are negative for their economies. The stretched market valuations contribute to investor concern during periods of weakness and can aggravate declines initially. However, with the correction, valuations have moved closer to fair value. Finally, while some indicators are showing a growth slowdown, growth remains positive. Investors’ major concern is a US recession however we see this as unlikely in the next 12 months.
The above issues have caused concerns for equity investors resulting in the sell-down we recently experienced. Corrections of 10% or more, while an uncomfortable event, are historically rather frequent, generally occurring once a year. The fundamental backdrop is an important consideration to what we have seen. In summary, from both from an economic and corporate earnings perspective conditions do appear supportive of current share prices. However, there are still valuation challenges in a range of markets and while some sectors are less stressed, overall market valuations have been increasingly stretched for some time.
A correction, considering the stretched valuations, is healthy for the market and allows everyone to take a breather. The reduced PE multiples are more sustainable and allow the expected growth in earnings to be reflected in stock prices and thus provide markets with some breathing space that previously wasn’t there. The FAAAN stocks being Facebook, Apple, Amazon, Alphabet and Netflix2, have come off meaningfully. However, they are still trading at significant price to earnings multiples; Amazon is trading on around 140 trailing twelve months earning and Alphabet is nearly 53 times. Apple is, by comparison, reasonably priced at a little over 18 times having been a little over 21 times.
While we cannot rule out further weakness in markets over the short-term, and a subsequent deterioration in fundamentals reflecting weakness in confidence, there is currently little sign of this. In addition, large market events are usually driven by a contagion effect from an external shock which leads to recessionary conditions in the economy and there is no indication of this at this point in time. Importantly for most major markets, the primary drivers of share price, earnings, and interest rates, remain supportive of equities.
Based on this we would consider investors being best served by retaining their exposure to the equity markets, while ensuring that they are appropriately diversified both across asset classes and within them.
Some cash reserves are also useful for funding requirements and to bring back into the market once the above concerns are behind us. We suggest caution in having excess cash exposure as it doesn’t provide a hedge against falls in equities, and timing of a re-entry to the market can be very costly in terms of the opportunity cost. Peter Lynch3 reportedly said, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Taking too aggressive positions away from your strategic asset allocation in light of the current risks and issues in the market is unlikely to be profitable. Our recommendation is to have a long-term investment plan and stick with it.