Investors need to keep their heads during market turmoil

Source: Refinitiv Datastream & Old Mutual Wealth PCS

Source: Refinitiv Datastream & Old Mutual Wealth PCS

Published May 14, 2022

Share

By Andrew Dittberner

“If you can keep your head when all about you are losing theirs…” – Rudyard Kipling

Things can change very quickly in capital markets. On the first trading day of 2022, the S&P500 closed at an all-time high, while just a few months later (on Monday, 9 May), it closed 16.8% below that level. Unsurprisingly, it is investors’ anxiety levels that are now at all-time highs.

We live in a world of abundance, and the last few weeks have highlighted that investors are happy to endure rising markets in abundance, but not the downside volatility that inevitably follows years of markets predominantly moving in one direction. At times like these, a little perspective always goes a long way.

Since the market bottomed in March 2009 following the Global Financial Crisis, the S&P500 has produced a return of about 700%, including the recent drawdown. Over the period, the sharpest decline was experienced during the short-lived Covid-19 induced bear market of March 2020, as shown in the graph below. In short, the current bout of market volatility pales in comparison to previous drawdowns. And in fact, one could argue that a market downturn was well overdue. Furthermore, as history shows, volatility and drawdowns are certainly part and parcel of investing in equity markets.

S&P500 drawdowns since 2010

Source: Refinitiv Datastream & Old Mutual Wealth PCS

What’s causing the current turmoil?

A myriad of well-documented factors have led to the recent volatility and drawdown. Global inflationary pressures are top of the list, followed closely by concerns around how quickly central banks pull the reins in on the ultra-loose monetary conditions that markets have become accustomed to. No central bank is more important than the United States Federal Reserve Bank (Fed), which many believe are late to the policy tightening party. But now that they have arrived, there are concerns around whether they will overstay their welcome. If they do, we could see a recession in the world’s most important economy and equity market. And if this is not enough, throw in geopolitical issues and ongoing draconian lock-downs in China, which exacerbate the world’s current supply chain issues and place a damper on consumer demand. Valuations are then the final piece of the puzzle. Coming in to 2022, there were pockets in the equity market that were delusional in their valuations given the economic backdrop, while many other areas were priced for perfection.

Understandably, these factors are weighing heavily on investors’ minds. However, once again, some perspective is required. Taking a step back, we believe that the core issue is the transition from a high growth, low inflation, low interest rate environment to one that will likely have lower growth, higher inflation and higher interest rates. And as this transition unfolds, it is easy to lose sight of the bigger picture by getting caught up in the short-term sentiment.

Historically, volatility can be expected during times of transition, given the uncertain outlook. As interest rates and bond yields rise, equity valuations are expected to de-rate. Given that valuations reflect the present value of future cash flows, higher interest rates will cause the present value of future cash flows to decline, all else being equal. Fortunately, once this period of adjustment is over and markets have reset to the new macro outlook, the uncertainty will subside and investors will once again focus their attention on the fundamental drivers of the equity market.

Focus on valuations, beware the COPS

Alongside fundamentals, valuations are also a critical determinant of long-term investment returns. The post-Covid market rally pushed many shares into frothy territory and beyond. We refer to such companies as COPS (crazy overpriced stuff). Many of the COPS are not profitable and can often be found trading on the Nasdaq, where their prices soared in 2021 as investors piled into these shares, which appeared to be well positioned to ride the tailwinds of recent trends. Whether it was online meetings, at home exercise, buying the latest crypto coin or meme stock, or hoping to own the next Tesla-like company, investors had to own them. The result of this mania is a market that has become very unforgiving.

We have witnessed a number of high profile companies, some of which are very profitable, retreat significantly on earnings announcements that did not live up to expectations. These companies include Meta Platforms (Facebook), Netflix, and NVidia. Unforgiving markets are quick to reprice shares that were priced for perfection, while punishing shares that were priced at stratospheric levels, such as the COPS highlighted in the accompanying image (not an exhaustive list).

The COPS 12-Month Peak Market Cap and Subsequent Return

Source: Refinitiv Datastream & Old Mutual Wealth PCS

Keep your head when others are losing theirs

Warren Buffett once said that he invests in businesses that if the market were to close for ten years he would be happy to remain invested in. In other words, he invests in great businesses that can withstand different economic cycles, all the while growing revenue and earnings. Another important point to this statement is that he is not interested in short-term price movements. Therefore, he can withstand unforgiving markets.

The reality is that share prices will fluctuate over the short term. However, in the fullness of time, companies with strong economic moats and enterprising management teams will adapt to changing economic environments and not only survive, but thrive.

So in the days and weeks that lie ahead, it is important to maintain perspective, keep calm and remain invested. We acknowledge that this can be hard to do, but history shows that the markets will work in investors’ favour as long as they remain patient and have a proper investment philosophy and strategy to guide them.

Andrew Dittberner is Chief Investment Officer, Old Mutual Wealth Private Client Securities

PERSONAL FINANCE

Related Topics:

investingstock markets