"In a negotiated purchase of a business, you’re almost always dealing with someone that has the option of either selling or not selling, and can sort of pick the time when they decide to sell. In stock markets, it’s an auction market. Crazy things can happen...So you will see opportunities in the stock market that you’ll never really get in the business market." Warren Buffett
Over the last 100 years, the Australian and US stock markets have delivered a return close to 10% p.a. They’ve provided higher returns than any other asset class. And if you understand the power of compounding, you'll know that small changes in annual returns equate to huge difference as the time horizon expands. All this despite a multitude of things to worry about - a world war, a depression, recessions, tech bubbles, financial crisis, pandemics and trade wars to name but a few.
Why volatility can scare investors at exactly the wrong time
Unfortunately, these annual returns don't come in a smooth fashion.
In fact, as pointed out recently by Howard Marks, over the last 65 years, the annual return of the US stock market has only been between 8% and 12%, six times. That means ninety percent of the time the market has delivered an annual return outside of this range.
It's a good explanation as to why investors struggle to match the market - the volatility can scare investors out at exactly the wrong time. If it was as easy as collecting a 10% coupon every year, other asset classes just couldn't compete.
The last four years have been a case in point. The US market fell 20% in late 2018, collapsed 35% during the COVID-19 pandemic and 2022 has witnessed an almost 25% market decline.1
It's certainly been a challenging few years for the world economy.
An almost perfect recipe for the emergence of inflation
The emergence of COVID-19 saw an unprecedented response from central banks who pumped the global economy with liquidity.
This provided fuel for stock markets through lower interest rates, higher consumer spending and improving corporate earnings. The fiscal stimulus coupled with a stock and real estate 'wealth effect' coincided with the inability to purchase services, as travel, entertainment, dining out etc were curtailed, and fed into an increased demand for goods.
The lack of worker mobility combined with the emergence and rapid spread of the Omicron variant hurt staffing levels, supply chain efficiency and factory output placing further upward pressure on prices.
A terrible conflict in the Ukraine has added an additional strain on commodity prices.
It's almost a perfect recipe for the emergence of inflation.
The blunt tool that is monetary policy
As a result of these inflationary forces, the world's central banks have commenced a tightening cycle.
The US Federal Reserve has two goals: price stability and maximum employment. With the latter being achieved the Fed has shifted its focus to reigning in prices. It's unfortunate the only real tool in its arsenal is monetary policy, which is a pretty blunt tool.
While increasing rates and inflation will constrain consumer's spending, the easing of travel restrictions, improved factory productivity (as COVID's impact wanes), and a redirection of spending on goods to services should help ease some of the pricing pressures.
Stock markets tend to be more volatile than the companies they represent
The stock market has taken notice. It tends to get ahead of potential issues and often overshoots, both to the upside and downside.
Remember, stock markets tend to be a lot more volatile than the underlying companies they represent.
It was back in March 2020, I wrote a piece titled 'PANdemIC - this too shall pass.' It was a call to investors to take a longer term view, recognise the world has been through a global pandemic before, and to not make the cardinal sin of selling the lows; history would likely show it was an opportune time to buy.
This view was predicated on the belief that the world would muddle through, humanity would continue to adapt and evolve and the future would likely be even better than the past. I think it's fair to say that view remains unchanged today. Technology by its nature, compounds. Capitalism is working and we are on the cusp of many technological breakthroughs across industries.
The level of bearishness is at record highs
Notwithstanding, the level of bearishness right now is at extreme levels. In fact, according to the AAII Investor Sentiment Survey, investors are more bearish now than at any time since 1988; even more so than the Global Financial Crisis or Covid-19 pandemic. Investors are dumping equities across the board.
The Nasdaq today is more oversold, as measured by the distance to its 200 DMA, than at the lows of COVID-19. While many of the companies hyped in the last few years perhaps don't deserve the multiples or valuations afforded them, plenty may prove to be outstanding investment opportunities.
The Nasdaq today isn't the tech bubble of 1999. The business models that have allowed the likes of Facebook, Apple and Google to thrive are still as powerful today as they were six months ago. The list of things to worry about maybe longer, but the characteristics that will determine the earnings and competitiveness of these businesses are little changed. Each trades on between 12 and 20X next year's earnings. A far cry from the 213X earnings that the poster child of the tech boom - Cisco - traded on in the 1999 tech bubble.
The key to capitalising in down markets
As famed investor Shelby Davis noted, “A down market lets you buy more shares in great companies at favourable prices. If you know what you’re doing, you’ll make most of your money from these periods. You just won’t realise it until much later.”
We believe the key is to buy quality businesses that can survive a myriad of economic environments. Seek out characteristics such as innovative cultures, aligned management, products in demand, pricing power, high returns on equity, leading industry positions, industry tailwinds and solid balance sheets.
The market isn't very discerning in its assessment of individual companies. Stock prices can move 30-40% over short periods, even in a news vacuum. Liquidity, or an absence of liquidity, is trumping fundamentals. Even positive news is often being ignored.
We are of the view that it’s in these types of market environments, where investors are panicked and selling on emotion, that sow the seeds for higher future returns. They don't feel great at the time. But neither did March 2020.
For more information about our equities capabilities and solutions, please get in touch.