Worry Returns

After a long absence, market worry returned with a vengeance over the last 10 days or so. The S&P 500 Index currently sits 7% off its all-time high, a figure that understates the recent volatility. The S&P 500 had a three-day period in which it closed more than four standard deviations (i.e., likelihood of 1 in 15,787 events) below its 50-day moving average each day (Table 1). Such a move has now happened twice in the history of the index, with the other time being May 15, 1940, right as Germany was invading France, Holland, Belgium, and Luxembourg. 

There are certainly big reasons for concern, which we have discussed regularly in recent years: low worldwide interest rates and inflation; high U.S. corporate profit margins; European currency, debt, and demographic issues; Japanese currency, debt, and demographic issues; and, highlighted in this recent round of volatility, Chinese investment, debt, and banking issues.

Yet, while we have a market that is valued at the high-end of its historical range (Table 2) on top of all-time-high corporate profit margins (Table 3), we do not think current issues approach those experienced at the outset of World War II.

We thought a few points might offer some useful perspective: 

1)     We think about expected stock- and bond-market returns in 10-year chunks. A 7% market decline increases a decade-long expected return by roughly 0.7% per year, all else being equal.

As a result, a 5.0% expected return over 10 years would turn $1,000,000 into $1,628,895, while a 5.7% return results in $1,740,804. The difference is not inconsequential, but it isn’t the kind of move that should encourage major portfolio shifts, unless there is more concern ahead.

2)     The S&P 500 was at today’s level as recently as 10/28/14. Of course, we didn’t believe the stock market was very attractive then, and corporate fundamentals have not improved significantly since. As a result, with a slightly wider frame, today’s level is attractive relative only to where it has ranged in the last six to nine months. 

3)     We wish our favorite stocks had more dramatic drops than the market in these more volatile periods. Unfortunately, that isn’t usually the case. When markets move down rapidly, the correlation of the downward movements is high across all stocks, due to across-the-board indiscriminate selling. Additionally, since we have a preference for high-quality stocks, our favorites may not fall as much as the market in highly volatile periods.

We remain worried. As discussed above, there are big reasons for concern. And we still think the stock market is high, with an expected future return well below that of historical levels. Of course, that’s offset by alternatives we find to be lousier – a bond market that yields about 2% and cash that yields about 0%.

But we believe your portfolio has been and remains reasonably positioned for these risks, attempting to balance the likelihood of each risk with the magnitude of its impact. Your stock portfolio remains focused on high-quality companies, and your bond portfolio remains oriented toward short duration bonds (i.e., those that mature in the next few years) and inflation-protected bonds. We are attempting to be conservatively positioned until more attractive values present themselves; at such times, we hope to be opportunistic by investing in more high-quality stocks and/or by increasing overall stock exposure. 

I have included an excerpt below from a CNBC interview with Warren Buffett in 2011. It clearly articulates our thinking and our current preference for stocks over bonds, despite our concerns.

The world’s always uncertain. The world was uncertain on December 6th, 1941; we just didn’t know it. The world was uncertain on October 18th, 1987; we just didn’t know it. The world was uncertain on September 10th, 2001; we just didn’t know it. The world—there’s always uncertainty. Now the question is this—what do you do with your money? If you leave it in your pocket, it’ll become worth less over time. That’s almost certain. You can put it in bonds and get a certain 2 percent for 10 years, but that’s almost certain to be less than the decline in your purchasing power. You can put it in farms, and the farms will probably keep growing corn and soybeans, and they’ll grow it whether Italy has trouble tomorrow or not. It’s very interesting to me…if you own a farm and somebody says Italy’s got problems…do you sell your farm tomorrow?

If you own a good business locally in Omaha and somebody says Italy’s got problems tomorrow, do you sell your business? Do you sell your apartment house? No. But for some reason, people think if they own wonderful businesses indirectly through stocks, they’ve got to make a decision every five minutes. So if Ben Bernanke comes up and whispers to me that he’s going to do X, Y, or Z tomorrow, I’m not going to change my view about what businesses I want to own. I’m going to own those businesses for years, just like I would own a farm or an apartment house. And there will be all kinds of events and there’ll be all kinds of uncertainties and in the end, what will really count is how that business or farm or apartment house does over the years.

I can’t perfectly time the buying and selling of it. I’m going to own these businesses 5 or 10 or 20 years from now, and there will be all kinds of good news and all kinds of bad news. But the good businesses, they do wonders for you over time.
— Warren Buffett, CNBC 2011