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.