2022 January Market Update
Dear Choate client,
We want to provide some context to the current downturn in the stock market. Market behavior is a combination of fundamental analysis and short-term changes in investor sentiment. We believe current market movements reflect sentiment changes more than fundamental changes in company earning potential. The market is reacting to recent changes in 1) the pace of the economic recovery, 2) rising inflation and 3) the lingering effects of the Covid pandemic. Investors often act on these changes rapidly, in a herd-like fashion. Some of the recent decline is an overdue correction from high valuations. As investors, we anticipate market overreactions that will reward patient investors, and we remain cautiously optimistic for 2022 and expect a continued rise in corporate earnings.
Over the past 3 years, global equity markets have averaged returns of 20% a year. By comparison, over the twenty years since 2001, stock market returns averaged around 9% a year as each company’s long-term value is linked to growth in annual earnings (around 7% per year) and dividend payments. Given the recent elevated market returns, it is not surprising that investors are seeing a pullback in 2022.
Market corrections (over 10% declines) are somewhat frequent, and the below chart illustrates that most calendar years see significant pullbacks before their eventual recovery.
Source: CIA analysis. Bloomberg. Returns are based on total return net of dividends. Max drawdown refers to the largest mark year.
Rapid corrections create significant investor anxiety and uncertainty. However, we believe these occasional dislocations can provide some opportunities for long-term investors and are the natural consequence of the imperfect market finding a balance between buyers and nervous sellers. The legendary investor Benjamin Graham famously said about market behavior: “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” We hope to use the recent voting behavior to help improve our long-term opportunities for client portfolios, as resilient companies become oversold.
Elevated valuations pose a conundrum for investors. It seems obvious to “sell high and buy low,” and we did indeed trim equities in client portfolios last fall. However, at present we do not believe there is a compelling reason to sell stock in companies that are profitably growing their business, even when their stock price appears relatively expensive. As cash is returning negative real returns, we look to broad weakening in the economic environment as a catalyst for reducing stock holdings. In addition, investors who choose to hold their sale proceeds in cash must time their re-entry to the market. As long-term investors it is sometimes better to hold the stock and suffer short-term discomfort, rather than sell and miss the continuing long-term appreciation of the stock.
To highlight this challenge, we look at a market bellwether, Microsoft Corporation. Over the past two years, Microsoft stock has returned nearly 80% to shareholders, while its valuation fluctuated between 32 and 36 times its annual earnings. Indeed, there were more than a few occasions where Microsoft’s valuation looked too expensive compared to the market. At each time, investors would have been mistaken to sell as the company earnings surged, and the opportunity to buy the stock back did not present itself. The company just reported solid quarterly results and expects growth to continue at a strong pace.
Green line - Forward 1 year price to earnings
Blue line - Price
We have written before that we favor managers who invest in growing, resilient companies that are forecasted to compound earnings growth over time. Typically, it is a breakdown in company business fundamentals that leads to investment mistakes and not just paying “too high a multiple”.
As an extreme example, Amazon was viewed as wildly overvalued during the “dot com bubble,” and the stock traded at $85/share. The current stock price is $2,836. Amazon’s continued success as a business means that prior stock peaks, no matter how expensive the stock appeared at the time, were ultimately buying opportunities. We will continue to focus on fundamentals and look to take advantage of any market dislocation to redeploy toward great managers and companies. Please reach out to your portfolio manager if you would like a further conversation.
Your ChoateIA team