The Correction and the Long-Term Investor

We are just a little over two months from the beginning of the correction that ended the dramatic “melt-up” of January. Since February 8th, when the S&P 500 found a low at 2581, the market has been volatile, with average movements of over 1% per day. After the preternatural calm of 2017, those daily swings may seem unnerving. However, those whipsaw moves haven’t taken the markets anywhere: from mid-February to mid-March the S&P traded almost entirely in a range between 2700 and 2800, and since mid-March in a range between 2600 and 2700.

Source: Yahoo Finance

We are now entering the first earnings season since the recent increase in volatility, a period that will include the positive impact of the corporate tax law on company income statements. Analysts expect full year 2018 earnings to grow nearly 19% over the level recorded in 2017 thus expectations for 1Q18 results are quite high. Though only about 10% of S&P500 companies have reported thus far, results have been quite positive with roughly two-thirds of companies exceeding these lofty expectations. So why hasn’t the stock market been soaring in recent days?

The answer, as with most things involving the markets, is “complicated”. Has the market already discounted excellent results for this year? Are investors concerned about the flattening of the yield curve, which has historically been an indicator of recession? The spread between the 2 year treasury and the 10 year treasury has narrowed to 43 basis points, meaning a 10 year treasury pays only 0.43% more than a 2 year. Are investors worried about the Fed overshooting and killing the economic expansion? In 1937, albeit with very different monetary tools, the Fed and the Treasury raised interest rates and tightened the money supply too quickly, and the resulting shock sent the US into one of the sharpest recessions in history. Are investors worried about geopolitical events? Are investors worried about a potential constitutional crisis?

It seems reasonable that investors could be concerned about any or all of these risk factors. The truth is that no one ever actually knows what causes the market to move up and down on a daily basis. Robert Shiller, the Nobel prize winning economist noted on CNBC recently, “Typically, there really isn’t any big news except news of the correction.” Farr, Miller & Washington doesn’t try to time or forecast the market because it isn’t possible to do consistently. Instead, we build diversified portfolios of high quality, reasonably priced individual stocks and bonds that are designed with the goal of providing downside protection when the next bear market arrives, while still providing solid appreciation during good times. Weak markets are a good time to pick up great companies at bargain basement prices. Strong markets are a good time to ease out of stocks that have become too expensive and redeploy capital into stocks that have perhaps not performed quite so well. Today, we are using extra cash to increase our positions in great companies that have dropped a bit during the recent bout of volatility.

Investors have enjoyed a very strong stock market for over 9 years. Profit margins are high, profit to earnings ratios are no longer low, and interest rates have been rising. Returns over the next 5 years are likely to be below where they’ve been over the past 5 years since they’ve been so high in recent years. Beyond this, who in the heck knows? Warren Buffett doesn’t know and if he doesn’t know, we certainly can’t tell you what will happen in the near-term!
Though we don’t know where the market is going near-term, we do believe that a basket of blue chip American companies, will make more money in the future than it does today, which will ultimately lead to higher portfolio values. While the overall market averages have not changed dramatically, the stocks within the averages have moved a lot. Though volatility can be unnerving, volatility also presents long-term investors with attractive investment opportunities as stocks that were fully valued are suddenly trading at prices that are significantly more attractive than they were a few months or weeks ago. Our investment discipline is based on a 3-5 year horizon and our responsibility is to look past the short term volatility to secure our clients’ goals. As we survey the current conditions, we remain fully invested, and vigilant to what the future will bring.