Sharp Drops Are Times To Buy, But Do Not Expect A Quick Turnaround
Summary
- The market's sharp downward moves offer long-term investors a buying opportunity, in my view.
- While the coronavirus is likely to disrupt economic activity for some time, history shows us that world stocks often recover from these types of events in the short-term.
- However, investors need to stay grounded here. While a 10% drop seems large, equities were trading well above historical norms.
- There have been downward revisions for earnings forecasts for the S&P 500, and that will be a headwind going forward.
Main Thesis and Background
The purpose of this article is to evaluate the current state of the equity market in the U.S. to decide how appropriate it is for investors to initiate new positions now. Towards the end of last year, I began reducing my equity exposure, which did not appear to be the best move at the time as the market continued higher. A few weeks ago, I reiterated the rationale for this positioning, when I reviewed the broad state of the market and continued to express caution.
Looking back now, this caution has now been vindicated. While the market was flat to positive in the days immediately following that article, this past week has had one of the worst sell-offs in years, with the broader market falling over 10%, and at a rapid pace, as shown below (through 2/27):
Source: Bloomberg
While being more defensive has paid off in the short run I, and many other investors, are likely thinking about adding to equity exposure to take advantage of the sell-off. Simply, I believe this is a good idea, and I have begun increasing my equity position over the past few days, and will continue to do so if the market decline continues going forward. However, I want to highlight some concerns I still have, and to recommend investors approach new positions carefully and within their risk tolerance.
Specifically, while I see better entry points in the market today, I need to point out that stocks are still not "cheap". The market was quite expensive on a historical basis before the sell-off, and a 10% drop is not really enough to put us in value territory. Therefore, I believe investors would be wise to maintain proper hedges, even if they decrease them to some degree. Further, while I generally believe equities will recover from a virus-induced sell-off, history shows that these types of sell-offs can have a diverse impact on the stock market and the rebound, which will happen eventually, can be uneven. Finally, corporate earnings estimates have been declining for 2020. This will pressure equities in isolation, as well as the multiples investors are willing to pay for stocks. This reality will make returning to previous highs quite difficult indeed.
US Stocks Are Still Pricey
To start the review, I want to reiterate a similar point to last time, which is the price to own U.S. stocks. Clearly, in the short term, the cost of ownership has come down quite a bit, given the broad sell-off. For investors who were considering purchasing broad U.S. equity funds such as Vanguard Total Stock Market ETF (VTI) or SPDR S&P 500 Trust ETF (SPY) a few weeks ago, they are now looking at a marked discount to buy in. As I mentioned, I do believe now is a smart time to start purchasing, but I want investors to consider the relative valuation of the S&P 500 when deciding how much to buy.
Specifically, let us consider the valuation, as measured by the current P/E ratio of the S&P 500 today, compared to where it was during my prior review. To illustrate, consider the two charts below, which are snapshots of the P/E ratios earlier this month compared to now, respectively:
Source: Multpl.com
As you can see, there has been a marked dropped in valuation for the S&P 500, with the P/E ratio falling from over 25 to over 22 in a short-term time frame. This reality does tell me that in a very short term, the market is much more attractively priced, and investors would be wise to use that as a time to pick up some broad exposure to stocks.
However, when we look further back in to history for relative comparisons, we also see that the updated P/E is not cheap by any means. While it may look it compared to two weeks ago, if we look back to over the past five or six years, we see that equities are still sitting with a relatively rich valuation today. Therefore, while I generally like the idea of buying in now, investors need to be aware that there is a real probability stock valuations could tick lower still. This could happen due to declining sentiment or earnings, and I will discuss next why I believe investors should be concerned about the latter. If that does materialize, we could see the P/E drop further still. Therefore, my takeaway here is to approach new positions carefully, and to leave some cash on the table to be able to buy more if the decline continues from here.
Earnings Revisions Suggest Corporate Concerns
My second point considers a critical aspect of the equity market - corporate earnings. As I have pointed out in prior reviews, while corporate earnings were generally strong in 2019, they lacked significant year-over-year growth. However, investors were still relatively pleased with the results, and were willing to bid equity prices up higher. The result has been rising valuations and, until this week, investors seemed content with that scenario.
However, now that equity prices have come under pressure, we would expect P/E ratios to come down, as noted above. The problem going forward is it will be difficult for P/Es to remain competitive if earnings decline, and that is the ongoing expectation on a broad scale right now. As coronavirus concerns stint travel plans, pressure supply chains, and lower confidence, corporate earnings are likely to take a hit.
And the impact is not insignificant. Since 2020 began, estimates for S&P 500 earnings per share have been cut for every quarter this year, albeit with the impact gradually declining as the year goes on. According to data compiled by Charles Schwab, this has resulted in a move from expected growth of nearly 10% for the year to less than 8% now, as shown in the graph below:
Source: Charles Schwab
My takeaway here is investors need to be realistic about market performance over the next few months. The good news in the chart above is that the hit to earnings is expected to lessen as the year goes on, with the biggest impact coming in Q1. If coronavirus concerns begin to fade, this makes intuitive sense, and the ride should be smoother once we get out of the first round of earnings calls. However, if the situation worsens, or simply takes longer than expected to resolve, we could see further declines in expected earnings, and that will certainly lower the premium investors are willing to pay for stocks.
History Tells Us Stocks Will Rebound, But It Takes Time
In times like this it is difficult to stay patient and remember the long game. Which equities are in free fall, it is easy to panic, because watching account balances decline by above-average amounts is not something anyone would relish. However, it is important to keep in mind that history shows us sell-offs like this are always opportunities. Of course, the challenge is not if the market will recover, but when.
With this in mind, I think it is useful to do a look back at previous market sell-offs, for a guide on what investors should expect the next few months to look like. While U.S. equity markets are down nearly 15% from their highs (at time of writing), this is unfortunately an occurrence we have seen many times over the past fifty years. During similar sell-offs, markets have rebounded, but not immediately. In fact, the average length of time to recover from market corrections (defined as a 10% drop or more) is roughly four months, based on data compiled by CNBC, as shown below:
Source: CNBC
The takeaway here is while I absolutely suggest buying in to this market, investors need to recognize that things are not going to return to normal, or previous highs, right away. Investors who buy now have to anticipate, or even expect, further equity declines and be prepared for plenty of volatility over the coming months. However, using the above guide, we are currently sitting at the average level for a market correction, so this tells me that shifting to a more risk-on approach at this point in the sell-off makes sense.
To expand further on this point, let us take a look at the performance of global equities during similar health scares. Looking back at some of the other pandemics we have seen in previous decades, stocks will often swing wildly, and have reacted much differently in such cases. For example, some health scares have been largely ignored by markets, while others have seen sharp sell-offs in the months that followed, as shown below:
Source: Charles Schwab
My takeaway here is, again, that investors should expect volatility over the next few months, and perhaps even up to six months. But while the chart above may look scary, the fundamental point is that markets have typically managed to register positive returns during such outbreaks. With a long-term focus, investors can use this as support to try to keep a level head when so many are panicking.
Bottom Line
I took some risk off the table going in to 2020, and while that decision did not pay off initially, I sure am feeling good about it now. Nevertheless, my equity positions are deep in the red, and that is certainly causing some anxiety and reluctance to add to these positions. However, I am absolutely getting back in the game at these levels, as I am trying my best to keep a level head amidst this panic selling. Clearly, I am going against the momentum right now, as the major indices in the U.S. and abroad are selling off, and investor sentiment has shifted in the short term. In fact, according to a weekly survey done by the American Association of Individual Investors (AAII), investors have unsurprisingly shifted from a bearish to bullish sentiment, as shown below:
Source: AAII
My takeaway from this is now is the time to act contrarian, and go against the grain. Big drops in equities present investors with unique opportunities to compound returns. However, I must emphasize that in order to buy during some volatile times, investors need to manage their own expectations, and stay in line with their own risk tolerance. If they don't, further drops in prices could encourage investors to follow the herd, and that is precisely what retail investors should avoid. Therefore, I am recommending building on to equity positions at these levels, but caution investors to manage the ongoing risk at a level that makes them feel comfortable.
This article was written by
I've been in the Financial Services sector since 2008, which gives me an invaluable insight in how markets can turn. I currently work for a large-cap US Bank in funds management. I was a D1 athlete in college (men's tennis) when I got my Finance degree. I received my MBA in 2013 in North Carolina.
My readers/followers can trust that I won't pump any investment nor discuss a topic I don't genuinely follow and research. In that spirit, I list my portfolio here for transparency
Broad market: VOO; DIA, RSP
Utilities: VPU, BUIÂ
Energy: VDE, RYE, IXC
Innovation: GINN, QQQ
Non-US: EWC; EWU; EIRL
Dividends: DGRO; SDY, SCHD
Municipals/Debt Funds: BGT, Individual muni issues (NC)
Stocks: WMT, JPM, MAA, SWBI, MCD, WM, MGM
Cash position: 25%
Analyst’s Disclosure: I am/we are long VTI, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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