Focus on Equities: Taking the Long View
Following a severe sell-off in the first quarter, global equity markets rebounded in the second quarter. The S&P 500 advanced 20.5%. Foreign stocks, as measured by the MSCI All Country World Ex USA Index, appreciated 16.1%. Small- and mid-cap U.S. stocks were up sharply, with the Morningstar U.S. Small-Mid Cap Index gaining 25.3% for the quarter. Dividend stocks bounced back, with the Dow Jones U.S. Select Dividend Index up 10.9%.
Fast Swinging Pendulum
Between February 20 and March 23, the anticipation and onset of an economic shock due to COVID-19 drove a 33.8% decline in the S&P 500. From March 24 through June 30, the market advanced 39.3% as aggressive U.S. monetary and fiscal stimulus appears to have nudged investors to look forward to what the economy might look like on the other side of being abruptly shut down for several months. In addition to these large, broad-market moves there’s been heightened daily volatility—26 daily moves of up or down 3% in the S&P 500 in the first six months of 2020. In the prior six years there were only 13 days with 3% market moves.
We suspect the volatility is linked to the heightened level of near-term economic uncertainty. We are in the midst of a recession and the current macroeconomic situation is complex, so there’s a much wider than usual range of potential outcomes for the economy and equity market returns over the next 12 to 18 months. We are aware that a variety of scenarios might play out, but our patient and long-term approach to managing equity portfolios does not depend on generating accurate near-term economic forecasts.
Most optimistic scenarios include containment of the coronavirus faster than expected due to an effective vaccine that can be widely distributed. Most downside scenarios involve a resurgence of coronavirus cases that triggers explicit and/or implicit headwinds for the U.S. economic recovery.
It appears as if U.S. investors are banking on one of the more optimistic scenarios playing out, based on an aggregate valuation of the S&P 500 as of June 30, 2020. Looking at two relative valuation metrics for the S&P 500:
- Trailing price/operating earnings = 21.8, versus a 10-year average of 18.0
- Shiller price/earnings ratio (which compares the S&P 500’s real price to its 10-year average of inflation adjusted earnings) = 29.0, versus a 10-year average of 25.9
On an aggregate basis, the S&P 500 does not look like a bargain when compared to its history. Of course, the Select Equity Portfolios don’t own an entire index, as we build portfolios by focusing on our highest conviction stock ideas.
Our strategies have a bias toward high-quality firms trading at a margin of safety (i.e., discount) to our estimate of intrinsic value. High-quality companies tend to have strong competitive positions, capable management teams, and strong balance sheets. In our opinion, strong businesses can extend their competitive advantage over peers during times of economic weakness or uncertainty—a fair description of the current environment.
Investing Through Volatility
Benjamin Graham, in his value investing classic, “The Intelligent Investor,” said, “Basically, price fluctuations have only one significant meaning for the true investor.They
provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal.”
Our approach to investing in equities is founded firmly on the premise that the intrinsic value of a business, at times, can differ materially from its market price. In simple terms, we look to buy stocks when the price trades at a discount to the value of the business and aim to sell stocks when price exceeds intrinsic value. The stock prices of the companies we own tend to fluctuate much more than the actual value of the underlying business. Thus, we see volatility as helpful given it creates more opportunities to buy and sell stocks at favorable prices especially when prices are moving due to excessive fear or greed.
Finally, we recognize our clients can get distracted during times of heightened market volatility, especially when there’s an economic and health crisis occurring simultaneously. That’s why we recommend consulting with your financial advisor, who can help you make sure your current asset allocation plan is appropriate for your risk tolerance and is on track to help you reach your long-term financial goals.
As always, we thank you for your business.
Individual index performance is provided as a reference
only. Each index is unmanaged and is not available for
direct investment. Since indexes and/or composition
levels may change over time, actual return and risk
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Although index performance data is gathered
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S&P 500 Index—An index of 500 stocks chosen for market
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Markets (EM) countries*. With 2,150 constituents,
the index covers approximately 85% of the global equity
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