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.
Index Information
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
characteristics may be higher or lower than those presented.
Although index performance data is gathered
from reliable sources, Morningstar Investment Management
cannot guarantee its accuracy, completeness
or reliability. Index data sources are as follows.
S&P 500 Index—An index of 500 stocks chosen for market
size, liquidity and industry grouping, among other
factors. The S&P 500 is designed to be a leading indicator
of U.S. equities and is meant to reflect the risk/return
characteristics of the large cap universe. The S&P
500 is a market value weighted index.
Moringstar US Small-Mid Cap Index—The index tracks
the performance of US mid-cap stocks that fall between
70th and 90th percentile in market capitalization of the
investable universe. In aggregate the Mid Cap Index
represents 20% of the investable universe.
MSCI ACWI Ex USA Index —Index captures large and
mid cap representation across 22 of 23 Developed Markets
(DM) countries (excluding the US) and 24 Emerging
Markets (EM) countries*. With 2,150 constituents,
the index covers approximately 85% of the global equity
opportunity set outside the US
Important Disclosures
The information, data, analyses and opinions presented
herein do not constitute investment advice; are provided
solely for informational purposes and therefore are
not an offer to buy or sell a security.
Except as otherwise required by law, Morningstar Investment
Management LLC and its subsidiaries shall
not be responsible for any trading decisions, damages
or other losses resulting from, or related to, the information,
data, analyses or opinions or their use. Please
consult with your financial advisor before making any
investment decisions. Neither diversification nor asset
allocation ensure a profit or protect against a loss in a
decliningmarket. Past performance is no guarantee of
future results.
Investments in common stocks involve risk (e.g., market
and general economic conditions) and will not always
be profitable. Common stocks are typically subject to
greater fluctuations in market value than other asset
classes as a result of such factors as a company’s business
performance, investor perceptions, stock market
trends and general economic conditions.