Let's be honest, the start of this year hasn't been great for investors. Both share markets and bond markets are down, inflation is back and uncertainty seems here to stay.
However, it may not be so grim as it seems. While we would love it if markets climbed every day like clockwork, we know it doesn't work like that. Periods where markets fall are normal, as investors adjust to new information and uncertainty.
I understand times like this can be unnerving, so I thought I would briefly discuss what is happening in markets and why we should stay the course moving forward.
What's spooking the markets?
The two big factors affecting broad markets have been inflation and interest rates. Inflation has taken hold across the globe, with most central banks indicating sharp rate hikes are on the way to control prices.
Bond markets reacted quickly to this new information, with prices falling in response to the announcements. Because newly issued bonds will generally provide higher returns in the future, bonds already held by investors are less appealing, hence the drop in prices.
With share markets, on the other hand, the effects can be harder to predict. In general, higher interest rates make raising capital more expensive for businesses and inflation can lead to increases in costs.
But share markets are complex and are comprised of many different company's stocks. For the year to date, high oil prices have benefitted energy companies considerably, while transportation costs negatively affect others. Banks and financial institutions also typically benefit from rising interest rates, as part of their incomes are derived from interest payments.
Pricing in uncertainty
In addition to inflation and interest changes, the war in Ukraine continues to create uncertainty, along with oil prices and supply chain issues.
Markets hate uncertainty, so this additional risk leads to a fall in share prices and volatility in the market, with prices quickly jumping up and down. Investors are effectively asking for a discount to compensate for the risk of the unknown.
When uncertainty is resolved, share markets can rebound quickly. We saw this in early 2020 when Covid-19 was spreading at an accelerating pace. Most markets fell by 30% or more in a single month.
Once government responses were organised and our understanding of the virus developed, markets bounced back remarkably quickly. The S&P 500 regained half of lost ground in teh following month and was at new highs by August, even while economies were still adjusting to the shock.
While we cannot guarantee such recoveries moving forward, it is important to note how uncertainty affects markets. When new information arrives, markets will quickly adjust to reach new, fair prices.
The return of value
While markets are down, value stocks have outperformed growth stocks by a wide margin for the year to date.
Growth stocks are those which have high share prices relative to their assets. Investors choose these companies as they believe earnings will grow in the future, justifying a high price now. In recent years, technology stocks stand out the most, with many having incredibly high valuations compared to their earnings.
On the other hand, value companies have low share prices relative to their assets, indicating investors see some risk in investing in the company. Consider airlines during the early stages of the pandemic. Their shares were heavily discounted due to the loss of income, but also the uncertainty regarding their futures.
Decades of academic research show that investors are rewarded for taking on value over growth. While growth stocks have done well lately, over longer time periods, value comes out on top.
For the year to date, growth stocks have been hit particularly hard. Tech stocks such as Netflix and Facebook have made the news due to their share prices dropping. With changing earnings expectations, it seems investors who paid a high price, banking on continued growth, have drastically reevaluated the value of these stocks.
In the US, IT and consumer discretionary have been among the worse performing sectors for the year. Overall, these sectors are comprised of mainly growth stocks. Energy and Materials have been among the best performing and are comprised of mainly value stocks.
The result is, as of today, the S&P 500 Index is down more than 10% since the start of the year. The S&P 500 Value Index is only down 2.5%. In Australia, the ASX 300 fell about 2% to the end of April. Dimensional's Australian Value Trust was up 8.8% over the same period.
Our investment strategies are built around pursuing value stocks, in addition to small company stocks and profitability. This recent comeback by value has buoyed our portfolios relative to the market for the year to date.
Four months is still short-term
In my last email, I mentioned recency bias, which causes investors to place more importance on recent events than those prior. When markets fall, we instinctually believe they will fall further. When we read bad news, we expect bad things will happen in the market. This can distract us from the long-term perspective needed to make good investment decisions.
With alarm bells going off regarding where markets are this year, it is easy to miss the S&P 500 is up more than 3% compared to this time last year. Over the past 5 years it is up about 80%, or roughly 12.4% each year, despite recent volatility.
Four months is a very short amount of time when we're talking shares. A fall of 10% is well within our expectations for this period. Remember how markets dropped around 30% in 2020, as discussed above.
Over 5 years, a 12% return is close to average, yet share returns could still be nil over this time, or higher than 20% p.a. Both outcomes are unlikely, but have happened before.
So how long is "long-term"? We agree with Sensible Investing's figure of 15 years or longer. Over this period, we can be reasonably confident our shares will deliver the returns we need to achieve our goals. We can also be reasonably confident value stocks will have outperformed growth stocks.
When investments are evaluated over a decade and a half, a few months make a small bump in the road. Although these bumps are pretty rough as we go over them, remember they are a small part of a long-term strategy.
Focus on what we can control
Nobody knows where the market is headed tomorrow, or the next month, or the next year. Over the next 20 years, we are confident it will be up a lot.
While no-one can predictably beat the market by timing when to buy and sell, or picking only winners, the good news is we don't have to. Time in the market rewards patient investors.
Ignore what we can't control. We can't affect what is happening with interest rates, inflation, oil prices etc. We can decide how we plan for the future, how we implement these plans, how we build our portfolios.
During times of volatility, when markets are up and down constantly, we rebalance portfolios to make sure they are aligned with our clients goals. When needed, we discuss with clients whether ups and downs affect their ability to reach their goals.
When it comes to predicting the future, we can leave that to sage's and oracles.