“The trick to forgetting the big picture is to look at everything close up” – Chuck Palahniuk
In recent weeks, the 10-year U.S. Treasury rose to three-and-a-quarter percent—a level not seen since 2011. In addition, the stock market sold off five percent from all-time highs, volatility has risen and the Chinese and European markets dipped. All this amid a backdrop of good corporate earnings and moderate-to-good economic news. In a vacuum, the immediacy of this stock market drop was jarring; pullbacks are always unnerving for investors, and this is especially true in what has been a long-term, low volatility, bull market.
Despite these events, the low in equity markets experienced last week only took us back to levels seen in July. Fundamentally, company earnings did not retreat with stock prices. As such, trading now at only 16x earnings, stocks are actually cheaper now than at the beginning of the year when the price-to-earnings multiple was 18.3x. Primarily negative in direction, the stock market experienced five 1 percent swings in the last eight trading days, pushing the market into an oversold condition.
Though the sell-off has been meaningful, we have not yet seen extremes or an exhaustive volume necessary to wash out the bears and bring bargain-seeking bulls back to the table. A firm sign of a cemented floor in a sell-off or trigger for a rally are days that see 90 percent of stocks up on high volume. While Wednesday saw more than 90 percent stocks up, volumes were not extreme. While not quite enough to call a bottom, it was encouraging, and we will continue to watch the market for these exhaustive days to act as insight into market sentiment.
Pullback and Investors
Consider the 20-year chart below, with all options using the same end-point.
Option A is a consistent straight line; any time an investor buys it is at a fresh high. Over time, investors will acclimate to the trajectory and gain comfort in its predictability. If this line were to break, the fallout would be immense. Option B is the S&P 500, jagged and oscillating, with major and minor highs and lows. As we can recall, investors ebbed from panic to euphoria and back again during that time period. Option C remains flat until the end, where it spikes; you invest at the same low level the entire time and when you need the money it multiplies. This line is both wholly unrealistic and the optimal line for retirement savers. However, there is comfort in the fact that every dollar invested is at the same level: no buyer’s remorse.
With these options, you can clearly see the trouble with investor behavior. No one wants to ride the roller coaster of the markets, but they want the returns it provides. Option A has been our experience since departing the 2008-09 financial crisis, especially in recent years. Investors have become accustomed to the consistency of the market and therefore are willing to buy new highs. But when that consistency breaks, investors overreact, causing pullbacks like we see now. Conversely, some investors sit on the sidelines nervous as markets run up and uncertainty grows. They want Option C, where dollars invested are not subject to market volatility and they assume markets will come back to more reasonable levels to invest in the future. We would like to see Option C investors use pullbacks like this to start buying. For better or worse, we invest in Option B and should look for opportunities to buy during times of pullbacks.
Week in Review and Our Takeaways:
Investors hoped good earnings reports from blue chip companies and hawkish notes from the Fed meeting would spur the market to rally, but fears of higher interest rates, European worries and continued lows in Chinese markets held the markets relatively flat for the week. Bonds stayed in a tight range with the 10-year U.S. Treasury finishing the week at 3.2 percent.
Technically, the current pullback has likely not yet bottomed
Pullbacks are viewed quite different by investors