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Sound Advice: March 31, 2021

The Market Drops Every Year . . . and Ends Up Higher Over Time

The market drops I refer to take place over a period of a few months within one year or starting in one year and running into another.  These short periods of weakness are not to be confused with 12-month changes from yearend to yearend.

Since 1980, the Standard & Poor's 500 Index has had average interim drops of 14.3%.  In more than half of those years, the corrections, as they are euphemistically known, were 10% or more.  We hit the worst air pocket back in late 2008 to early 2009: 49%.

When this happened, more than a few investors started to wonder what was going on. Yet each time, the pullback was followed by a full recovery and annual returns ended up positive in three out of four years.

The lesson learned from this pattern is that short-term movements are for the most part reflections of changes in investor psychology.  One day, there may be a series of encouraging earnings reports.  The next day, there may be a disappointment or perhaps increased concern about rising interest rates.

Whatever the reasons for these interim shifts in stock prices, they tend to wash out over time.  And for that matter, any attempt to provide a rational basis for same is really an exercise in futility.

By analogy, consider the difference between the climate and the weather.  Data collected over extended periods makes it easy enough to suggest probable ranges of temperatures over the course of the year.  There may be minor variations, but summer usually looks like summer and winter brings Jack Frost (unless you happen to live way down south).

Forecasting weather, except perhaps a day or two before, is fraught with considerable risk. Even so, by comparison with market predictions, weather forecasting looks like a science of great merit.  Those who talk, often in measured tones, about where the market will end up – even on the same day – are just plain silly.  These things are unknowable.

As recently as the early morning hours after Election Day 2016, the Dow Jones futures indicated a plunge of more than 800 points.  But even that ominous foreshadowing was misleading.  The Dow finished the next market day with a gain of more than 250 points.

Since market valuations reflect underlying earning power, a constant multiplier applied to those earnings would yield what might be called a normal valuation.  A normal valuation, however, is rarely seen.  Higher or lower is more likely.

Over time, stocks generally sell in a range of 10 to 20 times earnings.  During the most difficult of times, as in the mid-1970s, multiples actually narrowed to high single digits.

From one standpoint, it was among the worst of times.  But when valuations get that low, it's usually a signal that stocks are on sale.  And they most definitely were.

Yet back at the beginning of the 21st Century, i.e., the dot-com era, stocks were selling at 20 to 30 times earnings . . . and higher.  Not surprisingly, it took more than a decade for underlying earnings to rise sufficiently to bring valuations back into a normal range.

So even though the concept of a normal value might be appealing, it's not a common occurrence.  Best advice: Ignore the noise of the moment and take the longer view. 

“We've long felt that the only value of stock forecasts is to make fortune tellers look good.  Short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

                                                Warren Buffet in his 1992 letter to shareholder

 

N. Russell Wayne, CFP®

Sound Asset Management Inc.

Weston, CT  06883

203-222-9370

www.soundasset.com

www.soundasset.blogspot.com

Any questions?  Please contact me at nrwayne@soundasset.com

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