Since the 1920s, stock markets have averaged three 5pc falls a year and one 10pc correction. The 20pc slide that’s the usual definition of a bear market comes around on average every three years. Having gone 18 months without even one 5pc reversal, last week’s turbulence was overdue. No one enjoyed it but, equally, no one should have been surprised.
Having licked our wounds over the weekend, three questions arise: what caused the correction; has it run its course; and does it matter?
The proximate cause of the market wobble was the publication 10 days ago of US employment data that showed both a healthy level of job creation and, after a long absence, some meaningful wage growth. The non-farm payroll figures suggest that inflation may be stirring, providing some justification for the recent rise in bond yields. With an untested Fed chair, it is reasonable to worry that the trajectory of monetary tightening may be steeper than expected. Higher bond yields are bad for share prices for two reasons: they increase companies’ borrowing costs, reducing profits; and they make safer investments (bonds and cash) relatively more attractive.
The jobs data validated a set of market-related fears. As the duration of the unnatural period of calm extended into record territory, investors started to worry about stretched valuations. The surge in share prices in the first four weeks of the year, about 7.5pc, was unsustainable. After years of seeking safety in bonds, investors had regained their appetite for risk. The capitulation of the remaining unbelievers created the perfect environment for an accident.
Once markets began to unravel, the machines finished off what the humans had begun. There is nothing new about computerised programme trading (it has played a key role in crashes since at least 1987) but it is becoming a more significant factor. The automated de-risking of portfolios once a series of too-clever-by-half low-volatility trading strategies turned sour last week exaggerated market movements even if it didn’t actually cause them.
Rationalising last week’s market gyrations is easier than deciding whether they have run their course. The numbers are not particularly reassuring. While share prices are certainly a bit cheaper when measured against expected earnings, the long-run picture still shows shares towards the top end of the historic valuation range. This is true whether you look at profits, the book value of companies’ assets or their cash flow. Perhaps the most important determinant of value, the dividend yield, remains unattractive in the US compared with the income paid by safer government bonds (this is not true of the higher-yielding UK market, which may explain the relative outperformance of the FTSE 100 last week). So, if investors were worried about valuations a week ago, they are probably still concerned today.
High valuations may have something useful to say about the long-run expected returns from shares but they indicate little or nothing in the short term. This is particularly true when a case can be made to justify high prices. The world is enjoying a synchronised economic upturn, driving corporate profits higher and the tax reforms pushed through Congress by President Trump before Christmas look like extending that cycle throughout 2018 and beyond. So, at this point in time I see no particular reason why this correction should morph into anything more sinister. Bear markets are rare in the absence of a recession and that remains unlikely this year.
The third of my questions - does it matter? - sounds flippant but for most investors is more important than the other two. Volatile markets always seem more significant up close than they do with the benefit of hindsight. If you need convincing of this, print off a chart of the FTSE 100 since the index began in 1984 and look for the at-the-time-terrifying 1987 crash. It’s clear to see, of course, but it looks more of a stumble than the carnage that older investors still remember.
At times like these, I remind myself of a few things that are easy to forget when you are transfixed by a sea of red on your screen. The first is that volatility is normal, part and parcel of the investing journey. Markets over-react to events in both directions. It’s just that the natural human tendency to feel the pain of loss more acutely than the pleasure of a gain means that melt-ups like the one in January attract far fewer headlines than the melt-downs like last week’s.
My second reminder is that the risk we take investing in the stock market has in general historically been rewarded with higher returns over the longer term. In real, inflation-adjusted terms, with income re-invested, US shares have delivered more than 30 times the return of bonds since the 1920s. The numbers are slightly different but the story is the same for a high number of stock markets around the world.
When markets take a dip, I try to remember that the biggest falls in share prices have invariably followed shortly afterwards by large gains and that missing out on just a handful of these can devastate investment returns. Between 1992 and the end of last year, the FTSE 100 gave a total return of 552pc. Missing just the five best-performing days in the market over that period would have reduced that return to 339pc, while sitting on the side-lines during the 30 best days would have seen the return dwindle to just 47pc. Time in the market is better than timing the market.
Flying through market turbulence like last week’s is when we test our investment temperament. As Warren Buffett said: unless you can watch your stock-holdings decline by 50pc without becoming panic-stricken, you should not be in the stock market.
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