Newton’s Apple
As of yesterday’s market close, the S&P 500 was down 16.3% for the year. Apple stock was down a similar amount – 16.5%. Bonds haven’t fared much better with the US bond aggregate down 10.5% at the close of markets yesterday.
For many months the S&P 500 index did not reflect what was actually going on in the US stock market. According to a January 6th 2022 article in Bloomberg, 40% of the stocks in the NASDAQ Composite Index were down more than 50% from their highs. Since that time, I venture to guess that the majority of the stocks in that index are down by more than half.
The S&P 500 Index held up much better than the NASDAQ due to the fact that a few stocks had been doing the heavy lifting for the index. In January, the top 10 stocks led by Apple, comprised 30% of the value of the index. The famous FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) had been the investment darlings of the past few years, and all had been significant beneficiaries of the COVID disruptions. They all plowed strongly ahead in the past 3 years while many other companies struggled to keep the lights on.
2022, however, brought about some significant dental pain for the FAANGs – Facebook (Meta) is down 42%, Amazon is down 35%, Netflix is down over 70%, and Google (Alphabet) is down 19%. As previously noted, Apple is the star of the group being down only 16%.
It’s in periods like these that I appreciate the time that I have spent in this career. Since 1982 I have witnessed Black Monday (stocks down an average of 22%), the tech bubble crash of 2000, the Great Financial Crisis of 2007. All of these shared a common thread, stock prices had gotten ahead of the underlying value being created by the companies themselves.
To give you some perspective, here is a graph showing the average price earnings (p/e) ratio for the S&P 500 going back to the 1800’s.
What should be obvious is that every time that ratio gets much above 20, stocks tend to fall back. The most recent reading is a shade over 20 – down from the recent high of around 38.
I had recently heard many folks, both professionals and non, suggesting that we were in a new paradigm, that stocks could, and should be trading at higher multiples given low interest rates, and a lack of viable alternative investments. I heard the same arguments back in 1999. I didn’t buy it then, and I certainly don’t now.
When a stock is purchased, an investor is buying future cash flows. If a company continues to be profitable, that profitability will ultimately be reflected in increased enterprise value, and ultimately its stock price. Unfortunately, too many either don’t understand that lesson, don’t believe it, or think that companies can “grow to the sky”. Clearly, they can’t.
What isn’t helping matters this time around is the prospect of continued inflation (see my latest newsletter, Putinflation) coupled with a slowing economy, both domestic and foreign. And, of course, the prospect that the current war in Ukraine will have long-lasting negative economic impacts.
I’ve never forgotten a valuable lesson I learned from a client many years ago. He was a very successful real estate investor and had just closed the sale on a very large deal. He made a substantial amount of money on the transaction, and I had been complimenting him on the price that he had gotten for the project. He turned to me and said in a serious voice, “Will, I made my money the day I bought this property, not the day I sold it”. His message was clear – don’t overpay for an asset. If you do, you’ll have to hope that someone comes along and pays an even higher price (the “greater fool theory”).
I’ve been doing this long enough to understand that market swings are part of the deal. Markets get overpriced, and eventually gravity takes over and pulls things back into balance.
Over the years I have investigated many ways to protect portfolios – market timing, stop losses, option strategies, among others. What they all have in common is the underlying belief that the operator is ultimately smarter than the markets themselves. In the course of my career, I have never witnessed anyone consistently make the right market calls over a full cycle.
Instead, we prefer to build truly diversified portfolios that can withstand the short-term, emotional whims of the market. By paying reasonable prices for the assets we own, and positioning them in a way to take advantage of their inter-relationships with each other, we increase the odds of long-term success.
Periods like these are no fun for anyone. They do require discipline, and resolve to navigate them. We believe we have both.