By: Dividend Sensei
On Friday the Dow Jones Industrial Average fell 666 points, its 6th largest point drop in history. For the week the market fell 3.9%, its worst week in two years. And so far on Monday the market sell off shows no signs of slowing. After over a year of historically freakish low volatility, and over 80 all time highs since the election, it’s natural that many investors have become used to stocks pretty much only going up. So it’s important to put things in perspective.
Largest Point And Percentage Drops In The Dow
What we experienced on Friday, and may experience over the next few weeks, is not anything historic. In fact, large point drops are to be expected given that the stock market historically rises 75% of the time and since 1871 the S&P 500 has generated 9.1% total returns. In other words, over the past 146 years the S&P 500 is up 389,591.36 fold. So naturally, as the index gets bigger the point drops will also get larger.
What really matters is the size of the drop on a percentage basis. And from that perspective, Friday’s 2.75% decline in the Dow was not even close to being one of the top 20 biggest single day declines. But what if this is just the beginning? What if we get numerous 2% to 3% daily declines in the coming weeks? Well that would not be the end of the world, but merely a natural, and healthy market pull back (5% to 9.9% below all time highs) or correction (10% to 19.9% below all time highs). Investors need to remember that since 1950 there have been 35 market declines of 10+% declines (from all time highs) in the S&P 500. That’s basically one every two years or so.
The last correction ended February 11th, 2016. So almost exactly two years ago. And given that the market just had its best full month performance (in January) since March 2016 (recovery from last correction), and was up 33% since the election, a correction was not just due, but necessary. After all, stocks are ultimately valued based on the net present value of future cash flow and earnings. And while earnings rose 10.7% in 2017 and are expected to rise about 18% this year (+8% boost from tax cuts), the pace and magnitude of the last year’s rally was too far, too fast.
In other words, the market had priced in all the good news (about tax cuts, and accelerating economic growth) and then some. This actually caused some to speculate that we may be “melting up”. A melt up is the terminal phase of a bull market, when bubbles form because investors get so euphoric about stocks only going up (fear of missing out) that they abandon all sense of reason. Or to put another way, they get giddy, think that valuations don’t matter and buy at any price. Bubbles are what can lead to crashes, such as the 50% and 55% declines seen in 2000 and 2008, respectively. Now of course even crashes aren’t the end of the world, and should not deter you from adopting a long-term, buy and hold focus on quality companies, bought at good prices.
That’s because a study by a 2016 J.P. Morgan Asset Management report entitled “Staying Invested During Volatile Markets” studied the 20 year period between 1995 and 2014, which included both the tech and housing crashes. The market over that time, despite the gut wrenching volatility, increased 555%. But only if you held the entire time. What if you had tried to time the market and avoid corrections or crashes? Well here’s the problem with that. While the market’s biggest losses occur during bear markets and crashes, so do the strongest daily gains. Here’s why that matters.
According to the J.P Morgan study, if you had missed out on just the 10 biggest daily gains (most of which occured within 2 weeks of the biggest losses), your total return would fall to 191%. And if you missed the top 30 days, the top 0.6% of daily gains? Then your returns fall to zero. Literally market timing might not just reduce your long-term total returns, but eliminate them entirely.
This shows that what matters isn’t market timing, but time in the market. That makes sense intuitively, because markets are not always rational. In the short-term share prices are set by big institutional money flows, which are generated by retail investor demand. In other words, regular people, making often poorly thought out and knee jerk investing decisions based on the popular themes of the day; determine short-term prices. Ideas that sound plausible superficially, such as “$2.7 trillion in repatriation dollars will fuel crazy big buybacks so stocks can only go up!”.
Or inversely “tax cuts will drive inflation higher so interest rates will rise crushing REITs and other high-yield stocks!” In fact this last one is why many high-yield stocks are having a terrible 2018. But guess what? In the long-term the only thing that matters is the fundamentals, (cash flows, and earnings per share), because this is what gives a stock value and pays the exponentially growing dividends that are the core of my investment strategy.
The cause of this most recent pullback? Wages in November grew 2.5% YOY, in December 2.7%, and in January 2.9%. That’s a very strong (if short) up trend that now has many worried that strong wage growth will fuel stronger inflation and thus cause interest rates to rise. Ultra low rates have been the major catalyst for the market for the last eight years and now the party may finally be ending.
But to worry about the economy being too strong, and wage growth (which will drive stronger consumer spending and further strengthen the need for business investment) too high is silly. Especially since inflation, at least by the Federal Reserve’s favorite metric (PCE deflator) is still only 1.5%. In other words, the market has gotten so addicted to the drug of ultra low rates (and cheap money) that it is forgetting that growth, in the economy, wages, and earnings, are good. In fact, they are the reason to be invested in the first place, so that we own a piece of quality companies and thus benefit from their growth in earnings, cash flow and dividends.
The bottom line is that, as scary as the last few days seem, it’s not anything of importance in the long-term. In fact the reason the recent pullback is happening, stronger than expected growth in wages and the economy, is ultimately the very thing that will send stocks to all time record highs in a few months once this pull back or correction ends. In the meantime take advantage of the bargains! Even when the market is roaring to all time highs, something is always on sale. But during a correction? Then most everything is and so that is when the true fortunes get made.