Stocks Go Up, Stocks Go Down
Is it time to panic? On February 5th the Dow Jones Industrial Average index fell as much as 1,600 points, an intraday record. And the financial media lost their minds:
Source: Bloomberg, Wall Street Journal, Financial Times, Globe and Mail
As often happens when inflammatory headlines proliferate, the general public became worried. In a matter of hours, social media was abuzz with concern about the selloff. But was this concern justified? Should you be worried that your retirement lifestyle will be much more frugal? Are we about to answer all of our own questions?
Perception Versus Reality
The financial media are in the business of selling newspapers (or page views, or viewership), so they strive to grab readers’ attention. What the media are less concerned about, however, is maintaining perspective. This is where we will now step in.
The following chart shows that this record selloff took the Dow all the way back to… wait for it… December 7th, 2017. Were you panicking about the Dow on December 7th, 2017? No. Should you be panicking about the Dow now? No.
Source: Bloomberg, Cowan Asset Management
Why the Dow Now?
Another question came to mind on February 5th: why is everyone focused on the Dow’s 1,600 point drop? The S&P 500 index usually gets much more attention than the Dow. And 1,600 points on the Dow means absolutely nothing, in isolation, to the average investor.
We believe the S&P 500 is more indicative of the broad U.S. equity markets because it is weighted by market capitalization. This means that bigger companies get bigger weightings within the index. The Dow, on the other hand, is price weighted. This means a company’s weighting within the index is proportional to its per-share price. But the number of shares into which a company is divided is arbitrary. It would be like comparing how big two pizzas are based solely on the size of a slice from each – even though one pizza was cut into two slices and the other was cut into 20.
Additionally, while the 1,600 intraday drop was a record on a point basis, it represents just the 28th largest decrease on a percentage basis since 1947. So it wasn’t a great day, but there have been much worse. This fact seems to have been glossed over by most media reports.
So if we’re more interested in how U.S. stocks as a whole performed on February 5th, we believe a more accurate headline would read something like, “S&P 500 decreases 4.1% after rising 5.6% in January”. We believe this nuanced description isn’t nearly as dire as what the day’s headlines indicated, but that is likely why it wasn't reported that way.
How this Affects Individual Investors
The S&P 500 gives a broad indication about how U.S. equities perform, but it’s not a perfect metric. Just because it was down 4.1% in a single day, it doesn’t mean that all equities were down 4.1%. Thus, investors shouldn’t automatically assume that they’re 4.1% poorer after a day like February 5th.
There are over 5,000 companies listed publicly in the U.S. This means there are more than 4,500 that aren’t included in the S&P 500. When you consider that an individual investor may have numerous international holdings, plus individual weightings that differ from the S&P’s, it becomes even more questionable whether an index’s selloff has the same impact on an individual’s investment portfolio.
An ETF tracking the S&P 500 should perform almost identically as the index. But actively managed funds are another story. Depending on the manager’s mandate, a fund’s underlying holdings could bear little resemblance to any major index.
How the Selloff Affected our Funds
We have been worried about an equity market selloff for some time. As recently as November we articulated these concerns in some detail. And we have been putting our money where our mouth is: as of the end of January the Cowan Absolute Return Fund had just 65% net equity exposure. The rest of the portfolio was cash (the value of which remains unchanged during a selloff) and inverse ETFs (the values of which increase during a selloff). This asset allocation bears no resemblance to any major index, the S&P 500 and Dow included.
The following chart, which was originally provided in our Q2 2016 client letter, quantifies how different the Absolute Return Fund’s performance was versus major indices. If somone is wondering how the Fund’s performance has compared to these same indices in February 2018, they may as well keep that question to themselves: we don’t know either and we aren’t going to bother calculating it. First, we manage the Fund to generate absolute – not relative – returns. Second, we aren’t concerned about how the Fund performs on a day-to-day basis; we manage it for the long-term.
Source: Bloomberg, Cowan Asset Management
Despite this recent selloff, we believe equity valuations remain elevated. There has been some speculation that this decline was caused by rising U.S. inflation expectations. If that is the case, the worst may be yet to come. We have previously discussed the relationship between equity valuations and rising interest rates. So if inflation starts increasing faster than what the Federal Reserve is anticipating, the central bank may raise rates more quickly than expected. This could put even more downward pressure on equity valuations.
As a result, we will continue to position the Absolute Return Fund defensively. We always evaluate potential investments on a bottom-up, fundamental basis. But if market valuations remain where they are now, it will probably remain difficult for us to find attractively-valued securities to buy. Above all else, however, we will not let media hype affect how we manage the portfolio. In fact, if a prolonged market downturn was to occur, we would welcome the likely plethora of buying opportunities with open arms.