- 1 December, 2022
- 438
- Articles , Financial Services
The power of staying invested during a market storm
Since our last communication to you on 14 October markets have posted a welcome positive return despite being buffeted by two strong headwinds in the form of higher interest rates and recessionary risks.
For the month of October, the S&P 500 which represents the largest 500 American companies by market cap rebounded by a robust 8.1%. As Q3 earnings season unfolded, markets were buoyed by better-than-excepted earnings. The market had forecast a contraction in Q3 earnings of approximately 1% year-on-year, but by the end of October, 60% of US companies had reported growth of approximately 3% year-on-year. The JSE All Share also followed markets higher in October, up 4.9%, with domestic banks being the strongest performers, up 16%.
Relief rallies or temporary reprieves from falling markets as witnessed in October are common features of bear markets. The S&P 500 rebounded more than 17% from its mid-June low before setting a new low on 12 October. And while there is still enormous uncertainty on the economic front, which is discussed below, the best course of action is to remain invested. We demonstrate below that by not making rash, emotionally-charged decisions, your chances of investment success improve materially. Being out of the market for just one year can significantly impact your wealth prospects. Your Adviceworx investment plan is structured to weather these market storms, so allow it to do just that.
Higher for longer
The US Federal Reserve delivered its sixth consecutive rate hike and its fourth 0.75% increase this past week, resulting in a federal funds rate of 3.75%. The markets are now pricing that rates will peak at around 5% next year, reflecting that inflation remains stubbornly high. The big unknown is how long the Fed will have to keep rates high to rein in inflation. With inflation running at above 8%, real rates (nominal rates less inflation) are still negative which suggests that policy is not yet restrictive and monetary tightening could have some way to go.
At the press conference following the announcement, Jerome Powell, the central bank’s chairman, noted that the Fed would rather err on the side of caution by over-tightening rather than under-tightening to prevent inflation from becoming entrenched. What complicates the situation is that it takes time, usually several months, before the effects of higher rates are felt broadly across the economy. A key factor to watch will be the US labour market, which is the tightest it’s ever been, with nearly two jobs available for every employed person. Resilience in the US labour market is good news for the economy but bad news for inflation as it will keep the Fed in monetary tightening mode.
The probability of the Fed engineering a soft economic landing will become increasingly difficult the longer inflation remains elevated, which means the risk of a recession in the US has increased. Should a recession emerge, the severity of it will likely rest on the resilience of the labour market.
Without a doubt there are several factors at play, making the economic outlook very uncertain. As investors we have very little control over what comes to pass, but we can ensure that our portfolios are well structured and diversified, with a focus on investing in quality companies that have resilient qualities regardless of economic conditions.
Investing for resilience
The market has been brutal this year and very few company share prices have been spared. Iconic companies such as Alphabet, Apple and Microsoft have fallen dramatically. Apple has lost nearly a quarter of its value this year, while Microsoft is down 34% and Alphabet has fallen by a whopping 40%. One would be forgiven for thinking that these are companies are in great peril. Certainly, there are several technology companies that are not profitable, but not all technology companies are equal. The companies in which we invest are all well-established, generate real revenue and earnings, backed by strong cash flows, and are supported by solid balance sheets.
In an environment where interest rates are rising and liquidity is being drained out of the market, it becomes important to invest in companies that have well capitalised balance sheets and generate free cashflow, meaning they can cover their operating expenses but can also meet their financial obligations.
One of our top stock picks, Alphabet (formerly known as Google), is the parent company of the world’s most popular internet search engine. Alphabet’s portfolio encompasses several industries, including technology, life sciences, investment capital and research. Alphabet has pricing power as evidenced by its high gross profit margins as well as a strong balance sheet making it less vulnerable in a rising interest rate environment.
In its last quarterly update, Alphabet generated $69bn of revenue, operating income of $17bn at a 25% operating margin and generated over $16bn in free cash flow which is after all investing and financing activity. Yet the market punished Alphabet following its trading update, sending the shares down 10% on the day because of a miss on revenue and earnings expectations. Certainly, we are expecting slowing advertising growth to hurt Alphabet’s revenue and a ramp-up in its headcount will continue to dampen its operating margin (down from 32% in the previous quarter), but we believe that the company is fundamentally strong and that weakness in the share price provides a good opportunity to acquire a global leader in its field.
Understandably, the prevailing conditions are uncomfortable and painful to endure, but we view the current period as a great opportunity to maintain or gain exposure to superior businesses at attractive valuations. As with most things in life, patience and time are required to achieve meaningful results.
It is awfully hard work doing nothing (Oscar Wilde)
Rationally we know that we need to invest in risky assets to ensure financial success. Risky assets such as equity do most of the heavy lifting in our investment plans to achieve inflation-beating returns. However, they can be volatile and staying invested when markets have experienced a severe fall as we have witnessed this year is easier said than done. Market downturns undoubtedly test our resolve as investors and our natural, primal reaction is to get out, even if it means selling at a loss to avoid the pain of further loss. Equally hard to believe in the midst of a market storm such as the one we are experiencing, is that things will improve. We can easily become anchored to the expectation that markets will remain depressed, that recessionary conditions will persist, and our investments will struggle to recover.
The graph below demonstrates the power of staying the course during a market storm, which can be an awfully hard thing to do! If you had invested R100 000 in domestic equity (JSE All Share) at the beginning of 2007 and stayed invested during the Global Financial Crisis where markets fell over 30% peak to trough, your investment would be worth R439 000 today. If, however, you panicked and sold your investment at the bottom of the market and decided to stay in cash ever since, your investment would be worth only R181 292 today (grey line).
Alternatively, had you invested in the market a year after selling your portfolio at the bottom of the market, it would be worth R317 399. Trying to time the market is not a sustainable investment strategy. The key takeaway is that remaining invested whilst understanding that portfolio managers are monitoring your portfolio around the clock and actively managing it in response to and in anticipation of market volatility is the best strategy over the long term.
Even the brightest minds and most experienced portfolio managers in the world simply can’t know when the market is going to bottom or peak as markets are forward looking and respond before expected.
Choppy waters ahead but your financial plan remains your ballast
A delicate rebalance is underway as central banks continue to tighten monetary policy while governments attempt to support their slowing economies from recessionary risks. The next challenge we think markets will need to digest is a downward calibration in company earnings expectations. We expect earnings to come down as the impact of higher interest rates start to take effect on aggregate demand.
Has the market fully priced this in? While that is hard to say, but what we do know is that global equities are much cheaper today than they were at the start of the year. The MSCI All World Index is down 23% and trading at more attractive valuations – its forward price-to-earnings ratio was 21.2 last year and since fallen to 14.7, just under its longterm average. Could the market get cheaper as earnings are downgraded going into 2023? Yes, this is a real possibility, and we expect markets will be choppy for the foreseeable future as the markets digest this news. However, a fall from these levels will mean the prospective returns from global equities will become much more attractive.
In conclusion
Please be assured that Adviceworx is doing the heavy lifting in the background daily by ensuring that your portfolio is appropriately positioned from an asset allocation and share selection perspective. Just like the Alphabet example above, we are deliberate in how we look for investments and companies that demonstrate strength in quality and which will provide superior opportunities when markets eventually normalise.
Should you like to discuss any of the changes and/or review your investment portfolio, please don’t hesitate to get in touch.
The Adviceworx Investment Team
Adviceworx is a juristic representative of Acsis Licence Group (FSP 33002) and an authorised Financial Services Provider (FSP 44914).
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