Navigating Difficult Markets - Managing through Downturns
The arrival of a market correction or bear market offers investors three potential courses of action:
Sell – this sounds like a good idea - to sell and sidestep the falling markets, hoping to buy back in near the bottom after things stabilize. Reality is that this often means selling after a considerable downturn and then buying back after having missed the majority of a significant recovery. Nobody rings a bell and tells you when the selling is over, nor do they let you know that the recovery is real. As a result investors who time in and out of markets are often caught offside either too early or too late and before they know it their performance is lagging those who held on the whole time.
Hold – sounds simple enough - hold on to your portfolio that is full of high quality, great value investments. Doing so with a portfolio that is laden with speculative junk or overpriced investments the market is bringing back down to fair value is much more difficult.
Buy – if you’re confident in your positions, taking advantage of a market panic is the strongest action you can take. Of course this requires liquidity, ideally a result of holding a portfolio that is well diversified and not just entirely invested in stocks.
The recent -10% drop in stock prices driven by the United States ‘Liberation Day’ tariff announcements are a great example of the market offering investors a chance to add to their favourite positions at discounted prices. If we go back a bit further to 2020, the arrival of COVID lockdowns and the economic calamity that ensued was another great example of a time where market volatility presented a great opportunity.
In late 2019 before COVID we were not buyers of the S&P500 simply because it was trading at too expensive a multiple of its earnings – the PE Ratio is the price earnings ratio we follow closely as a good baseline indicator of value. Historically the US market has traded at about 16x earnings however in 2019, that was closer to 25x earnings. Not attractive.
Once the COVID market correction hit, the US market was down -37% in a few short weeks, and as a result, the S&P500 index traded into attractive pricing territory around 18x earnings. We were buyers and put on a position on March 27th, 2020. The market had bottomed a few days earlier on March 23rd, 2020, something we weren’t aware of at the time of course, but our decision to add was driven by value rather than market timing – we were buying a world class asset at a good price. Although slightly above that long term average of 16x earnings, with interest rates near 0%, paying a slight premium is justifiable.
The chart below shows the PE ratio of the S&P500 plotted from 2019 through to the end of 2024. The black squares marked our entry points at attractive levels and the red squares are our exits. As the market recovered from the lockdowns and as our position grew larger and larger we held on but monitored it closely. By the end of 2020 there was such a substantial rally we began trimming our position, with sell orders shown with the red squares with the index up above 30-40x earnings, both a consequence of rising index pricing as well as reduced earnings results due to the lockdowns. By late 2021, we had exited most of our position in the S&P500 and we continued selling it down to the end of the year.
The war in Ukraine and rising interest rates were the theme in Feb-Mar 2022, resulting in yet another bear market that drove the index back into attractive pricing territory, so we were again buyers of the index. We then again reduced and ultimately exited our position over the course of the significant bull market run in 2023 and 2024. The PE multiple showing the value of the index makes it very clear as to why we took the action we did at the appropriate times.
If we plot this action on a price chart of the index it is less clear as to why we were buying or selling in 2022-2024 and one might wonder if we could have perhaps timed our buys and sells a bit better. Remember, we are buying and selling based on value, not just unit price. While we might have made more money holding and selling at those peaks, we’d rather follow our discipline and make decisions driven by our process rather than hoping we’re able to time things perfectly.
We always have our eyes on a number of positions that we quite like, keeping tabs on them in case they come into our value strike zone. Markets can change in a heartbeat as they did here in early April, with index levels in Canada and abroad falling over -10% in 2 trading days. We have a couple of formerly expensive businesses that we are preparing to add to portfolios as a result of recent price movements.
Brady Clark Advisory Group