Some Volatility Thoughts

Yesterday the Dow Jones Industrial Average fell 1,175 points, marking its biggest one-day ‘point’ decline ever (not even close on a percentage basis however). For the S&P500, its 4.1% drop was its first 4%+ skid since August of 2011. It’s important to note, though, that historically there have been 144 prior 4%+ daily retreats for the S&P 500. So this was not an uncommon occurrence, and shouldn’t have been an unexpected event – they always just feel unexpected as they happen.

We have had a long bull market, coming up on 9 years old this March, and what has been truly remarkable is the ridiculously low levels of volatility we’ve enjoyed the last few years. In fact, the S&P500 until this last week, was on its longest ever streak – dating well over a year – of not even one decline of 3%. Additionally, it had been 19 months since the last 5% correction. None of this comes anywhere close to the average annual decline of almost 11% per year, going back the last four decades.

But interest rates have started to rise, stoking legitimate fears that this is the end of a decades long bond bull market, affecting all asset prices. Despite conventional ‘trading wisdom’ that says rising rates are more detrimental to higher dividend paying stocks, we beg to differ, particularly when evaluated in an ‘investor’ time frame. There are three components of total return: dividends, earnings and valuations. Rising interest rates act as gravity on stock valuations, and though higher yielders can get penalized from a sentiment perspective early on as rates rise, over time the income and the growth of that income matter a lot. In fact, the last calendar decade when rates rose considerably was the 1970’s. Price to earnings multiples (P/E’s) on stocks dropped from the start to the end of the decade, and because of that, total return relied not on continually higher valuations (in fact that detracted from return), but on the fundamentals of earnings and dividends. To that point, dividends actually accounted for 73% of the market’s total return in the 1970’s even as interest rates spiked. Investors not exposed to dividend payers had a very difficult time creating a productive return. As you can imagine we are maintaining our commitment to companies that share a portion of their profits with us in the form of attractive – and growing – cash dividends. This should matter over the next market cycle.

The positive fundamental backdrop of synchronized global growth and robust corporate earnings – and revenues – remain intact. Incredibly, with over half of S&P500 companies already reporting, nearly 80% have beaten analysts top-line estimates. This is the highest rate in over a decade, a remarkable achievement considering we are 9 years into this bull market. The tax cut and a less onerous regulatory environment appears to have materially boosted business confidence and goosed bottom line profits.

Despite this constructive backdrop, our view is that we should still expect more volatility. A decline like we’ve had the last few days could induce further selling in systematic strategies, as well as those serving the ‘one-way’ investor – meaning indexed ETF and similar structures, where all stocks are bought or sold ‘together’, without regard for individual, fundamental merit. Additionally many other strategies rely on margin debt to power returns, and this can have an unwinding effect as those investors are forced to liquidate and de-leverage.

Finally, the market is now likely in the initial stages of recognizing a transition from a liquidity driven market characterized by rising valuations and pumped up by all the rounds of quantitative easing, to one of an economic and ‘fundamental’ phase. This is where our portfolios are already focused – and owning companies that meet and maintain our Quality, Durability and Growth characteristics will remain as important as ever.