Market Correction and Value
Clients of the Firm,
The steep decline of over 11% in the market from its peak this week gives us pause, of course. Corrections of this speed are fairly rare. Yet, many corrections have happened of this magnitude in most bull markets. In fact, we have seen several declines like this even in the bull market we have recently experienced since March 2009. The obvious question is: Will this time be different?
At times like these, we look to the fundamentals of the market and individual holdings to re-confirm our investment theses. Today, I would like to share with you some of the macro metrics that help us evaluate the market’s price and what that likely means for long-term investment outcomes. As we write this letter, the S&P 500 is trading at 2,541 and the DJIA is trading at 23,457. These numbers don’t mean much from a valuation perspective. Instead, it is instructive to look at the market on an absolute and relative value basis to determine how cheap or expensive it is.
2018 earnings for the S&P 500 are expected to be $153. This equates to a forward P/E of the S&P 500 of 16.58 times, well within the normative range of P/E values, with 15 times being the long-term average. When we express this ratio as an earnings yield, or the amount of earnings divided by the price we are paying, we get an initial rate of return of 6.03%. This compares to a 10 Year Treasury bond that yields 2.79% as of this letter. The spread between these numbers is the initial annual expected return premium for stocks over risk free bonds and that currently stands at +3.25% per year. The +3.25% premium of earnings yield versus risk free asset yield is a contrarian argument to the idea that bonds are currently competing with stocks as a long-term investment alternative. Indeed, the initial rate of return in a rising earnings environment is more than double the risk-free yield.
The economy continues to perform well in 2018 with earnings and revenues from many big companies exceeding expectations and more importantly growing. Unemployment is extremely low and jobless claims remain muted. Business optimism is quite high. Despite a recent increase of +2.9% in last month’s labor report for wages, inflation remains muted. Credit spreads remain tight between high yield and investment grade debt and consumer sentiment and defaults remain low. These economic indicators are not the signs of an imminent imploding economy or a reason to expect a significant earnings decline in corporate profits.
Profits on a per share basis are the basis for stock prices longer term. Therefore, this week’s horrendous sentiment in stock markets as measured by stock price breadth and the number of S&P 500 companies in correction prices presents in our judgement a buying opportunity for long-term investors. With the expectations for increased profits still intact, amplified by increased government spending and tax cuts for corporations there is a compelling case to be made for equities at these valuation levels.
Allocation Decision Making
Of course, we should not abandon our individual asset allocation parameters, just as we should not abandon good companies that we own that are being sold off in the malaise of shorting and margin calls of a rapid selloff in stocks. While short-term the market has pulled back 11% and the market value of many investments has followed suit, the intrinsic value of companies has not changed radically as a result. We suggest neither should our decision to hold such investments.
The enterprising investor may choose to add to such investments to lower their average cost of ownership or put new money to work. Such action takes courage, but is often a wise strategy to improve long-term portfolio performance. Our role is not to dictate a client’s risk preferences, but to try to act within our judgement to achieve our client’s objectives within their risk guidance. We will continue to pursue that endeavor and welcome any and all client input into that process to make sure we remain aligned.
Thank you for your continued confidence in this turbulent time.
Peter C. Wernau
Wernau Asset Management
Important Legal Disclosure
This letter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Wernau Asset Management, Inc. ("Wernau Asset Management) is a registered investment adviser with its principal place of business in the Commonwealth of Massachusetts. Wernau Asset Management and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which Wernau Asset Management maintains clients. Wernau Asset Management may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. This letter is limited to the dissemination of general information pertaining to its investment advisory services. Any subsequent, direct communication by Wernau Asset Management with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Wernau Asset Management, please contact Wernau Asset Management or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Wernau Asset Management, including fees and services, send for our disclosure statement as set forth on Form ADV from Wernau Asset Management using the contact information herein. Please read the disclosure statement carefully before you invest or send money.