Why every setback is accompanied by a different narrative
In this week’s video insight Roger discusses why setbacks are a necessary part of investing, especially for those keen to realise better returns. Remembering that the lower the price you pay, the higher your returns, it makes sense that we should welcome market pullbacks. Eventually, there will be an end to rising interest rates and eventually, inflation will peak.
Throughout history, markets have experienced setbacks. Indeed, experienced investors should be quite familiar with them. They’re more frequent than we would like, but they do form a necessary part of investing, especially for those keen to realise better returns. Remembering that the lower the price you pay, the higher your returns, it makes sense that we should welcome market pullbacks, particularly if we are net buyers.
Ben Graham once suggested we should buy stocks the way we buy groceries. When they’re cheap, buy more. Now, for example, I enjoy the all-year availability now of blueberries and raspberries, for example, but when they’re $7 or even $9 a punnet, I simply steer clear. When they’re $2 or $3 a punnet, I stock up and it’s the same with equities. All I want to suggest is that if we know we’re going to be buying shares over our lifetime, we should want the cheaper entry points. And market corrections are one transmission mechanism that provide just that.
The purpose of this discussion, however, is to remind investors that every setback is accompanied by a different narrative. Professionals try to explain why the market is falling. This time, it’s China, Russia, supply chain disruptions, and even the risk of a recession. But really, I believe it’s none of these things. You see, without exception, since at least the 1970s, whenever interest rates have risen and/or inflation has accelerated, price to earnings multiples have compressed. Simply speaking, amid those conditions investors are unwilling to pay as much for a dollar of earnings.
Now, since the start of the year, when talk of U.S. interest rate rises really ramped up, PEs have been crimped. The consequence has been a large fall in the share prices for many companies. Since the beginning of the year, when interest rate fears really took hold, and by way of example, Netflix has fallen as much as 67 per cent. Starbucks is off 35 per cent. PayPal is down 55 per cent. Facebook is down over 45 per cent. Google and Amazon are both down as much as 18 per cent, and Apple has fallen 14 per cent. When interest rates rise, the intrinsic value of all income-producing assets is lower. That’s because there’s an inverse relationship between the discount rate used to value an asset, and the present value of a future dollar of earnings from that asset.
In other words, rising interest rates act like gravity on the underlying value of every asset, and while the stock market is already reflecting that change, property investors and art, wine and car collectors won’t be immune.
When interest rates rise, cash investments become relatively more attractive, and eventually investors move their funds from risky assets into cash. The stock market, of course, casts its shadow before it and stocks tend to fall in anticipation of that shift in relative attractiveness. In other words, it becomes a self-fulfilling prophecy. But this is the good news. Eventually, there will be an end to rising interest rates and eventually, inflation will peak. That end could be marked by a recession, which remember is only two quarters of negative growth, but it doesn’t have to be marked that way.
In any event, on the other side of the peak in interest rates and inflation, are falling rates and disinflation, and both are very positive for equities, especially companies able to show that they are growing materially. Investors will once again be clamoring to invest in those stocks. Now, we’re not at the that point. We haven’t even come close to maximum fear. If and when that time comes, we of course will be here ready to offer our insights. So be sure to tell your friends to subscribe to ensure they don’t miss an update during what I believe will be one of the important times for investors to be prepared.