For those of you paying attention to the stock market returns over the past several months, you have likely seen your balances trimmed by a hefty percentage. Since the start of the year the Dow Jones is down 15%, the S&P is down 20% and the NASDAQ is down a whopping 29%. And those figures include a slight recovery at the time of writing this in the past week. Even the normal safe haven of bonds has taken a beating with long term treasuries down 20%.
So just how bad are things? To put things in perspective let’s go back and look at the past couple of years as we have been in a very unique place in market performance due to Covid. While Covid started making the news in early 2020 it wasn’t until late February that the markets started to react. Looking at weekly charts, the S&P was at 3380 on Feb. 14, 2020. It had a slight drop the following week but then fell over 10% the week of Feb 21, another 7% two weeks later and then the bottom fell out with another 15% drop the week of March 13. In just five weeks, the S&P had lost over 1000 points, a 32% drop. That is a huge fall in that short of a time period.
But I think we could all understand why this was happening. While the science still had a way to go we were seeing cases spread around the globe and countries were starting to shut down. No one really knew how bad this was going to be or how long it would last, and you have heard me say this here before, markets hate the unknown and this was a doozy.
Markets tend to overreact to big news that rocks the status quo. Was 32% too much of a downside? Maybe. But very quickly the markets started to bounce back. A month after hitting the lows, the S&P was back up to 2835, an increase of 23% from the bottom and didn’t stop there. In fact, the market kept chugging along in a positive direction and by August had fully recovered. Now here is where we should have asked the question, does that make sense? Should our stock market really have been at the same place in August 2020 as it was prior to Covid? You could make the arguments that new technologies were being adapted at record pace to allow people to work from home, conduct commerce and interact with each other but there were entire industries that were completely stuck in the mud; travel, hospitality, entertainment, sports. There was nothing happening in these areas.
Now here is the odd thing. The market didn’t just get back to where it was, it kept going and going and going. By early September 2021, the S&P sat at 4535, 34% higher than the pre-Covid peak. Can anyone really say we were in a 34% better position at that time than pre-Covid? I doubt it. But when things are rolling in the right direction, we tend to convince ourselves that it all makes sense and we ignore the warning signs.
From an academic stand point the price of a share of stock is based on the future cash flow of the company. Refer to the chart below and you can see that historically the S&P has traded at about a 16 to 17x P/E ratio. This means that the price of an average share of stock costs 16 times the earnings of that share. That was until the end of 2014 when the P/E ratio started climbing steadily and we sat in the 23-24 range until we had a correction at the end of 2018 when it dropped back to 19. By the time Covid came around the P/E ratio was up to 26. Understandably, the PE ratio goes up and down with the markets so when the market dropped due to COVID so did the P/E ratio to 21 at the end of April 2020. We already discussed how the markets not only rebounded but went on a huge run through the end of 2021. The P/E ratio was all the way up to 46 by the of June 2021 and was still at 30 at the end of 2021, well above normal levels.
Different companies and industries will have different values depending upon where they are at in their growth lifecycle, but this average has been a pretty decent standard for a while. What this can tell an investor is that if the P/E ratio gets above historical ranges that is an indicator stocks might be getting over priced and are due for a correction to get back in line. Likewise, if the P/E gets below those marks that can indicate a buying opportunity.
With P/E ratios in the 30s it was a clear sign the market had gotten too expensive. Tech stocks which, in general, have a higher rate of growth will carry a higher P/E ratio with the thought that the company’s profits will grow into a reasonable P/E. Well, during the bounce back from Covid this theory was on steroids. We can all remember the darlings that benefitted from everyone staying at home during Covid; Zoom, Peloton and Docusign among others. Plus, you had tech companies that facilitated everyone working from home and allowed us to access things from the cloud. These companies saw P/E ratios in the hundreds and in many cases weren’t even profitable. In this segment, things had gotten completely out of control from a stock price standpoint
Welcome to 2022 and the adjustment is in full swing. Many of those high flying tech companies that benefitted from stay at home are down as much as 75% while even mainstays like Apple, Google and Amazon are down 20% or more from their highs. We are back to a P/E ratio of under 20 as of this writing so have come more than full circle from where we were pre-Covid.
It feels like the sky has fallen a little bit in terms of the market and many of our portfolios. But has it? Look at the chart below. The S&P ended May 2022 at 4132. That’s 750 points, or 22% higher than that pre-Covid Feb 14, 2020 number. Any reasonable investor would take that gain over a two year period. It feels hollow because at one point the market was up over 100% in less than a two year timeframe and has since fallen.
So what lessons about investing does this cycle teach us? Many are the same that have been mentioned here before.
1. Have a diverse investment portfolio – Some areas of the market will get crushed in a downturn and others will do better. An investment portfolio that has holdings across the board is key to having access to those areas which are performing a little better.
2. Rebalance your portfolio – This keeps you from being too heavily weighted into an area that has great results. Having some high growth tech might make sense for your portfolio. Let’s say you targeted 10% of your portfolio to that segment and after the run up you were up to 20% in high growth. You then would have suffered a 30% loss. Instead, had you rebalanced from high growth to an underperforming area like small value when high growth hit 15% you would have kept your gains and then gone into another area that had growth when high growth had its troubles. In short, rebalancing keeps your diversified portfolio at proper levels.
3. Stay invested for the long run – This goes hand in hand with not trying to time the market. It is very difficult to know exactly when to move in and out of the different areas of the market. That is a full time job to know what to look for and even then you are likely to be wrong half the time.
4. Have a risk appropriate portfolio – This recent downturn should not be a major concern for those in their 30’s as there is plenty of time for their investments to recover. But for anyone within five years of retirement or already retired, this has likely been concerning because they need this money for their retirement in the near term. As you near retirement, it’s a good idea to keep a portion of your portfolio in cash-like safe investments so you can ride out these short term periods of volatility. That way you have the money you need for the next several years that stays safe while the rest has time to rebound.
What do you do now?
As with everything in financial planning it depends on your particular situation. For those that have a longer time horizon for their investments you are much more likely to be able to ride this out and wait for the market to rebound. That doesn’t mean you don’t need to work at it but by following the steps mentioned above you can keep yourself on track for the long run.
On the other hand, if you need to tap into the money within the next few years, you likely need to take a different approach. Not that you run for the exits and pull your money out of the market, but you need to be aware of the risk within your portfolio. For example, a 30 year old might be able to let everything ride for the next five years but a 60 year old that retires in two years should have been diligent along the way updating their portfolio so they are positioned appropriately from a risk standpoint.
As I frequently say with investing, the starting place is to know why you are investing and what your objectives are. Develop a strategy that is based on your goals, risk tolerance and other key life circumstances. Stick to this long term plan and don’t make wholesale changes every time there is a new shiny object or sign of trouble. Make the small adjustments as needed mentioned above to help stay on track. If your long term goals and objectives change then adjust your strategy accordingly.
My guess is most of you reading this have felt pain with your investments so far in 2022. I am not here to tell you everything will turn around any day soon. Investing is fraught with this type of short term risk but also has consistently rewarded investors over the long term. We don’t know how much longer this will continue or if/how much lower things might go. Re-evaluate your plan and hang in there.
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