From the pandemic-induced lows of March 2020 through January 3 of this year, the S&P 500 index rose 120% (including dividends) without a single setback exceeding 10%. There are no straight lines in financial markets, but this prolonged rally came close. Ah, how times have changed! Through May 9, 2022, the S&P 500 is down 16% so far this year, and thousand-point swings in the Dow Jones Industrial Average have become regular occurrences. We are reminded daily that volatility is a feature of financial markets, not a bug.
The question on most investors’ minds is: Where is this volatility is coming from, and when will it go away? As much as we like for effects to have causes, volatility does not require a catalyst: It is endemic to markets. We believe that financial markets are reasonably efficient over time, but only as efficient as the participants that comprise them. To the degree that people are susceptible to irrational bouts of greed, envy, doubt, anxiety and every other human emotion, so, too, are markets. Efficiency is more like gravity than it is a stable state of affairs: Market prices trend toward an efficient reflection of value but always overshoot on the upside and the downside. Disciplined investors can take advantage of these deviations from reality.
The search for reasons for the current spate of volatility reveals a target-rich environment. As we have discussed in various webinars and commentaries, the only bull market at present is the bull market in uncertainty. Economic leadership is transitioning away from policy and back to the more fundamental driver of household spending; the future trend of inflation is unclear, as is the Federal Reserve’s aggressiveness in tightening monetary policy to combat it. To this already volatile mix, add a land war in Ukraine and a midterm election looming in the U.S. There is plenty to worry about, and it is unlikely to clear up soon.
Investors hate uncertainty, and prices reflect this. At a philosophical level, price is a wonderful concept. Prices are transparent – anyone with a smartphone can retrieve the price of a publicly quoted security on a moment’s notice. Furthermore, prices are updated continuously during a trading session, and we can all agree on the current or closing price of a security. The downside, as we’re seeing at present, is that prices are volatile.
Value has the opposite constructs. Value is not transparent or readily obtainable. It takes a lot of work to derive the fundamental value of a security, either in the public or private markets, and different analysts will almost certainly disagree over intrinsic value. Unlike price, value is characterized by little transparency, infrequent updates and widespread disagreement. Value, however, is far more durable and stable than price.
It is for this reason that our investment approach, across all asset classes, hinges on the identification of value, coupled with the patience to allow market volatility at the security level to provide an entry point at a discount to the intrinsic value of the asset.
Let’s look at a few fundamentals to illustrate the potential disconnect between price and value at the macroeconomic level. Over the past year, the S&P 500 is down 1.2%, indicating that we have given up most of last year’s rally. The nearby table outlines the usual suspects for this reversal. Compared to last year, the fed funds rate is up 77 basis points, the 10-year bond yield has risen 1.31%, and the two-year yield is up a whopping 2.56%. Inflation last year was a modest 2.6% but stood at 8.5% in the last report. No wonder the market is down.