The abrupt reversal of equity markets in the last few weeks has sent shivers down investors’ spines, particularly as momentum was the dominant factor behind the rally that preceded it. Time to panic? On the contrary, history shows that buying into short-term weakness has been a fruitful strategy for long-term investors.
Recency bias tends to exaggerate the importance of our most recent experience, but market moves of this magnitude are in fact more commonplace than we care to remember. The MSCI AC World Index is 6-7% lower than its peak on January 26th and looking back over the last 30 years there have been 30 occasions when similar pullbacks have occurred over a similarly short timeframe (Source: BofAML Global Quantitative Strategy, 6 February 2018). More pertinently, global equities, on average, have generated a positive return of 13.9% in the following 12 months, taking just four months to recoup the initial loss – as the chart below illustrates.
MSCI AC World Index return post 6-7% pullbacks
Source: BofAML Global Quantitative Strategy, MSCI, ExShare, Factset, 6 February 2018.
‘Buy low, sell high’ is an oft-quoted mantra which is seldom applied when markets are under pressure. We strongly believe that investors should embrace short-term market volatility to take advantage of long-term opportunities. That said we would highlight the importance of being selective in today’s environment where valuation disparities across the market are striking.
At one extreme, defensive stocks which were in fashion for many years against a backdrop of low growth and low interest rates look vulnerable now with many of yesterday’s heroes carrying the potentially toxic combination of high multiples and deteriorating fundamentals. Until relatively recently, investors were willing to pay up for safety and security, often without any heed for value, in a way that was ultimately unsustainable. A valuation discipline is essential to generate excellent returns over the long term, in our view, and the dangers of ignoring value are already becoming apparent in some areas of the market. Sectors such as consumer staples have benefited in the past from their status as bond proxies, but their fall from grace is not simply a matter of rising bond yields, we would argue. Investors have started to question the stable growth which they have taken for granted, in an operating environment where competitive pressures are eroding the growth rates these companies have delivered in the past. Fundamentals do matter after all.
We take comfort from the observation that investors are starting to pay attention again to what drives equity returns over the long run, and in this context, we find our best ideas in cyclical businesses. This is the area of the market where value characteristics are most pronounced, backed by solid operating performance. Elaborating on fundamentals, dividends provide the ultimate sign of a company’s confidence and the dividend increases we are seeing in the current reporting season reflect well on the long-term potential and financial health of companies. We believe that the combination of strong dividend growth and attractive valuation, not short-term market direction and sentiment, will stand investors in good stead to generate competitive returns over the long term.