We are probably already in a bear market for major US Equity Indices – and that’s OK

By | April 9, 2018

For the week beginning on April 2nd, 2018, S&P 500 Index opened at 2,633.45, fluctuated violently through the week with a high/low spread of 118.28 points (2,672.08 vs 2,553.8), or 4.49% of the opening level of the week. On Friday, the index ended the week at 2,604.47, nearing the low point of the week and lower than the opening level of the week. The highest level of S&P 500 (2,872.87) was made in the week beginning on Jan 22, 2018. As of April 6, 2018, S&P 500 has declined 9.34% off its highest point, flirting with the definition of a correction (down 10% from previous high).

Based on the fact that Federal Reserve is quite set on further interest rate hikes down the road, elevated equity valuation across the board, potential disruptions from policy impacts and complacency among investors (Ray Dalio said on Jan 23rd: “If you’re holding cash, you’re going to feel pretty stupid”), we think the bear market of various US Equity indices probably is already here.

And that is OK.

Before further elaboration, please note that we are value-oriented investor at Fuji Investment Corporation. Forecasting general market direction is just a pastime hobby and it carries close to zero weight to our investment decision making process. Also, a US Equity Indices’ bear market is not equivalent to no opportunities in US Equities.

1.       S&P 500 companies are NOT cheaply priced comparing to other measures and considering a rising interest rate

In our recent post: “The beginning of the end for Facebook (and probably the FANG stocks)”, we argued that there will be more and more headwinds to such companies and their current valuation was pricing in a future as if they can keep such growth rate for another 10 years or 20 years. Since our post on March 26, Facebook declined 2%, Amazon declined 10%, Netflix declined 10% and Google went down 4.4%. Information Technology sector almost weighs 25% in S&P 500, which is the largest sector within the index.

Current S&P 500 PE Ratio stands at 24.32, if you flip this ratio, you have an income yield on equity at around 4.11%. 10-Year Treasury Yield is around 2.8%, which implies S&P 500 is having approximately 130 bps risk premium against a long-term risk-free measure (let’s assume for a moment that 10-year treasury is still risk free).

If Fed is implementing another 3 hikes (or 75 bps) this year, and 2 more hikes next year, assuming the inflation is supporting Fed’s decision and unemployment rate remains low (two mandate of Federate Reserve, not including S&P 500 valuation), after 5 interest rate hikes, 10-year treasury yield will be around 4.1%. If S&P 500 can post 10% earnings growth for next two years, its earning yield will improve to approximately 4.9% holding constant today’s valuation, which implies a further narrowed risk spread of 80 bps. According to Robert Shiller, S&P earnings per share growth rate since 1980 was 2.6%. We certainly have the work cutout for us in terms of delivering the strong growth a lot of valuations have priced in today.

2.       S&P 500 is heavily weighted toward Technology Stocks and Technology Sectors are expensive now

Among S&P 500 sectors, Technology sector’s PE Ratio is 32.5 times, which implies an earning yield on equity at 3%, which is 20 bps risk spread against 10-year treasury! Here is the problem: if you are pricing in 20%+ future earnings growth into the valuation, if there is a slow down or any kind of headwind, your math will not hold anymore. The stock will face a repricing. If 25% of the index is facing a repricing, S&P 500 will face lots of challenges.

3.       How to invest in a bear market – 5 principles

It is not easy to deliver strong performance in a bear market. Ben Graham said: “The stock market is a voting machine in the short term, a weighing machine in the long term”. Near term, negative sentiments may drag down everything across the board: trade disputes, interest rate hikes, potential inflation surprises, mediocre earnings growth or political disruptions. However, in any investment environment, a few rules always hold true:

  1. If you buy a company worthy of 1 dollar for 50 cents and keep on deploying capital in this consistent manner across a list of diversified businesses, something good will happen
  2. If you don’t price in aggressive growth assumptions to a great business when you make the purchase (normally such opportunities are only available in bear market), and accept the fact that business will fluctuate and there will be peaks and troughs in its earning history, your investment will turn out to be fine in the long term
  3. Never borrow money to invest so you can always have strong staying power during panic times to pick the best that are on sale in the market (with due respect to Ray Dalio, normally the moment you should keep enough cash is when cash is considered worthless and holding cash is stupid)
  4. Look for long term durable competitive advantage in a business and be decisive when you find one, even it is in the middle of a bear market.
  5. Don’t trade, spend your energy to some other productive areas (some sports or reading great books).

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