Is this pullback something long-term investors should be concerned about? We don't think so. Here's why:
1. Stock Market Volatility is Normal
The market's unbroken march upward in 2013 caused many investors to forget what market turbulence looks like.
With so many forces at work in the stock market, it is difficult for one particular trend to last for a sustained period of time. The market is positive 7 out of 10 years, but the standard deviation of 20% around the long-term average of 10% would make anything between 0% and 30% normal. Rarely does the market advance higher without
temporary periods of "consolidation" (price drop of less than 10%) or "correction" (10% or more).
The long-term total return of the stock market has averaged about 10% per year going back to the 1920s. It rises about 7 of every 10 years. However, in a normal year, the difference between the market's high and the low is nearly 20%.
temporary periods of "consolidation" (price drop of less than 10%) or "correction" (10% or more).
The long-term total return of the stock market has averaged about 10% per year going back to the 1920s. It rises about 7 of every 10 years. However, in a normal year, the difference between the market's high and the low is nearly 20%.
The majority of market pullbacks are triggered by some external event that makes investors nervous. This month, the trigger came from softening of emerging market currencies and sub-par economic data from China.
2. Market Valuations are Not Overblown
Since 2009, the market has been responding to very real economic events. The U.S. economy has been slowly strengthening as unemployment has steadily fallen. The global economy has emerged out of a crisis and appears to be getting better. Monetary actions from central banks have driven down interest rates all over the world, leaving investors with very few good alternative investments. Furthermore, aggressive productivity initiatives and new technology have boosted profit margins and earnings.
The bottom line on all of these events has led to a nearly 200% total return on the S&P 500 since March 2009. Despite the significant increase in price, stocks are nowhere near the "bubble" described by many perma-bears.
To begin the year, our proprietary Dow Jones model showed that the market was approximately fairly valued. Current price-to-earnings (P/E) ratios are in line with historical levels, especially considering the low inflationary environment and improving economic conditions.
3. Consolidation Periods are Good for the Market
This pullback neither surprises nor dismays us. In many ways, these consolidations and corrections are good for the market. They allow bearish investors the opportunity to get out of the market, leaving the buyers to pick back up and push the market to fresh highs.
4. Timing the Market is Rarely Profitable
Since pullbacks are usually as a result of profit taking, investor psychology, or some unpredictable external event - no one can really know when they will happen.
As a result, it becomes virtually impossible to time the market with any amount of long-term success. Academic studies have shown that daily, monthly or annual price movements have virtually no predictive ability for stock prices 6-12 months into the future. We have found dividend growth to be much more predictive of stock market growth than trading based upon short-term price swings.
5. Strong Dividend Growth
Rather than worry about the daily movements in stock price, we find it more prudent to observe changes in economic conditions or underlying company fundamentals. As long as the long-term fundamental value of a particular company does not change, price movements are of very little concern.
Company fundamentals have not shown much weakness. Dividend growth - which we believe to be the best long-term predictor of price growth - has been better than expected. Over the past 12 months, the S&P 500 saw dividend growth of 9.6%. Our primary investment style (Cornerstone) had dividend growth just over 11.5% while our growth-oriented portfolio (Capital Builder) grew dividends by nearly 15% - both better than expected.
Unless the outlook for dividends and earnings start to change, we believe stocks will continue to do well over the long-term. So far, we have seen nothing that indicates to us that this "emerging market crisis" will have any measurable impact on company fundamentals over the coming 12-18 months.
What Do We Plan to Do About It?
Not much of anything. We remain alert to any buying opportunities that present themselves, but have no plans to make any measurable changes to our portfolios.
Dividend-paying stocks have historically been safe harbors during times of market turmoil. Furthermore, dividend growth has shown to be one of the only consistent indicators of long-term price growth. Therefore, our plan is to stay the course. We will continue to navigate these choppy waters using the dividend as our guide.
