Market Update: Recent Pullback
The market experienced a sharp sell-off over the past two months as yields on the 10-year treasury continued to rise towards 5% and the possibility of an expanding geopolitical conflict in the Middle East began to be priced in.
Note that when we refer to the market, we are typically referring to the S&P 500 – an arbitrary index to which we pay almost no attention (other than presenting it in quarterly letters due to institutional tradition). In fact, we think that one of the most common mistakes most investment managers make is outsourcing their thinking to the market index – chasing stocks that are currently outperforming often at the time that they are most overvalued.
Remember that the S&P is market capitalization weighted, so as stocks rise their weight in the index rises, meaning that over time the index becomes more and more exposed to the most expensive (and likely risky) stocks. Sadly, the rise of passive investing has turned the S&P 500 from an index of the largest US companies into an index of the most popular stocks. We’ve written in detail about the rising risks that indices present as an investment option here.
Just consider that while the S&P 500 continues to be up single digits this year, that performance is in large part due to just a few technology companies (i.e., Nvidia up 182%, Meta Platforms up 138%, Tesla up 91%). Two of those three are not only some of the highest performers but also two of the most expensive stocks in the entire market – Nvidia currently trades on a forward PE of 37x and Tesla 64x. The impact on the Nasdaq of these outliers is even more profound.
If we instead look at the equal weight S&P 500 index (where the 500 stocks are held at fixed weight, so rising stock prices don’t increase their weight in the index), the market is currently down -5.3% YTD, and if we look at the world of small caps it looks even worse with the Russell 2000 index down -6.5% YTD. The S&P 500 and the Nasdaq are masking a huge amount of overall negativity in investment markets while concentrating their risk in a few large-cap technology names.
Returns must always be thought about in the context of risk, and we remain confident that our portfolio will continue to provide attractive returns from today’s prices while taking on less risk than either the S&P 500 or the Nasdaq.
Now as far as current events are concerned, we have no crystal ball as to what the near term will bring and even if we did there would still be no way to know how markets would react to those events. Recall that over just the past few years we have been through a trade war with China, a global pandemic, a contested presidential election, an impeachment, and what could be characterized as a proxy war between the West and Russia in Ukraine. And now there is this crisis in the Middle East. Before these recent events, there was the Global Financial Crisis, the dot-com bubble, multiple World Wars, we could go on.
At each turn, there were lots of investors that threw in the towel thinking they could time the market – most subsequently finding themselves buying back in at higher levels. As Peter Lynch said, “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
The only thing we can predict with certainty is that we will live through many corrections over the years to come and that we should try to benefit from them as much as possible. This means having a fundamental basis for what we own, and buying more when prices are falling relative to a business’s intrinsic value.
As you know, we maintain a concentrated portfolio of high-quality businesses. Outside of those we own actively, there are many others that we know well and monitor closely. There are times such as this recent pullback when high-quality companies get sold off unnecessarily and we are presented with an opportunity to buy a new position at a discounted price. We have taken advantage of one such opportunity recently by starting a new position in U-Haul (UHAL.B). A write-up on U-Haul can be found here.
As always, please feel free to reach out if you would like to discuss any of the above in more detail.
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