Is it time to buy the stock market crash?

This article first appeared in the Telegraph

PURCHASE dives has generally made sense. In the 14 years since the financial crisis, it has generally been worth assuming that central banks or the government would come to the rescue at the first sign of trouble in the markets. Don’t fight the Fed has been a profitable mantra.

It is not just the authorities’ desire to keep the show going that has encouraged the view that a correction is always an investment opportunity. Arithmetic also says so. To illustrate this, imagine a hypothetical market that is up 10% per year, with large annual swings between a 20% gain and a 10% decline. Now imagine two investors, one of whom only invests at the top of those cycles and one at the bottom.

Obviously, whoever buys the dips does better. But the scale of superior performance may surprise you. If each investor puts £100 a year into the market on this basis, one will end up after five years with £560 and the other with £745, a third more. Obviously this is an unrealistic scenario, but you get the picture. Buying the dips makes sense in a bullish but volatile market. And, given enough time, markets tend to be rising but volatile.

Buying the dips is less obvious today than it has been because investors are worried that there may be something fundamentally wrong with the global economy right now. Two years ago, the arrival of the pandemic was an unexpected and unpleasant blow to a healthy market. Today, the ground under our feet feels more unstable. But is it really? Here are six reasons to believe that buying the 13% drop in global stocks since the start of the year will make sense, if not in the short term, then in due course.

The first reason is the feeling. Risk aversion is one of the best indicators that the time has come to return to the market and sentiment has not been this weak since the low point of the financial crisis. The percentage of investors who describe themselves as bearish was last this high in 2009. Even in 2003, after the dot-com bubble burst, people weren’t so pessimistic. That’s a good thing because there is often an inverse correlation between investor sentiment and future stock investment returns. Not always, because investors can feel bearish long before the market bottoms, but often enough for the sentiment to be a useful signal.

The second measure to watch is the extent to which investors have already priced in trouble ahead. The bond market tends to be a better place to find these signals than the stock market because fixed-income investors are natural pessimists and, as a result, make better canaries in the coal mine than perennially bullish stock investors. The measure I’m looking at today is the yield on safe government bonds. At 3%, the proceeds of a super-safe 10-year US Treasury bond appear to have discounted virtually all of the interest rate hikes currently spooking investors. Once again, that’s a good sign. I’d be surprised if bond yields were much higher than this for the foreseeable future.

The equivalent measure of sentiment in the stock market is the earnings multiple that investors are willing to pay for a share of a company’s earnings. This so-called price-earnings multiple has been falling for over a year. Last spring, investors were willing to pay perhaps 24 times the earnings of America’s largest companies. Today, it is only 18 times. I am not entirely convinced that this measure will not drop a bit more yet, but it feels closer to the bottom than the top of its likely range.

The price-earnings multiple is determined partly by price and partly by earnings. it is a ratio. So what happens to the company’s earnings is clearly important. The good news on this front is that about halfway through the current earnings reporting season (which covers the three months from January to March) about 80% of companies are beating expectations. Earnings are forecast to have risen nearly 9% on average over that period, up from 5% expected at the start of the reporting round.

A fifth argument to buy this dip is Mr Market’s tendency to overshoot. Here, it makes no sense to look only at the averages, but to look for the most extreme examples of excessive pessimism. Like the 47% drop in Cathie Wood’s Ark Innovation ETF or, closer to home, the 32% drop in the share price of the Scottish mortgage investment trust so far in 2022. Or the drop in the 25% of Amazon to date. Things are rarely as good as we hope or as bad as we fear, and I wonder if, when the war is over, inflation has receded and Covid has finally been eliminated, we will look back on some of these price movements and wonder why. we do not act on them.

In the long run, dips simply disappear from the charts or at least begin to resemble harmless pauses for breath. The biggest mistake we can make as investors is that these temporary setbacks take us out of the market. The second mistake is not taking advantage of them by recharging along the way. We cannot hope to emulate the investor who only buys at the bottom of dips. We don’t need to. Investing consistently through the ups and downs is a good second choice.

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