In a Perfect World, Volatility Shouldn’t Even Matter | Denewiler

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In a Perfect World, Volatility Shouldn’t Even Matter

Written by Greg Denewiler, CFA® // August 23, 2022

When the stock market is trending higher, volatility seems to be your friend. When your statements start showing losses each passing month, volatility creates potential frustration. Throw in higher inflation and the uncertainty is only magnified, the windows of market clarity become foggy. Quick answers are plentiful, however, the prognosticators are usually wrong. They seldom give you the whole story beyond what’s scary. The assumptions currently embedded in the stock and bond markets have not changed much in the last several months, but the interpretation of those assumptions appears to change daily. The market is up 5% one month, and down 5% the next. What are the assumptions now?



For perspective, the estimates for 2022 corporate earnings have fluctuated modestly since the beginning of the year. Full-year earnings estimates for the S&P 500 were $220 in January, they peaked at $225 in June, and are now down to $210. This 5% decline in expected profits hardly seems to justify a 25% decline in market prices. That partially explains why we have experienced a rebound of greater than half the decline since recent market lows. For 2023, earnings expectations have only been revised downward by $8, or 3%, hardly the evidence suggesting a severe recession. (While expectations are usually wrong to some degree, there is value in observing what the current thinking is). On the other hand, interest rates tell a different story, though still not a disastrous one. At the beginning of the year, investors were anticipating one-year interest rates would rise to 1.37% by next year. Expectations are now up to 3.45% for next year. Clearly, investors are anticipating the Fed to be aggressive, but nothing beyond 3.5%, given current short-term interest rates. This explains part of the volatility, but a few more observations may expose even more.



Jamie Catherwood of O’Shaughnessy Asset Management looked at historical returns and came to a couple of interesting conclusions. From 1871 – 2021 the stock market return was split between 45% attributed to earnings growth and 49% from dividends. Nothing new there. However, from 2011 – 2021, earnings accounted for 61% of returns and dividends only amounted to 15%, price expansion made up the 24% difference. This means that over the last decade investors were willing to pay 24% more than what they had historically paid for stocks. Low-interest rates have been a powerful catalyst for higher prices. With current inflationary pressures still highly uncertain, it doesn’t take much to spook investors and erase some of that premium. Taking this one step further, the composition of corporate profit growth has also changed. From 1963 to the present, sales growth has been responsible for 64% of earnings growth, and profit margins improved by 15%, with stock buybacks again making up the difference. Sales growth has slowed in the last decade, only accounting for 32% of earnings growth while margins improved by 51%. This implies that if a company had $1 of revenue ten years ago, it made 8 cents in profits. Today, that same business earns 12 cents for every $1. Low-interest rates partly explain the increased profitability (there are other factors), but now interest rates have reversed. Thus, investors have been willing to pay more for their investments, and companies have simultaneously become more profitable. With that balance now upset due to uncertain inflation expectations, it becomes very easy to scare the market. This may lead you to think that it is going to take a while to work this out – but sometimes what appears obvious is not.



Earlier, we looked at corporate earnings estimates for 2022 which are currently $210. You could easily say the economy had major issues back in 2009 and 2020. Earnings peaked in June 2007 at $91 and now 15 years later they are 130% higher. Again, in December 2019 corporate earnings saw a high of $157 before the economy was shut down, now they are 30% higher than the previous peak. The point of this is that the economy overall continues to move higher, but the details continually try to distract us. Details create volatility and shouldn’t be ignored, yet they do eventually lead to a growing economy.

Observations On The Market No.374