Guest blog: Tips to counter the despair of volatile markets

 

You may find this especially hard to believe as global markets lurch wildly up and down but most investors do behave in a very consistent pattern. Look back through the history of investment and it is possible to discern a consistent and predictable cycle of emotional responses that as, we have discussed in more detail in Why value investing works, rotates through the two polar extremes of euphoria and capitulation.

 

Where we are in the cycle at this particular moment in time is rather harder to say, however – to take the main US market as an example, over the last couple of months the S&P500 index has seen both its steepest fall and its biggest rally since the Great Depression. Still, ahead of offering any view on how investors are thinking at present, let’s first sketch a useful mental image of how this psychological cycle looks.

 

If you would prefer to leave Why value investing works – and its exciting little Gifs – for another day, then imagine instead a clockface with euphoria at 12 o’clock. Here the wider market is feeling very positive indeed about life but then, as things start to go wrong, the cycle passes through anxiety, denial, fear, despair, panic and, at six o’clock, the trough of capitulation – at which point most investors have sold up.

 

 

The market cannot feel this negative about life forever, though, and having passed through disinterest and dismay, acceptance turns to hope, hope to relief, relief to optimism and then onwards through enthusiasm and exuberance. Sooner or later, we are back round to 12 o’clock again. If pushed, here on The Value Perspective, we would suggest investors are now hovering between despair and panic – call it four or five o’clock.

 

One of the curious things about this phase of the cycle, however, is that it can still be punctuated by very substantial bouts of positivity as investors briefly decide everything is going to be all right. That is why you can see significant bounces – such as the main US market’s largest single-day rally for the best part of a century – before those negative forces of despair and panic reassert themselves.

 

Forgive the abrupt switch of analogy but, at times like this – at any time, in fact – it can be helpful to think of investing as if you are driving at 70mph. Do you simply focus six inches in front of your car? Of course not – it would make driving impossible as everything shoots towards you at high speed. Lift your head, however – look down the road a mile or two, then in the rear-view mirror – and things look almost stationary.

 

 

This way, you can judge whatever you see in the road ahead as either an opportunity or a threat – switching lanes, braking or whatever. Here on The Value Perspective then, we are looking to use these big rallying days potentially to sell stocks where we think we can do better elsewhere. As for the big negative days where no-one seems to want to buy a single company – those are the best possible times to be buying value businesses.

 

At the risk of labouring our car analogy, there are of course plenty of signs and indicators a driver can use when on the road – and the same holds true for investors. In current markets, where the ‘fight or flight’ instinct is likely to be at its strongest – which is why we are seeing these 10%-plus daily swings – the rule should be to try and keep things as simple as possible.

 

In order to take emotion out of the equation as much as we can, here on The Value Perspective, that means focusing on some pretty straightforward valuation metrics, such as dividend yield or the price/earnings (PE) ratio – or, moving a little higher up the sophistication scale, the cyclically adjusted PE ratio, which aims to smooth out the effects of the market cycle.

 

 

We accept profits will fall for most businesses over the next six to 12 months but, at the same time, we do not believe the long-term future of many of these companies is as impaired as current prices imply. Yes, in the short term, life is going to be incredibly painful for investors but the silver lining to that cloud is we would hope to be afforded the opportunity to buy some good long-term businesses at better-than-average prices.

 

One way to sum up the job of a portfolio manager is ‘using bad headlines to make good investments’. That is how, on average and over the long term, you make money. It is why we have our eyes focused on a broad stretch of road ahead and some pretty straightforward indicators around us – and we will continue to do so throughout the current volatility as we work hard to make the best long-run choices for our investors.