Broker Check

Dow Jones Normal Volatility

August 02, 2019
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Welcome to this first edition of Sterling Financial Report, we hope you find this information useful and that we continue to be a resource for you and your family.

With the first half of 2019 complete, financial markets have rebounded significantly from the poor showing in 2018, and the especially difficult 4th quarter. While Sterling Financial Group has focused on long-term results when making asset allocation and investment strategy decisions, and our investment choices reflect that outlook as a priority, we are not immune from the news distraction and market declines that occasionally occur. When experiencing volatility, most investors are very pleased to participate in the upside swings, but at times may be extremely anxious over downside volatility, which in reality is a fairly normal pattern and should not be feared. What volatility should we expect in stocks, and what is normal? Below we try and examine some of the facts and point to an example that hopefully illustrates the long-term nature of how companies have grown.

The S&P500 tracks some 500 companies in many industries, but many investors are more familiar with the Dow Jones Industrial Average, thus we are using the Dow index for example purposes, even though it only tracks 30 large U.S. stocks. According to Dow Jones Market Data, since 1896 the Dow has fallen by at least 2% in a single day on more than 1000 occasions over the last 120 years. This is an average of about one decline of 2% or greater every 6 weeks or so. With the Dow currently over 26,000 as we go to print, a 2% decline is equal to more than a 500-point drop in the Dow. If such declines occur every 6 weeks, can investors make money in stocks with this level of volatility?

In our opinion, the answer is an unequivocal yes. Stocks represent a share of ownership in a business, and while the market value of a company on any day is determined by the “market” price on any given day, the long term correlation that we believe is most compelling for stocks, is the link between corporate earnings with stock prices. Over time, business’ goal (from a financial standpoint), is to produce earnings, and they do this by offering valuable services or goods to their customers at a profit over the costs of offering such products. As businesses find more customers, develop more value and grow revenue (and hopefully) profits at a faster rate, the marketplace typically rewards them over time by sending share prices higher; this keeps the relationship intact between the price of a stock, and the earnings, the so-called PE Ratio. Returns to shareholders generally come from increases in earnings that are frequently reflected in increases in stock prices over time, and payouts in the form of dividends or other corporate distributions. However, this process doesn’t normally unfold neatly over 1-2 calendar quarters, or even 1-2 years, but typically is a pattern we can observe over a multi-year period, as the following example illustrates.

Headlines often feature technology or other fast-growing companies like Google, which increased its revenue to $137 billion by 2018, a spectacular growth of nearly 27% per year since 2005. Over that same period, Google’s earnings increased 20-fold. However, let’s look at a more traditional company, 180+ year old equipment maker, John Deere. In 2005 Deere had revenues of $19.8 billion and earnings of $319 million, and in 2018 they had revenue of more than $37 billion, not quite double, but earnings of $2.4 billion or more than 7.5 times the 2005 level. Over this 13-year period, Google stock increased 11-12 times, but Deere also increased about 4-fold. And, importantly, John Deere pays nearly a 2% dividend, (and has averaged around 2% dividends for years), while Google pays no dividend. Thus, we believe even established companies in mature industries, if they are well run, have the opportunity to increase revenue and profits over time. Neither of these examples are meant as a recommendation to buy Google or Deere, or to state that Deere and Google are equivalent companies, but to illustrate that while very different companies, they were both able to generate significant growth in revenues and earnings over time. And it is the power of that growth in earnings over time that our investment management approach seeks to leverage for our clients’ benefit.

Volatility and downturns in the market make for good television commentary on CNBC and grab front page headlines, but they often mask the long-term wealth building effect of markets reflecting growth in corporate earnings over time. Even in the difficult financial recession of 2008-09, such downturns have historically been temporary, not permanent conditions, and we believe investors should keep a close eye on the long-term goals they have, their overall asset allocation and financial structure, and pay less attention to what is going on in the stock market on any given week or month. As always, we look forward to speaking with you soon.