Volatility Got You Nervous? Think of It as an “End of Year” Sale

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2018 may have started off strong, but volatility in the last quarter has made a lot of market participants nervous. The VIX (a measure of stock market volatility) roughly tripled from early October (where it hovered around a typical 12) to December 26, when it spiked to 35.5. While volatility has settled down since then, investors are still concerned over how to proceed and whether the uncertainty will continue.

How do we navigate this situation?

Well, let’s analyze this from the perspective of the price-earnings ratio (PE), which is considered one of the best indicators of long-term returns. The PE compares the current market price per share against current company earnings per share. Put differently, it tells us how much buyers are willing to pay for future earnings.

Last year, the average PE ratio for the S&P 500 had one of its largest drops in decades, going from about 24 at the beginning of the year and ending at 14.5 (the average is about 16) according to JPMorgan Chase.[1] At first glance, this may seem like a negative occurrence. After all, if the market is not betting on the success of companies, something bad must be coming.

So, what does this mean for investors? Should it be taken as a signal of a coming recession?

It’s a good question, but when we look closer, things are not always what they seem. The drop in the PE ratio is significant, but it may present an opportunity for the future. An analysis conducted by JPMorgan showed a significant negative correlation between the P/E ratio and subsequent 5-year annualized returns. Historically, as P/E ratios decrease opportunities for returns increase.[2]

And the discount is not limited to U.S. markets and companies. According to Barron’s, emerging markets, which have traded to developed markets at an average 22% discount over the past decade, are trading at a 27% discount right now. Additionally, emerging markets have higher predicted profit expansion for 2019 than U.S. companies (6% versus 4.5%). The EM financial sector is particularly discounted and is currently trading at a 20-year low.[3]

Volatility (and drops in the PE) are rarely a reliable predictor of a bear market or recession, and that could be true right now. In fact, they can create an opportunity for a patient, long-term investor. The economy looks strong, a U.S.-China trade deal is starting to take shape, and the Federal Reserve appears to be more flexible than we thought.

Call us with any questions.

[1]J.P. Morgan Asset Management. “International Equity Earnings and Valuations” Infographic. December 31, 2018

[2]J.P. Morgan Asset Management. “P/E Ratios and Equity Returns” Infographic. December 31, 2018

[3] Mellow, Craig. “What to Buy in Emerging Markets Right Now”. Barron’s.

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