Should we buying the dips?

Feb 08, 2021 | Richard So


Putting future volatility in perspective

During the month of January, our team kicked off the year with three client seminars delivered in multiple languages. In those events, we shared our outlook for the economy, interest rates, inflation, and stock markets. We used our discretionary PIM model (Private Investment Management) as an example of how this outlook has been implemented within the context of portfolio management. As investors look towards the potential start of a new investment cycle, we discussed new secular investment themes and created a plan for one’s asset mix, sector weights, and geographic mix while overlaying volatility management strategies. If you had missed these events, feel free to reach out to an advisor from our team and they can review the most popular topics and questions that we received from clients.

As we enter a new month in February, investors are hoping to take a breath from the volatile month end of January that was driven by a major unwinding of leveraged positions by hedge funds. The veracity of the volatility was extreme, with global investment flows logging the sharpest decline since March of 2020. In the world of statistics and actuaries, this was a 7-sigma event, which some view as so rare that it should mark an immediate upside recovery. I find these tidbits and predictions interesting, however, it would not be the driving reason to invest additional capital into the markets.

For those familiar with our team, you know we do not identify as short-term market timers. The majority of our seminars looked at investment periods marked by years and decades rather than weeks or months. We regularly take a step back and look at the current investment landscape in the context of historical averages. We also have to consider whether there are any factors that render the historical averages less useful. In combination, this helps determine the potential direction of markets

For example, at first, it may be alarming when one sees that the S&P500 Forward PE Ratio is near all-time highs. With the current 21.3x multiple, the market is well above the one standard deviation band. Although the valuation appears high, an asterisk is warranted as we are in an unprecedented time where interest rates are so low that asset and stock premiums should be expected and justifiable.

That being said, rather than solely looking at the PE ratio, investors can look towards other charts and ratios that better point to the strength of a company which we believe is better reflected in a company’s free cash flows. The following 3 charts below paint an encouraging fundamental picture for investors.  

Below, the U.S. market appears reasonably valued on a free cash flow basis, with the current P/FCF multiple of 24.0x, which is in line with the historical average and far from peak levels seen in previous cycles.

Moreover, U.S. large-cap companies have become significantly more cash flow generative in the past decade, perhaps signifying that above-average valuations may be warranted.

Finally, strong free cash flow generation has historically resulted in greater dividends and buybacks as the charts all move congruently. These events are typically well received by investors and help drive prices higher.

In all, no one chart is the decisive reason to invest, however, taken together and combined with current market fundamentals, clients should be rewarded by staying patient and being investors. As long-term investors we believe the early innings of a post-covid recovery will surely be volatile, but will also provide opportunities for long-term investors to “buy the dip”.