The Stock Market Decline is Good for Investors

I admit it.  Last year, I asked Santa Clause for a stock market selloff.  No, I am not unamerican; nor am I a glutton for punishment.  I am a value investor who has had a hard time finding bargains in an exuberant market.  After Friday’s and Monday’s selloff, it looks like I got my wish.

On Monday, the Dow Jones Industrial Average (a well-known market index) declined by 4.6%, following a decline of 2.5% the preceding Friday.  But whereas others are panicking, enterprising investors (those investors who view stocks as shares of businesses, rather than pieces for paper to be traded for quick gain) see a big “For Sale” sign.  As Warren Buffett has said numerous times, the key to outsize investment returns is to be greedy when others are fearful, and fearful when others are greedy.  We were scared as heck last year but licking our chops now.

Ironically, the cause of the selloff was a better-than-expected jobs report, specifically a jump in wages.  This has led many market participants to fear higher inflation and, thus, for the Federal Reserve to increase short-term interest rates at a faster pace than anticipated.  For a very brief discussion of how interest rates can affect stock prices, consider that the fundamental value of a stock is the company’s (per-share) expected future earnings discounted to the present at a rate which reflects the perceive risk of stocks versus bonds.  Thus, a stock’s price changes (ignoring short-term noise) when either (a) expected future earnings change, or (b) interest rates change.  In simple mathematical terms, a stock’s price equals EPS ÷ (rg), where EPS is earnings-per-share, r is the discount rate, and g is the expected rate of growth in earnings-per-share.  Higher-than-anticipated interest rates can influence either the discount rate, the assumed earnings growth rate, or both.  But don’t blame the Federal Reserve.  As former Fed Chairman William McChesney Martin once explained, it is the Fed’s job to “take away the punch bowl just as the party gets going.”

I remember reading a post several months ago by a prominent market strategist, who stated that the market was underpricing political risk.  I think he was wrong; the market was not pricing in any risks.  All else equal, risk is a function of price.  The recent market decline means investors may be more adequately compensated for the long-term risks of owing stocks.  And this, investors should welcome.  For enterprising investors, it is time to go to work.

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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