Over the past few days many talking heads have spent an exorbitant amount of time trying to explain the recent sell-off in equities. We have seen a number of reasons, but for us here at Ironwood, it represents one thing: opportunity! We believe the markets were overdue for a pullback. Most equity indices have not seen a correction – a pullback in price of 10% or more from a recent peak – in over two years. The last one occurred between early December of 2015 and early February of 2016, when the Russell 2000 pulled back more than 20%. The S&P 500, over that same period, sold off around 13%. Twenty four months is a long time for stocks to go without a correction. Even the Brexit event in June of 2016 didn’t qualify as a correction, although small caps did sell off over 8% and the S&P 500 was down just over 5%. The point here is we were long overdue for a correction in equities.
It’s very normal for stocks to periodically pull back and for valuations to adjust a bit. At Ironwood, we were waiting for this to occur so we could do what we do best, which is buy great companies at prices that will result in strong long-term returns for our clients. Prior to the correction, the inexorable upward march of the markets made it harder to find investments at prices that would provide our clients with acceptable returns over the long term. As opportunistic investors, we welcome the chance to consider new investment opportunities that present themselves as a result of this pullback.
There are a number of factors which indicate to us that this is a long-overdue correction in prices and not the early stages of a deeper drawdown due to an oncoming economic recession or something more systemic. The global macroeconomic picture looks very good as the world seem to be growing in unison for the first time in a long time. The yield curve has ceased flattening and has actually started to steepen over the past few weeks. Yes, we are at a point in the cycle where the Federal Reserve is tightening; but the current spread in the yield curve is still predictive of positive economic activity in the near future. If the Federal Reserve was more aggressive with rates and the yield curve inverted, then perhaps we would have more reason to worry. We do not see that today and thus believe the economy is in good standing in the near term. Valuations have come in some as the S&P500 and the S&P600 sell for 16.9x and 18.2x 2018 earnings estimates, respectively. These P/E levels are close to long-run averages and down a tick or two from the recent peak in the market. Taking these factors into consideration, we will use this pullback in equities to make investments in companies that present solid, long-term returns for our clients. We are not market timers; we believe this is great time to optimize our screening process, sharpen our pencils, and dig for the next batch of ideas. Opportunity has presented itself.