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Keeping your composure in the stock market during uncertain times

Mathias Malhotra

Keeping your composure in the stock market during uncertain times

Social media and experts are constantly talking about a recession, the Nasdaq has lost 33% in value this year and the index that analyzes investor sentiment indicates that 73% of fund managers are pessimistic about the financial markets, the highest percentage since this index was created in 1994.  Since the beginning of the pandemic, the government has spent a considerable amount of money on health care as well as financial assistance for their citizens.  These measures, although necessary, have greatly increased the money supply and are causing a hyperinflation problem.  In an attempt to ease this phenomenon, the central bank has raised its policy interest rate from 0.25% to 3.75% in 2022.  The change has rapidly slowed down economic growth which was already a bit sluggish due to the logistical and supply problems caused by the war in Ukraine.  All these factors added together lead us to believe that Canada will soon be in a recession.

This has many people wondering if investing in the stock market is a decision they will regret…

Compelling valuations

In reality, it is quite the opposite, when the market is very volatile and the price of the stock has dropped significantly, the risk/reward associated with an investment increases.  This may seem a little counter-intuitive, but when you buy a stock, you are buying a piece of a company, so if it has not fundamentally changed and the macroeconomic situation is only affecting the business in the short term, it is possible to buy its stock for a lower price.  For example, Google’s stock is down 40%, yet the company will not be fundamentally changed by the difficult economic times ahead, although in the short term the revenues from some of their services will decrease.  This justifies part of the drop, but another part is associated with investors simply deciding to withdraw from the market due to general pessimism.  The share price therefore often reflects the worst case scenario and if the quarterly revenues are not catastrophic, the share price will rise rapidly. 

Different strategies depending on risk tolerance

First of all, in an uncertain market with high interest rates, companies with a lot of debt and very few profits are the riskiest and therefore the ones to avoid when you want to invest without taking too much risk.  Indeed, borrowing money becomes harder because banks are particularly careful about the companies they lend money to and when they approve a business, it comes with interest rates that greatly affect their cash flow.

It is often the lower capitalization stocks that are the most affected by negative investor sentiment.  These companies are often perceived as risky and are avoided.  However, some smaller companies with very strong balance sheets have been completely overlooked by investors.

figure 1: Forward P/E ratio of S&P large, mid and small cap stocks from 1999 to 2022

The following graphs illustrate the price/earnings ratio for large (10-2000B), medium (2-10B) and small (0.3-2B) companies in the last 20 years. As we can see, companies of different sizes are impacted very differently in a crisis situation relative to their usual price/earnings ratio.   Small and medium-sized companies can be extremely interesting for an investor with a long investment horizon who is willing to have its portfolio fluctuate. When investor sentiment turns positive, these stocks are the ones that rise the fastest. 

Investors who want to take less risk, but still enter the stock market, can look for stable companies that offer dividends.  When a dividend stock goes down but the company still pays their normal dividends, the percentage received by the investor is higher, which is very attractive.  Even if the stock price does not rise in the short term, investors will still receive a constant cash flow.

Finally, once the company is chosen, it is possible to make a lump sum investment, which consists in paying the total amount of money to be invested in a single transaction. However, this strategy is a bit risky and is often used by very confident investors.  To reduce the risk, it is recommended to invest several amounts spread out over a certain period of time.

Is a GIC really the answer in harsh times?

Guaranteed Investment Certificates (GICs) are financial tools that allow you to deposit an amount of money that is guaranteed and offers an annual rate for a fixed period of time.  This annual rate fluctuates in correlation with the key interest rate.  The yield is therefore more interesting when interest rates are high.  Thus, many investors leave the stock market by selling their shares at a reduced price to obtain a fixed return with a GIC.   Therefore, they won’t benefit from the rise in these assets when investor sentiment turns positive.  The opportunity cost of this type of capital transfer is often too great to justify such a move. 

Conclusion

It is easy to get fearful when financial articles and the media are pessimistic.  However, when one’s investment horizon is based on long term gains, its stock holdings have not been fundamentally affected, and it reflects the level of risk wanted, it is crucial to keep its composure.  This exact mindset has made Warren Buffet successful.  As he always repeats, “Be fearful when others are greedy and greedy when others are fearful.”

 

References

Gouvernement du Canada.  Certificats de placement garanti et dépôts à terme : Connaissez vos droits.(2022) Certificats de placement garanti et dépôts à terme : connaissez vos droits – Canada.ca

Yardeni research Inc. (2022). Stock Market Briefing: Selected P/E Ratios. Available on :

Stock Market Briefing: Selected P/E Ratios (yardeni.com) (Consulted on : 2022-11-05)

ZHANG, H. Investor Sentiment Drops to Lowest Point in 30 Years. Instituonal Investor.(2022). Investor Sentiment Drops to Lowest Point in 30 Years | Institutional Investor

BROWNLEE, A. Warren Buffett : Be Fearful When Others Are Greedy. Investopedia.com (2022). Warren Buffett: Be Fearful When Others Are Greedy (investopedia.com)

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