The Dow Jones Industrial Average (“DJI”) fell from a high of around 26,600 on 1/26 to an intraday low of approximately 23,800 on 2/6, a downswing of 2,800 or 11.7% from top to bottom. By definition – typically considered 10% price movement – it was a “market correction”. We think “market correction” tends to carry an underlying investible opportunity connotation – a buy-the-dip moment. The January-February market correction was astonishing to most people, but not to Ballast because we looked at it quite differently. Here are some of the ways we put it into perspective:
Year-over-year price performance of the DJI from December 31 of 1900 to 2017 yields another perspective. Index price returns for December 31 over the prior year-end from 1900 to 2017 generates 117 observations. For the year 2017, the index price return was 25%. This is right at the 20th percentile of observed returns. This means 80% of all the return observations were lower than 25%. For context, the range of returns were -52.7% in 1931 and 81.7% in 1915, all with a mean of 7.4%.
We consider the correction a modest giveback considering the generous returns provided up to January 26, and we would not expect an equally benevolent remainder of the year.
From the beginning of the year at 24,800 to the peak of 26,600, the index gained 7.2%. That annualizes to more than 86% (a level even the most bullish can agree is unsustainable). From the beginning of the year, the DJI was down a paltry 4% to the intraday low, and it was essentially flat by close of February 6. Remember, this was just one month into the year. There are no alarm bells going off here.
Days Not Years
To us, it hardly seemed like a market correction, or at least the buy-the-dip, investible variety. Each leg down in value, we looked back in time and measured the decline in terms of days, weeks, and months since the last time the DJI was at that price. In other words, the price gain that was eroded during the retreat. At its lowest intraday price of 23,800 during the correction, the DJI only retreated to November 28, 2017 price levels. To us, that is hardly a noteworthy movement. If anything, the reverse was true – the run-up from November 28, 2017 to January 26, 2018 was awesome. If the market had retreated more than a year we might be wowed and seek greater opportunity. What this highlights to us, and hopefully to you, is how uncharacteristically one directional (up) the market has been for the past few months and year. It was simply unsustainable, and so, the trend reset.
Think of the market as an intense workout. The athlete needed a break to cool down, but the athlete didn’t have a medical emergency. However, the media would have you believe the market was on life support.
Relative Strength Index
In fact, a popular technical indicator, the Relative Strength Index (“RSI”), which measures average price advances as a ratio of average price declines for a specified period, was at its highest level for DJI since 1904. We saw an internet commentator digitally overlay an image of a protractor on an index price chart with a caption that said, “just checking”. He was making sure the index price chart had not gone to 90° – straight up. It wasn’t far off. We found it funny because we held similar thoughts (a 2-year price chart shows increasing upward acceleration from November 2017 through January 2018). Some call this a “melt-up”, which is something common in late stage bubbles – yep, bubble. It happens as FOMO takes hold and indiscriminate buyers enter en masse.
No science here. Just look at it visually.
Buy the dip or revert to trend?
Another way we look at it is to ask how long it would take for an investor to recoup the lost market value in terms of earnings. (We prefer to think in terms of cash flow, but we’ll settle on earnings here.) The DJI constituents reported 1,240 in 2017 earnings per DJI “share”, according to Bloomberg. The 2,800 peak-to-trough price swing would take 2 ¼ years to regain through earnings. This is nothing to balk at, but the peak price-to-earnings ratio (“PE”) was 21.5x, a lofty valuation by historical standards. As reference, the DJI PE last saw those levels in the Dot-Com bubble. We would say, owning an asset at 21.5x earnings starts with expecting stable long-term intrinsic value, investing without earnings in mind, or expecting strong growth. In any of those cases, the 2 ¼ year breakeven should not now be concerning.