Before the selloff began, the market was exhibiting the following characteristics – several of which were noted in Brandon Snow’s year-end blog, posted on December 15:
1) At 395 days, it was the S&P 500 index’s most ever consecutive days without a >5% setback.
2) Cash levels continued to hit new lows and net exposure to equities have been hitting cycle highs.
3) Across several brokerage platforms (E*Trade, Schwab, etc.) the number of new brokerage accounts, client activity and trades had been surging.
Source: Bloomberg, February 12, 2018
5) The short VIX trade was in full force, before it came to a screeching halt.
6) According to Bank of America Merrill Lynch (BofAML), global equity fund flows had increased to record levels. They have since reversed.
7) Anecdotally, most investors and advisors agreed that “equities are expensive”, but saw no catalyst to stop the momentum-driven rally.
While these items were concerning (see blogs: Defensive positioning in our most risk-averse portfolio, Year-end review: From trepidation to speculation, Is FOMO driving this market?), it was due to the fewer number of attractively valued opportunities in the markets that we have been holding elevated levels of cash.
The upside of volatility is that more opportunities are now presenting themselves. We are pleased to see rationality returning to a market that has been highly driven by momentum and non-fundamental factors and have been active across the dividend suite, putting some real cash to work. To be clear, the fact that we are putting cash to work is not because we have any particular short-term macroeconomic insight; it is because we are finding specific cases of excellent businesses at prices we feel comfortable paying.
The selloff has been relatively broad-based with correlations rising. This has resulted in great businesses being punished alongside those that present more risk or are generally of lower quality. Here are a couple of businesses we have added to after seeing an improvement in their risk/reward ratio. It is important to note that our team regularly reviews targets to incorporate new information and changing market conditions.
The decline in the share price at a time when fundamentals are broadly unchanged has resulted in a better risk/reward. We have been able to add to this position during this period of volatility.
Despite this stock being off only modestly, both our upside and downside target increased because of an improved fundamental outlook (reported solid numbers with an improving capital allocation pipeline). When combined with the new (lower) price, the risk/reward has improved materially.
Thank you again for your support. Our investment team will continue to apply our fundamentally based investment process to whatever market conditions we find ourselves in.
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