By Yona Rom, CFA
While this year’s equity market drawdown is painful, understanding the potential impacts of mean reversion helps put things in perspective.
“For every action, there is an equal and opposite reaction.”
While Sir Isaac Newton famously presented this theory almost 350 years ago, its implications still resonate in many areas of life, with the financial markets being no exception.
The 2020 to 2021 period will likely go down in history as an extraordinary time in which financial markets remained resilient in the face of lockdowns, quarantines and economic shutdowns. Opportunities to “buy the dip” were subsequently rewarded as markets were propped up by aggressive monetary and fiscal policy intervention. Many companies raised money at record levels, M&A activity was robust, IPOs were plentiful, and cryptocurrencies and non-fungible tokens (NFTs) created newfound wealth. However, as is often the case, the law of gravity eventually prevailed, removing much of the market’s froth. Specifically, as of November 3rdthe S&P 500 is down roughly 21% year-to-date, capital markets have been closed for much of the year, the term “crypto-winter” has become more common vernacular, and 2021’s IPOs have seen negative 50% returns, on average, since their public debuts.
At the outset of the COVID-19 pandemic, it would have been unfathomable for us to see many investors generating total returns of over 50% from 2020 – 2021. In fact, the S&P 500’s annualized return for the five years prior to 2022 was over 18%—more than 1,000 basis points above the long-term average of about 8%. So, while this year’s 20%+ drawdown is undeniably painful, the average five-year annualized return still stands at about 9%1.
To us, this reversion to mean—or gravity—was highly likely, yet its reversal could occur as well. A rollover of inflation could act as a harbinger of a potential market reset, especially for many equities that have de-rated over the past year while still possessing strong fundamentals. While we cannot predict exactly when inflation could peak—no one seems to ever formally announce a market bottom—we believe that this inflection point is likely to occur sooner rather than later. Effective analysis of company fundamentals should be essential in this next leg of the market cycle: in our view, product/service differentiation matters, as do pricing power, scale and discerning management teams; “outcome makers” and not “outcome takers” will likely prove to be winners in the normalized post-COVID world.
Mean reversion has the potential to have powerful and sometimes painful impacts, and while market volatility often clouds perspective, much to investors’ chagrin, defying gravity only works on Broadway.
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