After a return to what seemed to be an unlimited up market in 2013, stocks are down approximately 5% year to date. Is this the start of a market crash so many talking heads have said is inevitable, or simply the ongoing normal volatility that accompanies markets? To answer, let us start with the key determinants of value and asses the current market environment to determine if any obvious courses of action become apparent.

Over the past 20 years, The Applied Finance Group has been the leader in applying valuation concepts to understand equity markets around the world. The most basic component of AFG’s Value Framework is the following seemingly simple concept:

Value = Future cash flow discounted by a risk adjusted cost of capital.

Over subsequent articles we will deconstruct each component, but for today let us just apply this concept to the overall market and try to make sense of how investors should act in the face of increased volatility. Spoiler alert – the answer is nothing! Markets go up and down and you should only change your long-term strategic investment plan when markets are clearly out of normal valuation boundaries.

As we discussed a few weeks ago, the market entered the year fairly valued. Whether it is valuing companies based on what analysts expect of them or backing into the growth expectations embedded into market prices, AFG’s research showed that large cap stocks are fairly valued.

Therefore, the question facing investors is the following: Since the start of the year, what has changed that would cause a 5% or more decline in market values? In the context of the AFG Value Framework, let us evaluate each component:

Future Cash Flows

Economic Environment

While the economy is growing slowly, it continues to grow and the momentum is expected to accelerate in 2014. The new job number came in below expectations today, but not enough to warrant a significant revision to overall economic growth. With the exception of a few strident politically partisan “clingers”, it is obvious that absent a fundamental change in fiscal policy, the economy will just sputter along. Companies and markets have adjusted to Obama’s economic agenda and as long as Congress stays divided, few significant policy initiatives are likely to pass. The end result is to expect below normal growth for the next few years, consistent with expectations entering the year.

Earnings Environment

Corporate profits have continued to meet market expectations year to date. Both reported results and future guidance have more or less been within the range analysts anticipated. Certainly there have been some winners and losers, but that is always the case. Nothing substantive has changed since the start of the year regarding corporate profitability. If anything, as the Obama administration has continued to push out the implementation of Obama Care, the corporate profit environment has improved in the short run.

From a cash flow perspective, nothing has really changed since the start of the year to warrant a change in equity values. The next question is whether cost of capital issues justifies the decline in equity values.

Risk Adjusted Cost of Capital

The Fed and Tapering

The Fed publicly announced last year that it would begin tapering its ongoing QE program. At the time, the news was met with heated debates on whether investors should view tapering as a sign of sustainable economic recovery or simply a drag on the value equation due to a higher denominator. Given that the Fed is a political animal, I suspect Janet Yellen will arrange a set of policy moves to slow any tapering activities until the economy turns around or another party takes over the White House. This certainly is not unprecedented. Volker was appointed by Carter, but it was not until Reagan became President that he felt it imperative to fight inflation. However, for current purposes, I believe the safe bet is that Yellen will avoid jeopardizing a below average growing economy by turning off the printing presses anytime soon.

Risk Aversion Worries

Whenever there are issues globally, investors get spooked. In some instances it makes sense, in others it does not. In the past year, emerging markets have declined approximately 15%, which is a stunning divergence from the 30% increase in US stocks. However, absent tangible proof that the global economy is headed off a cliff, I would not let the ongoing chirping from the doomsayers change your long-term investment plans. Ultimately, emerging markets are less than 40% of the world’s economy. The markets that dominated headlines recently (Turkey and Argentina) have minimal impact on the world economy.

Bottom Line

It is natural for markets to go up and down. This year is no different, and there is little in the market that warrants changing your long-term strategic plan with which you entered the year. It is very easy to fixate on short-term price changes and extrapolate recent events into the future, but that is typically a big mistake as an investor. The 5% market decline so far this year will mean absolutely nothing to your wealth ten years from now. Unless you believe markets are grossly overpriced, your best course of action right now is to do nothing and let compound returns build your wealth over time.

About Value Expectations 18 Articles

ValueExpectations.com, by the founders of The Applied Finance Group is an investment blog that provides institutional quality equity research using AFG’s proprietary Economic Margin framework.

About Value Expectations 18 Articles

ValueExpectations.com, by the founders of The Applied Finance Group is an investment blog that provides institutional quality equity research using AFG’s proprietary Economic Margin framework.