Oakmark Funds’ Bill Nygren believes now is a great time to pick stocks

Bill Nygren recently released his third-quarter commentary. Here is a summary of what he had to say.

Bonds are performing unusually poorly.

Usually, bonds are less volatile than stocks. And they are generally not correlated with each other. This means that when stocks are down bonds tend to be up and vice versa.

The S&P 500 is down 24% this year. Bonds are faring worse, with the U.S. Treasury 20-year bond down 30% year to date. There have been six years out of the past 30 when the S&P 500 was down. The average loss was 15%. During those six years, the average return of the Bloomberg 20-year+ Government Bond Index was plus 13% and it only had one down year, losing 2%.

What is different this year?

Interest rates started the year at close to zero. As interest rates have risen in an attempt to tame inflation long-term assets including stocks have gone down. The yield on the 20 year Government Bond is 4.13%. It hasn’t been this high since the end of 2013. Yields issued since then are lower than today so the bonds have decreased in value. Stocks have declined because as the risk-free rate rises, the value of riskier assets decreases.

This has been a normal bear market (so far).

The stock market has fallen by 20% 11 times in the past 77 years. After falling 20% the median fall would be another 10% and the bottom would occur 117 days later. On June 13, the market had fallen 20%. Since then we have lost another 7% in 109 days. We are within both a couple of days and a couple of per cent loss of a “normal” bear market.

It could get worse. And it did in half of the previous bear markets. But it’s comforting to know that so far this has been a typical bear market.

Don’t throw in the towel

The table above shows the average 1, 5, 10 and 20-year total returns for the S&P 500 over the past 77 years. It also shows the best and worst returns for each period. There are two things you should note.

One, is the power of compounding. The average return in any given year has been 12%. But keep your money invested for 20 years and your investment will grow almost ninefold.

The second is that as time increases, returns increase but losses also get smaller. The biggest loss of -39% was after a 1-year return. The lowest return after holding for 5 years was a loss of -22% and if you held for 20 years the lowest return was a gain of 155%.

Nygren believes stocks are only for investors who can leave their money in the market for many years.

It is a stock picker’s market

Nygren believes a good time to buy stocks is when there is a wide range in how stocks are being priced. Meaning more stocks than usual are selling at high and low valuations. One way to measure the opportunity is to look at the distribution of P/E ratios.

Oakmark Funds looked at the distribution of trailing P/E ratios for the S&P 500 over the past 30 years. They compared the 450th-highest P/E stock to the 50th-highest P/E stock. They found that the 50th-highest stock averaged a P/E of 47 while the 450th-highest had an average P/E of 11. Today the 50th-highest stock is at a P/E of 50 which is above average and the 450th stock has a P/E of 5.6 which is below average. This range is 40% wider than normal. Nygren believes this is a good environment for picking stocks.

Nygren’s 7 pieces of advice.

1. If you wake up at night thinking about your investment portfolio, you should reduce your risk.
2. Defer discretionary spending until markets have recovered.
3. Don’t listen to media pundits’ advice on market timing.
4. Asset allocation matters, and investing in both stocks and bonds helps control risk.
5. Market volatility creates an opportunity to rebalance to your target asset allocation.
6. When valuation spreads are above normal, look to add value by stock picking.
7. Investors hurt themselves by selling after declines and buying after increases. Do the opposite.