What’s in a price?
It’s an important question for the markets today. The price decline in equities this week is nothing short of astounding in its magnitude and pace.
On most days, many investors believe that markets are “efficient” – that is to say that the market price of an asset incorporates all publicly known information. These are not “most days” and it is apparent to all that something is off.
That “something” is actually several things:
First, there is an absence of real information on which to form a stable view. There is no shortage of data points and speculation, but little on which the market can solidly rely. Economic data releases as recently as a week ago on retail sales or employment growth are cast aside as outdated.
Second, the three shocks to our global system (supply, demand, and energy) are occurring simultaneously. While it is widely understood that these will drag down growth, there is no ability at this point to measure the depth and duration, especially as policy makers appear reactive in providing sizeable counterbalance. The result is guessing.
Third is the emotion in the face of an “unknown” from the human reality of a health scare. Responsibly, government and corporate leaders are taking action to mitigate large gatherings and unnecessary activities as advised by medical experts seeking to reduce the strain of on our healthcare system. The reality of suspending popular, crowd-oriented activities like collegiate/professional sporting events and holiday celebrations is hitting home in daily lives. The constant “push notifications” appearing on every screen leave us in constant reminder and build our fear.
Wrap all of that into a market whose structure has evolved these last 11 years to be volatility-enhancing and we have daily price action that is untethered from fundamental evaluation. Regardless, even the most tenured investment professional can’t help but wonder if the price knows something we don’t.
As we always do, we work to instill discipline in our emotions and thought processes to help make sound financial decisions amidst this uncertainty. Having set our game plan of quality and preparedness the last time the equity market swooned in late 2018, we are able to see this dislocation as a source of opportunity by thinking over a long term time horizon.
There are three core economic scenarios that could result from these shocks.
The first scenario is the “transitory” view. In this scenario, the demand shock from efforts to contain the virus fades by late spring/early summer. Thus, pent up demand snaps back in the second half of the year (the supply shock is already abating as China is coming back on line) and the financial markets quickly look-though the nasty statistics as an aberration.
The second scenario is a “delayed” view. The demand shock lasts through the rest of the year and perhaps into the early part of the next. Recession occurs but it is a “garden variety” where there is confidence that longer term effects (health and economic) are mitigated. There is a cycle of earnings and defaults, but not outsized.
The third scenario is a “prolonged” view. The disruptions are of a scale that pulls the world into a global recession (or at minimum slow enough growth that it feels like one). Defaults are widespread and there is a combination of lower valuation with depressed earnings that makes the equity bear market on the nastier side of historical experience.
Nobody can say for certain at this point which of these scenarios will be the most likely until we have better information. The timeline for having better information, both a sense that new virus cases are abating and that we see what economic effect has occurred, is likely months.
But we come back to price.
In the absence of good information, the quick swings of price dislocate it from the long term value of a quality business’ earnings stream. However painful, this is called opportunity. History has shown time and again that even the hardest economic and social challenges will be overcome by human resilience and adaptation – time is our best hedge. Determining when financial markets factor in an outcome more pessimistic than the probable reality is the source of value creation. But how much economic downside is priced in?
It’s a hard question. Traders are guessing at “P” (price) and investors are guessing at “E” (earnings). Despite the fact that the price you pay for an asset (ie its valuation) is the primary driver of its future return, that matters only in the long term. In the short-term, psychology drives markets. Market psychologists look at price charts.
The median bear market is a 30% decline. The average is 34%, pulled by the skew of grizzly bears in 2000 and 2007 of 49% and 57% respectively. As of Thursday’s close we are 80-90% priced (26.7% off the high) into the median/average bear market.
Thankfully, we are long term oriented where price (valuation) does matter and volatility smooths out. With that horizon, we know you can’t pick a bottom but you can pick a spot where can feel comfortable having created value by buying a quality asset on sale. On a trailing earnings basis as of Thursday’s close, the P/E ratio is 15x (S&P500 index level 2,480 divided by $165). That is roughly equal to the average trailing P/E since 1935 – a period which on average had much higher interest rates then we do today and expect to have for a while more. A 15x multiple implies an earnings yield of 6.6%, a far heap better than the 10 year US Treasury at 0.7% (and a better dividend to boot), if only there were rational eyes to perceive it.
That is not to say things can’t get worse before they are better. The tumult of these last few weeks is likely to continue until we have sufficient data to form stable views. We need the velocity to slow down to allow rationality to return.
In the meantime, we are harvesting tax losses, re-balancing portfolios, developing buy lists on assets that look dislocated from value, being patient in deploying fresh cash, and actively standing our ground.
Until then, stay safe. Wash your hands. And keep your eyes open for the opportunity of when the worst-possible scenario is priced-in.
Will Skeean, CFA
Partner – Investment Management Team Chair