Gaining perspective in times of market stress
08th April, 2020
“These are small, but the ones out there are far away” implored Father Ted, gesturing between a set of plastic toy cows on a table and a herd of cattle in a field in the distance. In a classic scene from the eponymous sitcom, Ted tries to explain the concept of perspective to his daft protégé, Father Dougal.
When it comes to making sense of the coronavirus related turmoil that has ravaged global stock markets over the last couple of months, perspective is critical, albeit difficult in times of stress.
We are quickly running out of adjectives to describe how extreme stock market performance was in February and March. And a sense of trepidation is clearly evident across markets as a new quarter gets underway.
It seems there is an absence of guidance from the analogies to the past. Yes, each crisis is unique in its own way but no single factor is usually responsible for driving markets in the longer run. It is therefore imperative to put the market impact of the coronavirus in some context.
Reframing the comparative set
You wouldn’t ever pay €40 for a jar of coffee. However, sold as a one-cup-serving plastic pod and all of a sudden my 40c coffee is only a seventh the price of my Americano. In a similar vein, Rolls-Royce found that an easier way to sell its £300,000 cars was not at motor shows but at boat shows, where, alongside an $8 million yacht, they seemed like a bargain.
If you can reshape your comparative set, you can transform your fortunes. Something can be a ripoff and a billion-dollar business all at once. It’s all about perspective.
Almost everything in finance is similar. For anyone trying to make sense of the financial world, the honest answer to nearly every question is, it depends. Nothing is clear cut; everything's a matter of perspective. And we seem to be losing it in the current crisis.
Without question, there are difficult days, weeks and months ahead, economically and otherwise. There’s no shortage of dire news about the economic fallout from Covid-19. JP Morgan economists released estimates on 25th March in which it is anticipating a US Gross Domestic Product (GDP) decline of 25% in Q2 2020 (annualized quarter over quarter). This would be the largest decline since data has been gathered by the Fed since 1947. And that’s positively sanguine compared to the more extreme forecasts, like that from Goldman Sachs which estimates a 34% drop in Q2 GDP (estimate as at March 31st).
Stock market implications of the Coronavirus
So what does this mean in financial market terms? Stock markets are an extremely good discounting mechanism – essentially baking into prices today what the consensus thinks is the likely outcome several months from now. Remember share prices are the present value of a stream of future cashflows from an asset over the forthcoming 10 or 20 years and beyond.
Clearly markets are concerned about declining corporate earnings as a result of Corona virus. Some sectors will be harder hit than others. But when looking at the magnitude of the fall in earnings now priced into equity markets, JP Morgan, in a report dated 20th March, finds current prices discounting a whopping 45% US earnings decline by the end of 2022 , followed by a slow recovery in which the prior earnings peak is not even reached by the end of the decade.
To put that in perspective, since 1870, with the exception of the Great Depression, it generally took less than four years to regain the peak, and sometimes less than three. Sometimes the market’s expectations for future free cash flow is too optimistic, and sometimes too pessimistic. It would be foolhardy to try and second guess whether market expectations are currently overcooked or under done, given the pace of daily change. Standing back, what’s useful is to consider where the world will be a year from now, since, according to JP Morgan, that has been a useful framework for investors during prior calamities.
Many investors will attempt to buy what they see as the opportunity provided by the recent sell-off through individual company investments. Major crises create changes in the business environment and regulations that reshapes the economy and resets competition. There will be new winners and losers in the post-virus environment. But trying to predict that is a fool’s errand, so it is best to implement this with a diversified approach.
Markets have often bottomed before manifestations of a crisis started to meaningfully improve; If you are waiting for the robins, Spring will be over cautioned Buffett. Indeed global stock markets have rallied strongly since the recent low on March 23rd.
This may not prove the be the ultimate low in this bear market phase. There is the danger that equity and credit markets have run ahead of the as-yet-to-be determined economic fallout. This is not the time for blind trust where you are at the mercy of mood and momentum. Though nor is it a time to require precise answers – the investment landscape is changing weekly.
A prominent financial commentator whom I can’t recall once used the following analogy which is so apt for today’s market. If you are playing Texas Hold’em and waiting for a pair of aces to play, you’ll end up throwing a lot of hands that have a good chance of winning, but aren’t dead certs. Applying that perspective to financial markets over the course of the next year will prove valuable in due course.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.
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