Reward v. Risk

Opinion: It’s Never A Good Time To Panic, It’s Always A Good Time To Do The Math
February 27, 2020
Our Dot-com Moment
June 9, 2020

For those unacquainted with every equity position within their investment portfolio, they might want to take a look under the hood. I fear that those who do not are going to be reacquainted with the full extent of their risk tolerance in the very near future. Why? Well…look around.

Investors currently face the very real possibility that unless the best possible – and, perhaps, even best imaginable – economic outcomes are realized over the next six months, the value of a basket of equities that track major market indexes might be approaching the highest levels that they will see for years to come. In the meantime, if history can be any guide, I’m sorry to say that these same indexes probably won’t just tread water.

After global equity (and nearly everything) prices took a terrible tumble to recent lows back in March, as the internals of financial markets ceased up almost entirely, the Fed took steps of unprecedented scope to douse the financial system with the liquidity that it so desperately needed. And it did need it. Having the behind the scenes glimpse that we asset managers have to tic-by-tic prices and price changes of massive swaths of assets across various markets, I can attest to the fact that things got pretty precarious there for a couple of days. Okay, very precarious. This, combined with additional liquidity injected into the financial system on the fiscal side to stave off immediate business a societal collapse due to the fallout of COVID-19 lockdowns, not only had the very welcome effect of preventing the total collapse of financial markets around the globe, but simultaneously set domestic equities on a nearly vertical course towards reclaiming their pre-COVID valuations.

The only problem? The vast majority of the equity securities caught up in this launch towards all time highs probably aren’t worth their pre-valuations from a fundamental perspective, and probably won’t be for some time. That is, in theory, the current price of equity securities should represent a reflection of the current and future earnings potential of any given company. The issue is that, many companies – where earnings guidance hasn’t been suspended altogether – have provided forward looking guidance of their own earnings potential that is far short of where they were at the beginning of the year, prior to the outbreak of the virus that led to the recent economic shock. Yet, although this is widely available information, broad based equity indexes currently march consistently towards their pre-COVID valuations.

As a justification for these present valuations, I have heard things like “The stock market is a forward looking discounting mechanism.” This, in principle, is very true. Typically, participants in in the stock market look to forward earnings potential and pay a price for securities that they believe is warranted based upon the expected return over a given period of time. If the current price is too high according to the expected return over the anticipated investment horizon, a rational investor either does not buy the security or, if owned, sells the security. The opposite is true when the current price is considered to be too low relative to expected earnings. So those who are presently attempting to justify current market valuations are saying things like “Investors are looking through 1st and 2nd Quarter earnings. Investors knew that these would be bad because of the impact of the virus, and they were. What investors are looking forward to are the earnings of these companies once the virus threat has passed.” That investors are looking past last and current quarters’ earnings is also apparently true. While analysts might ordinarily reference the next twelve months of earnings potential while providing their target valuation for a given company’s stock, I have recently seen examples of analysts simply ignoring a company’s expected earnings for the remainder of this year and skipping out to 2021…and beyond. The problem here? Myriad.

The first big issue that I have seen in general is an expectation that things will go “back to normal.” Some analysts are using models that expect for consumer behavior to largely return to something very similar to what it was at the end of last year by the end of this year. The only trouble is that much has changed between the end of last year and the present moment, and much change seems likely to come before the end of this present year too. Changes such as tens of millions of Americans becoming newly unemployed. Sure, we all hope that many of these jobs will return, but many are not expected to. The Congressional Budget Office’s own projection is that the unemployment rate will be as high as 16% in the 3rd Quarter of 2020 and will remain as high as 11.7% in the 4th Quarter of 2020. Those figures represent multiples of 4.2 times and 3.1 times the unemployment rate during the 1st Quarter of 2020, respectively. Perhaps more unsettling is the CBO’s projection for the annual unemployment rate for all of 2021 to remain as high as 10.1%.

Any thinking person can imagine that unemployment rates remaining, on average, as much as 2.5+ times higher than they were six months ago might have a measurable impact on consumer demand and, therefore, not align with an immediate return to “normal”…if what was occurring prior to the virus really could be classified as normal.

Another glaring issue is that the way humans around the globe live and work and play has quite obviously changed over the last several months. One can only imagine that some of the changes will persist regardless of the virus’ apparent threat. However, some of these changes will almost certainly persist in some form if the virus appears to present any threat whatsoever. From what I can tell based upon information provided by various pharmaceutical companies working on treatments and cures for this virus, as well as updates from agencies such as the CDC and WHO, the prospects for durable treatments or a vaccine are still months and months if not a year or more away. This might mean that human life looks different for longer than what is currently being anticipated.

To be clear, I do not believe that the changes to daily life introduced over the last several months will all have a negative impact on global economies. Quite the contrary, in fact. I think that some of these changes, over the long-term, might actually increase productivity and efficiency in some cases and, therefore, contribute to economic growth. But that is in the long-term. Over the near-term, advancements in productivity and efficiency have to contend with elevated unemployment and decreases in consumption associated with said lack of employment, as well as efforts to maintain social distance. At the very least, the impact of these changes on human life cannot be assumed to be a net positive, and should be viewed as an unknown variable over the near and intermediate-term.

In a similarly troubling vein, there is much discussion about economies opening up in the context of things returning to “normal.” Even the best case scenario that could be reasonably expected would include a period of transition into normalcy. It takes no more than a handful of conversations with neighbors, family or friends to realize that not everyone feels the same way about launching themselves back into life the way that they were living prior to virus related lockdowns. Unless the economic activity of those that are ready to get back to the way they were living pre-COVID makes up for the lagging economic activity of those that are more hesitant to resume their pre-COVID lifestyle, there will likely be a resultant net drag on economic activity relative to pre-COVID levels.

Beyond what appears to be a long road to “normalcy,” there is one fact that very few people seem to be paying attention to. According to the classic – and still commonly accepted – definition of a recession, which was two or more quarters of decline in real Gross Domestic Product (GDP) (the timing of a recession is now officially established by the National Bureau of Economic Research), the United States economy is currently in a recession…a deep one. This is according to the Federal Reserve’s observation of a change in 1st Quarter real GDP of -5.0% and the Federal Reserve Bank of Atlanta’s currently forecasted change in 2nd Quarter GDP of -52.8%. Yes, that’s negative 52.8%.

Based upon the extent and expectations for the persistently high relative levels of unemployment and some of the largest drops in national GDP ever recorded, I would not find it terribly difficult to believe that when the period of time that we have been living through and are about to enter into is referred to 20 and 50 years from now that it is referred to as an economic depression and not recession. But that determination is nuanced and usually made in arrears, so only time will tell. Nonetheless, based on the economic data that we have available to us today, we have just seen and are about to see – if the official forecasts are even close to reliable – some of the worst economic hard data points recorded in the last 100 plus years. But, thanks to the quick action of the Federal Reserve and governments around the globe, an instant plunge into the financial abyss was averted and, instead, the effects of economies around the globe largely shutting down for two months will take time to trickle through financial systems. I do honestly believe that this slow burn is preferable to what could have been the alternative, but I also believe that it is naïve at best to assume that these effects can be avoided because they did not materialize all at once. Herein lies my immediate concern.

Investors of all stripes have been conditioned over the last 10 plus years to believe that the Federal Reserve and political representatives will step in and rescue the stock market whenever it appears to falter. And for the last 10 plus years, that has been a pretty safe bet. Unfortunately, because of the economic destruction recently and currently being wrought by the impact of COVID-19, that is what this is assumption is at present. A bet. The question should not be: will the Federal Reserve and lawmakers do everything in their power to buoy the economy, but, rather, can they buoy the economy to the extent currently anticipated by investors?

Knowing all that we know about the last few months, all that we can reasonably forecast about the next couple of months, and what we can see with our own eyes, can we believe that the average fundamental valuation metrics of the companies that are constituents of major domestic equity indexes will be what they were at the end of 2019 tomorrow or six months from now? The data is available to everyone, we just have to look. While shaping our opinion about near-term to intermediate-term economic prospects, it might not hurt to also just look around at the world in general and ask ourselves “What might happen to the value of my investment portfolio in the meantime?” If we find that what we come up with either threatens our long-term financial objectives, or poses the threat of violating our tolerance for risk, it is only rational to evaluate how our assets are allocated accordingly.

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