Eight best/worst investment strategies during the coronavirus

The utility of living consists not in the length of days, but in the use of time.

— Michel de Montaigne

For better or worse, many of us have had more time than usual to engage in new or different pursuits in 2020. Even if you’re as busy as ever, you may well be revisiting routines you have long taken for granted. Let’s cover eight of the most and least effective ways to spend your time shoring up your financial well-being in the time of the coronavirus.

  1. A Best Practice: Stay the Course

Your best investment habits remain the same ones we’ve been advising all along. Build a low-cost, globally diversified investment portfolio with the money you’ve got earmarked for future spending. Structure it to represent your best shot at achieving your financial goals by maintaining an appropriate balance between risks and expected returns. Stick with it, in good times and bad.

  1. A Top Time-Waster: Market-Timing and Stock-Picking

Why have stock markets been ratcheting upward during socioeconomic turmoil? Market theory provides several rational explanations. Mostly, market prices continuously reset according to “What’s next?” expectations, while the economy is all about “What’s now?” realities. If you’re trying to keep up with the market’s manic moves … stop doing that. You’re wasting your time.

  1. A Best Practice: Revisit Your Rainy-Day Fund

How is your rainy-day fund doing? Right now, you may be realizing how helpful it’s been to have one, and/or how unnerving it is to not have enough. Use this top-of-mind time to establish a disciplined process for replenishing or adding to your rainy-day fund. Set up an “auto-payment” to yourself, such as a monthly direct deposit from your paycheck into your cash reserves.

  1. A Top Time-Waster: Stretching for Yield

Instead of focusing on establishing adequate cash reserves, some investors try to shift their “safety net” positions to holdings that promise higher yields for similar levels of risk. Unfortunately, this strategy ignores the overwhelming evidence that risk and expected return are closely related. Stretching for extra yield out of your stable holdings inevitably renders them riskier than intended for their role. As personal finance columnist Jason Zweig observes in a recent exposé about one such yield-stretching fund, “Whenever you hear an investment pitch that talks up returns and downplays risks, just say no.”

  1. A Best Practice: Evidence-Based Portfolio Management

When it comes to investing, we suggest reserving your energy for harnessing the evidence-based strategies most likely to deliver the returns you seek, while minimizing the risks involved. This includes: Creating a mix of stock and bond asset classes that makes sense for you; periodically rebalancing your prescribed mix (or “asset allocation”) to keep it on target; and/or adjusting your allocations if your personal goals have changed. It also includes structuring your portfolio for tax efficiency, and identifying ideal holdings for achieving all of the above.

  1. A Top Time-Waster: Playing the Market

Some individuals have instead been pursuing “get rich quick” schemes with active bets and speculative ventures. The Wall Street Journal has reported on young, do-it-yourself investors exhibiting increased interest in opportunistic day-trading, and alternatives such as stock options and volatility markets. Evidence suggests you’re better off patiently participating in efficient markets as described above, rather than trying to “beat” them through risky, concentrated bets. Over time, playing the market is expected to be a losing strategy for the core of your wealth.

  1. A Best Practice: Plenty of Personalized Financial Planning

There is never a bad time to tend to your personal wealth, but it can be especially important – and comforting – when life has thrown you for a loop. Focus on strengthening your own financial well-being rather than fixating on the greater uncontrollable world around us. To name a few possibilities, we’ve continued to proactively assist clients this year with their portfolio management, retirement planning, tax-planning, stock options, business successions, estate plans and beneficiary designations, insurance coverage, college savings plans, and more.

  1. A Top Time-Waster: Fleeing the Market

On the flip side of younger investors “playing” the market, retirees may be tempted to abandon it altogether. This move carries its own risks. If you’ve planned to augment your retirement income with inflation-busting market returns, the best way to expect to earn them is to stick to your plan. What about getting out until the coast seems clear? Unfortunately, many of the market’s best returns come when we’re least expecting them. This year’s strong rallies amidst gloomy economic news illustrates the point well. Plus, selling stock positions early in retirement adds an extra sequence risk drag on your future expected returns.

Could you use even more insights on how to effectively invest any extra time you may have these days? Please reach out to us any time. We’d be delighted to suggest additional best financial practices tailored to your particular circumstances.

 

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Is the stock market overvalued?

Many of our clients have been asking why the stock market has recovered so much in the last two months while the economy is shrinking, and unemployment is hitting record highs. Implied in the question is whether the stock market is “overvalued” and will drop in the near future. The stock market may drop in the future because of new information and events that have yet to happen, no different than any other day. Here we will try to put the market’s actions into perspective and provide an explanation for current share price.

The best way to look at market valuation is through fundamentals. The price of a stock, or the market as a whole, is the value of all future earnings, from now until the end of time, discounted back to today. If you’re retired and think “But I don’t have forever”, worry not because the market does and that’s what prices stocks.

Our valuation equation consists of earnings (numerator) divided by a discount rate (denominator). Earnings will be less this year, though the degree of the drop and its longer-term impact are open to debate. According to FactSet Market Aggregates, analysts are expecting a 22% decline in earnings for 2020 (still positive just smaller than 2019), with 2021 reverting to just shy of what 2020 was supposed to be. If this were to hold, and using a 12/31/2019 valuation baseline, the S&P 500 should be around 3,000 – a 2.7% discount from where it stands today. A larger decrease in earnings or a prolonged reduction in earnings growth would harm stocks further.

Earnings are only half the equation. Even a slight change to the discount rate can meaningfully alter equity valuations. Were the discount rate to drop from 8.2% to 7.7% equities would increase 9.1% in value. The most indisputable thing affecting discount rates at the moment is the drop in inflation expectations and bond yields. If inflation is lower and you’re getting a lower return from a safe investment like a treasury bond, it stands to reason the market will demand a lower return from the stock market, meaning a lower discount rate and higher stock prices.

Many think of stock market returns as an “equity risk premium” or the extra return you get by bearing the extra risk associated with the stock market. Since 1926, the S&P 500 has returned an annualized 7.3% more than inflation and 5.1% more than five-year treasury notes. At the start of the year, the 5-year treasury note was yielding 1.67%, which was about the same as 5-year inflation expectations. Now the five-year note is at 0.33% and five-year inflation expectations are 1.06%. If real bond returns are lower, you’d expect real stock returns to be lower which is manifested through a lower discount rate and higher valuations.

Some argue the market’s increased volatility should mean a higher discount and lower stock prices. This argument has merit and may be partially responsible for lower equity prices. However, others argue the recent fiscal policy of the legislature and monetary policy of the federal reserve has been faster and more accommodating than previously expected. With the government quick to intervene to protect corporate profits and prevent bankruptcies perhaps stocks are less risky than previously thought and the discount rate again should be lower.

Things that decrease future risk, lead to a lower discount rate, and lower expected returns.

In the appendix of this article we run through several scenarios adjusting corporate earnings and discount rates to assess their impact on S&P 500 fair value.  Some interesting observations:

  • At the end of 2019, the price of the S&P 500 Index, projected earnings (analyst expectations in the near term and historical real growth in the long-term), implied a discount rate/expected return of 8.2% over a 50-year window.
  • A temporary reduction in earnings, and a slight decrease in the discount rate can explain current market valuations.

No one knows what the market will do in the coming months, but it’s wrong to think the market must go down. Things like future earnings and discount rates are impossible to know and subjective to each persons’ point of view, but it is not difficult to get to current equity values under reasonable assumptions. The following are key takeaways:

  1. Markets are forward-looking and move when events transpire differently than expected.
  2. Earnings drive prices but one bad year will not make an enormous impact as long as future years return get back close to expectations.
  3. The rate at which future earnings are discounted is very important. A lowering of the discount rate will cause market prices to increase substantially and there is good reason to believe the market’s discount rate is lower today than it was six months ago.

Appendix

Key Terms

Discount Rate: The interest rate used to calculate the present value of cash flows in the future.

Earnings: Corporate earnings, either of a single stock or a weighted earnings of a whole index. For all examples below, we assumed a long-term growth rate of 3.5% which represents the 2% real earnings growth rate we’ve seen over the last 140 years, plus the 1.5% current long-term inflation expectation.

PV of E: The present value of earnings are the future earnings that have been discounted back to today’s dollars by the discount rate.

Value: This is the sum of the “Present Value of Earnings.”

The following table shows the value of a fictitious stock that will earn $5 next year, those earnings will grow 3.5% a year, and the discount rate applied to the stock is 8.5%.

 

 

 

If you sum the “PV of E” (present value of earnings) for the next 50 years you get $90.55. We cut the chart after 11 years to make it fit on one page. The most sensitive variable is how much larger the discount rate is than the growth rate. In this case it was 5%. If we lowered that to 3% (say a 4.5% growth and a 7.5% discount rate) the value jumps to $126/share. If we widen it to 7% it drops to $69/share. What makes valuing stocks difficult is that no one knows future growth, or the market assigned discount rate. A critical thing to note, the discount rate is the expected return.

We can put this formula to practice with the S&P 500 looking back to the end of 2019. At the time, the S&P 500 was trading at 3,231 with expected 2020 earnings of 170.

 

 

 

 

Using the same method of summing the next 50 years, we get an index value of 3,231 (the index’s close on 12/31/2019) from a discount rate of 8.2%.

With this premise in place, we can explore different scenarios. First let’s look at the consensus estimates by Wall Street analysts. They are forecasting the S&P 500 to make 127/share in 2020, with 2021 being close to 2020’s original forecast or 165/share in earnings.

 

 

 

Were that to happen we should see an S&P 500 valuation of about 3,000 or 1.7% below today’s prices. This is assuming no change in the discount rate. This may be what the market is expecting and how it’s currently priced.

But what if the effects of the Coronavirus are substantially greater than the market is expecting. The following scenario assumes earnings are 50% below expectations in 2020, stay at the same level in 2021, and then revert to expectations in 2022 and beyond.

 

 

 

We now get a fair value that is 8.2% below where the market is currently trading. To get a market valuation down in the 2,300s like we saw near the bottom  in March, earnings would have to come in substantially below expectations and would need to have a lasting impact through the rest of the decade, and likely we’d need an increase in the discount rate (we revisit this later).

The prior scenarios are all assuming a change in earnings but not a change in the discount rate. If the discount rate is altered, even slightly, then equity valuations would be meaningfully changed.

If earnings forecast came in on top of expectations, but the discount rate was lowered by 0.70% to match the decrease in the real yield of treasury bonds, we’d actually see a valuation near the record highs we saw in February.

 

 

 

 

The next table incorporates a more severe earnings decrease combined with a reduction of the discount rate. The result is an equity valuation about 3.2% above what we see today.

 

 

 

 

If you’re pining for an equity valuation around the lows we saw at the end of March, the following table is one way to get you there.

 

 

 

We’d need very depressed (50%) earnings for the next two years, followed by a year that gets us halfway back to what analysts are currently expecting for 2021. Furthermore, the discount rate would have to increase to 9.2% which would happen if investors became more nervous because of stock market volatility or if inflation were to increase substantially over expectations.

It is important to remember the relationship between discount rates, valuation, and expected returns. Most people’s Intuition would say to root for a lower discount rate in order to increase equity valuations. However, a lower discount rate means lower expected returns in the future. On the flip side, a larger discount rate would cause the market to drop, but you’d be compensated in the long run by greater expected returns going forward. For the market to do well in the long-run companies need to create wealth and make money.

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Fact checking stock market wisdom

Claim: Stock market volatility has been crazy this month.

Our Ruling: True! This past month has been shockingly volatile. On average, there are 21 trading days in a month. Looking back on the previous 21 trading days ending 3/23/2020, we see an average daily move of 4.56%. There were more days with a 9% or greater movement (3) than days which moved less than 1% (2). The only time we saw more volatility in a month was in November of 1929. What we are seeing now is slightly more volatile than what we saw during the height of the financial crisis in 2008.

Takeaway: If the markets seem wild to you that is understandable and rational. Feeling uneasy because of this is normal.

 

Claim: Because volatility is so high, we will experience a market drop like we saw in 2008 or the Great Depression.

Our Ruling: False! While that claim is possible, believing it to be certain is wrong. No one knows where the stock market will be in a day, week, month, year or decade. The logic of high volatility could have been applied to the stock market in 1987, when in just 4 trading days, the market declined 28.5%. But selling stocks then would have been a mistake. Over the ensuing 10 years, the market did little besides rise, appreciating at an annualized 18.7%.

Takeaway: Timing the market is a zero-sum game, it’s not investing. Every trade has two people on either side of it. If you are selling, someone else is buying. If you sell now thinking you’ll get back in when the market calms down, you’re counting on someone wanting to sell out when the market calms down. You may find markets can rise as quickly as they fall. Investing means enduring the ups and downs and being compensated for it. And you are compensated for it! Even with this month’s move, stocks have returned 9.75% annualized over the last 94 years.

 

Claim: Some investors are irrational.

Our Ruling: True! We have noticed two funny examples in the last month of irrational behavior. The first involved a hot stock and the second an unfortunate trade.

Zoom Video Communications (ZM), the video conferencing company from San Jose, is up 134% this year as their remote conferencing services are growing rapidly. Zoom Technologies (ZOOM), a defunct company from Beijing that hasn’t filed a 10-K in six years, was up 1,890% on the year as of Friday, March 20th. It has no reason to be up other than people confusing it with ZM.

State Street’s Mortgage-Backed Securities ETF, SPMB, had an interesting day on Thursday, March 12th. The fund which holds AAA-rated debt guaranteed by Fannie Mae and Freddie Mac was trading close to flat before plunging 12% in the last half hour of trading. The next day, it rallied to close little changed from where it opened the day before. The reason was a single trader placed a market order, rather than a limit order to sell 500,000 shares or $13 million worth of the ETF. When volatility is high, markets can be thin, especially near the end of the day. The order blasted through the bid, costing the seller roughly $1,000,000.

Takeaway: The market isn’t perfect, and some investors are irrational at times. Be wary of trying this at home on your own!

 

Claim: I should try to profit off other people’s foolishness.

Our Ruling: False! While the capital markets aren’t perfect, it’s the best system there is. Anomalies happen, but they can’t be predicted or modeled, and they vanish quickly.

Trying to profit off the movement in ZOOM is a risky endeavor. You could have bought early hoping for a greater fool to come and pay more in the future. This is a dangerous game; after peaking on Friday, the stock dropped 60% yesterday. You might think you could buy put options or short the stock. Unfortunately, you’d find no options market exists on ZOOM, and good luck finding someone long ZOOM willing to lend you the shares so you can short it. What happened with ZOOM is entertaining but profiting off it isn’t practical and it’s not investing.

There was a quick 10% to be made with SPMB if you bought right at the close on March 12th. To ensure you don’t miss the next opportunity you only need to create a system that monitors the 2,000 ETFs that trade in the United States, have several million in capital ready to put to work, and have the gumption to buy a plummeting ETF on a day the stock market is down 10% and bond liquidity is extremely low. In addition to all that you need another dummy to come along and place the foolish trade. Again, it’s not practical.

Takeaway: Profiting from irrational investor behavior is like betting on a game. In hindsight, it may seem obvious what was happening, but in the moment it’s challenging. You’re only going to make money if the person on the other side of the trade is losing money.

This is separate from investing where you give companies capital, the companies in turn provide goods and services, and wealth is created. You should expect a return from investing, but not from playing a game. At Rockbridge, we try to ensure you are investing.

 

That concludes this edition of Stock Market Fact Checker. Please reach out to Ethan directly if you have any claims you’d like a ruling on!

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