Between a double-digit unemployment rate, sputtering economic activity, and a pandemic that has now taken the lives of more than 120,000 people in the United States, there was plenty to be worried about as equity markets plummeted in the month of March. And after the S&P 500 declined by more than 30% from its February 19th highs, market participants were wondering when – or if – the pain would end. With hindsight, we can see that the market has reported a historic rally over the ensuing three months: as of June 25th, the S&P 500 trades at 3,040 – up roughly 35% from the March lows. From its prior all-time highs, the S&P 500 is down by 10%.
For many, this outcome is confounding. How could the stock market do so well during a period when the “real economy” had effectively come to a halt?
When viewed through that lens, the answer is that few market moves make sense. That’s because the stock market and the economy are not perfectly correlated, particularly in the short-term. As a corollary, it’s a mistake to conflate market volatility (up or down) with the health of the economy.
Many people incorrectly anchor their views on short-term macroeconomic data, rather than the long-term considerations that ultimately determine market prices. That’s an approach that is likely learned from the financial media, which tries to explain what’s happening on a daily basis in the stock market – it’s down one day because of the impact of social distancing on economic activity, then it’s up the next on renewed hopes for a vaccine. Given the fact that there’s always a combination of supportive and concerning data points available, this makes economic data the easiest thing to reference – to use as an explanation for – daily market moves. There’s always an easy answer, even if it’s the wrong one.
The knee jerk reaction for many is to use their views on the economy as a justification for short-term decisions – for example, selling equities. But that approach loses sight of the underlying long-term value proposition offered by individual securities, particularly the shares of high-quality companies whose success or failure is driven by the long-term value that they provide to customers, not a reliance on government intervention or an artificially low cost of capital. If anything, these companies are relative beneficiaries in tough times. As Warren Buffett once noted, “A really wonderful business is very well protected against the vicissitudes of the economy over time and competition.”
That said, it’s always important to remember that one shouldn’t confuse a good company with a good stock. As we’ve discussed in the past, multiple expansion has been supported by the current interest rate environment (a lower discount rate). In addition, we believe certain companies are being rewarded in the stock market based on the fact that they seem to have minimal short-term business risk from COVID-19, as well as the assumed benefit of long-term industry growth (think large-cap technology companies). While we do not disagree with that assessment, it comes with its own considerations. Specifically, there’s a heightened risk for investors that, at some price, the market is pricing in unrealistic long-term expectations (and as a corollary, unattractive expected rates of return). As investors, it’s our job to understand not only what we’re buying, but also our expectation of what that investment will yield in terms of future returns based on the price that it trades at today.
In terms of what lies ahead, the future remains uncertain – just as it was at the highs in February and the bottom in March. There are various pathways that the economy and the stock market can take from here. There are any number of scenarios that can play out – some good, some bad, and some ugly.
A good scenario would include the development of a vaccine or other treatments in the near future, reducing the need for social distancing, providing the conditions for a rapid economic recovery (which would be supported by stimulus and other short-term government fiscal and monetary support).
On the other hand, if social distancing and other measures implemented to hinder the pandemic need to be maintained – or reinstated if there’s a second wave – it will materially impact economic activity. That would likely result in a slow recovery, along with the possibility of a double-dip recession.
Notably, parts of Asia and Europe – and now the United States – have seen a surge in new infections after reopening, which introduces the possibility of a second wave of closures and lockdowns. In a scenario where individuals and businesses are forced to sustain another period with lackluster activity, it’s likely that a wave of bankruptcies and (permanent) layoffs would follow.
Which outcome is most probable? While we attempt to improve our forecasts with each successive data point, the reality is that the future is unknown. We hope for the best, but prepare for the worst.
This overhang of previously unimaginable uncertainty has led some to sell equities. Short-term concerns about social, political, and economic factors pushed them to abandon timeless investment principles, pulling their focus away from the long-term fundamentals that should drive investment decisions. It’s the economic narrative that people internalize and translate into “the market is going to fall,” which leads to short-termism and an attempt to predict economic outcomes.
We appreciate why market participants care about macroeconomic data because the trend and magnitude of global economic activity matter to corporate profitability over the short and long run. But it’s also important to recognize that, from an investment perspective, it’s what you do with the knowledge offered by any given data point that matters (as an example, to avoid making short-term mistakes by overweighting your own perceptions of what this recovery will look like). We can lay out scenarios that are bullish or bearish given the facts, but no one has a crystal ball. Said differently, we always operate under the belief that the short-term macroeconomic environment is uncertain.
How can you have the confidence to invest in the face of uncertainty? We believe the answer to that question lies in the key tenets of our investment philosophy:
- We are investors, not speculators. A share of stock represents an ownership interest in a business. The long-term result of the stock will depend upon the success or failure of the business, not the opinions of other market participants (short-term price movements).
- Asset allocation and diversification are important risk minimization tools. Clients are best served by holding globally diversified portfolios consistent with their investment objectives, risk tolerance, and time horizon. Historically, diversification across non-correlated asset classes and geographies has resulted in reduced portfolio volatility and better risk-adjusted returns.
- We are focused on the long-term. We have a low turnover bias and a long-term time horizon. While asset allocation and security selection are the underlying drivers in the decision-making process, we’re mindful of the costs and tax implications associated with portfolio decisions.
- Decision-making at the extremes matters. When the seas are calm, investors are generally capable of sticking to a long-term plan. But in times of acute stress, most notably when markets are reporting sizable short-term losses, there’s an urge to change course. For many, that “safety” proves irresistible. But it also proves costly. In investing, the ability to stick with an appropriate asset allocation during peak uncertainty is crucial to long-term success. We endeavor to be a voice of reason for our clients in times like February and March when emotions are heightened.
As always, please contact us if you have any questions or concerns.