COVID-19 triggered a rapidly unfolding story of human tragedy and economic devastation. It also unleashed a disturbing volume of content masquerading as objective analysis. Much of it is just a smoke screen to advance personal and corporate agendas.
My inbox, clutter and junk files are full of thinly veiled attempts to gain from, or capitalize on, the historic events we are living through. Some are from perma-bears who, after more than a decade of crying wolf, are claiming justification for their gloomy views. Others are from product providers whose high-fee hedging strategies or “diversifiers” have added no value for years, but are now touting their great performance for the month of March. Even the market timers have re-emerged claiming they can navigate these volatile markets and trauma-proof your portfolio.
This smoke-screen commentary does the advisory profession a disservice. Advisors are seeking help to make sense of the chaos and guide their clients through a volatile period infused with emotion and uncertainty. At best, it distracts from the search for clarity. At worst, it misleads and sends advisors and their clients down a misguided path.
One version is articles that declare that the recent decline in the stock market proves that the market was over-valued. Those articles are inevitably penned by people who have wrongly predicted a decline in the market for years and appear to be seeking vindication for their erroneous prognostications. One example is an article by Bob Rodriguez that recently appeared in this publication. Preliminary Thoughts—The New World Order.
In that article, Rodriguez stated, “Many times I expressed the opinion that I thought the various equity markets were at least 40-60% over valued. Recent events would tend to confirm my assessment…We knew there would be a pin that would prick this unbelievably speculative bubble but we just didn’t know what it would be. Now we do.”
Rodriguez predicted in 2009 that, “if we did not get our economic house in order, we would experience a crisis of equal or greater magnitude than the 2008-2009 period, and that this would take place after 2017.” Showing the courage of his convictions, he stated in a recent interview with Jane Wollman Rusoff that he has not, “had direct ownership of equities since 2016.” The stock market ignored his predictions and rose by over 70% from 2016 through 2019.
Making bold predictions shapes how one perceives events as they unfold. Everyone wants to be right. But the recent market declines had little if anything to do with the market being overvalued or our failure to, “get our economic house in order.”
The market declined because of the adverse and still unquantified impact the coronavirus is having on the firms whose stocks are publicly traded. Rather than showing that the stock market was, “at least 40-60% overvalued,” the recent market declines show that the stock market is performing its function – pricing stocks based on future expected earnings.
Legendary investor, Benjamin Graham, explained the stock market in the following way: “In the short run, the market is a voting machine, but in the long run, it’s a weighing machine.”
What he meant was, the day-to-day price movements of stocks are greatly influenced by news, trends, the popularity of certain stocks or industries, and the emotions of market participants. But in the long term, stock prices are determined by the prospects of the firms whose stocks are traded. A firm’s prospects are measured primarily by its future expected earnings.
Since the emergence of COVID-19, the stock market has been acting both as a voting machine and as a weighing machine. Many people are voting by expressing negative emotions and fears through the selling of stocks. On the very next day, others vote by expressing their optimism and hopefulness through their buying activity.
But the weighing machine is broken.
That is the main cause of the volatility. Market participants know the expected earnings of many firms have been adversely impacted. They also know the expected earnings of a smaller number of firms have improved significantly. But they can’t accurately quantify the impact that COVID-19 will have on the earnings of any of those firms. There’s not enough information available.
Since stock prices are being determined based on incomplete data, those prices are unstable. As new information emerges, the weighing machine incorporates it into its pricing calculation even though the total picture is still far from clear. This creates spikes in stock prices – both up and down – as the weighing machine seeks the “right” price for every stock.
This situation will persist until the weighing machine has enough reliable data to perform its long-term function – providing accurate and reliable prices for the stocks that are traded. In the absence of such information, there will be uncertainty. Markets do not like uncertainty. It creates anxiety, which further damages the voting machine.
Eventually, sufficient data will be available, the uncertainty will dissipate, and the weighing machine will restore order and stability to the markets. There is always some level of uncertainty; the weighing machine is always making adjustments based on new information. But the magnitude of market movements will return to “normal” range – until the next new cycle of major repricing takes place. What will cause it, we do not know.
Once relative order is restored to the markets (and order is always temporary), Rodriguez may find some measure of vindication. Valuations of stocks may be lower than they were pre-virus, as investors “de-risk” or whatever buzz word you want to use to describe the process of becoming more cautious after a period of extreme volatility. But that will not change the fact that recent market declines were caused by a serious hit to the future expected earnings of firms whose stocks are publicly traded, not a pin pricking a speculative bubble.
Why is it important to make this distinction? It helps advisors determine their path forward and how they will counsel their clients. In his interview with Jane Wollman Rusoff, Rodriguez said, “Diversified portfolios have had much of their returns of the last seven to 10 years washed away. I don’t think they’re going to recover 100% of what was lost.”
If advisors accept this view of the world, they could easily provide misguided advice to their clients. An investor who put $100 into an S&P 500 Index fund at the beginning of 2010 would have had about $357 by the end of 2019 (not taking fund fees into account). The market advanced into mid-February 2020 and then declined as much as 30% (the market is currently off its February high by about 22%). A 30% decline in the investor’s portfolio value of $357 would still leave about $250 – a decent, if not spectacular return on investment.
So, even with the market declines to date, the U.S. stock market has been a solid place for long-term investors, despite Rodriguez’s suggestion to the contrary. What’s more puzzling is his suggestion that investors will not eventually “recover 100% of what was lost.” What is his basis for saying this? The market has always recovered from bear market losses. It’s possible that this is the end of markets as we know them, but I wouldn’t bet on it.
The individual firms whose stocks have been punished in this market are already working to turn things around. They’re taking action to minimize the damage, while positioning themselves to thrive once the crisis has passed. Some will be successful, some will not.
The rest of the country has thrown itself into the fight to contain the coronavirus. That effort will succeed. The wheels of commerce will roll again, and the stock market will regain its positive momentum. Patient investors will be rewarded.
I live in Colorado and I like to climb big mountains. Each one is different, and conditions can change from hour to hour. But the rules about how to approach the journey in order to stay safe and maximize the chances of success remain the same. I grow, evolve, and learn from each ascent. But, in the end, the mountain is still a mountain and I am still a man.
Collectively we are climbing a very gnarly mountain. We cannot see the summit. Eventually, we will arrive at our destination. But we will not get there by throwing out the rulebook we have used to get us this far on our journey.
The post-virus world will be different in many ways from the world we just left behind. We will be changed by the experience. In the transformation, our financial markets have been seriously disrupted. But their fundamental underpinnings have not been obliterated and the mechanics of how markets work have not been permanently suspended.
Stay calm, and don’t be pulled off course or distracted by smoke-screen commentary. We must see through the smoke being blown about by those who would turn tragedy into opportunity for themselves, and keep our feet firmly planted on the ground.
Our clients are depending on us.