As you are no doubt aware, a fiscal stimulus bill was passed on Friday March 27, 2020. In the coming days, I intend to send you a letter outlining the provisions of the bill and an explanation of how you will be impacted.
Go to www.wellergroupllc.com to view information related to the coronavirus crisis, market perspective letters and links to important sites.
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The topics covered in today’s letter are patterned after many of the conversations I’ve had with investors over the past week. (Disclosure: Weller Group does not endorse any company mentioned in this letter)
How is the stock market (supposed to be) priced?
The stock price of a company should reflect the present value of all expected future earnings of the company – not just the earnings expected over the next several weeks or a few months, but all future earnings, including all of the expected earnings for all future years. A company earns money by selling products and services to consumers. Thus, the collective amount of all products and services we consume – over the coming weeks, months and years – should drive the earnings of a company, which in turn drives the stock price. The combined stock price of all publicly traded companies is “the market.” In theory, future earnings would be used to price stocks. However, we know emotion sometimes takes over as the driving force in determining stock prices.
Will we substantially decrease our consumption of goods and services?
We now know the stock market peaked in mid-February. Since that time, the S&P 500 has decreased by about 25% (as of late morning on Monday March 30th). For a moment, forget that we tend to think of the stock market as the S&P 500 or the Dow. Instead, envision the stock market for what it truly is: the combined share prices of several thousand companies, with the share price of every company reflecting the expected future earnings for the company. Now, reintroduce what we know happened with the stock market in the past month. If the market truly reflects expected future earnings, which in turn are based on expected future consumption from the world population, does it seem reasonable that our expected future consumption will be 25% smaller than it was only a month ago? That is totally unreasonable to me. My belief is this: life will gradually return to “normal,” and as it does most people will revert back to the same behaviors of a month ago. In other words, my belief is we will not decrease our future spending habits to be only 75% of our spending habits from February 2020.
What are stock price dislocations?
Stock price dislocations occur when the internal actions of a company and the external actions of stockholders have a disconnect. As stockholders of a company, the day-to-day internal activity of the company is not transparent to us. However, the day-to-day external activity by stockholders is extremely transparent to everyone: stock prices are broadcast all day long for all to see. Consider Company X. Company X sells laundry detergent, toilet paper, sanitizing wipes, hand soap, dish soap, shampoo, diapers, etc. These products are in high demand due to the coronavirus. Consider the possibility Company X has had to ramp up production due to the increase in demand. While the internal actions of Company X over the past several weeks are probably positive, what do we know about the external actions taken be shareholders? The stock price of Company X has decreased from $126 in mid-February 2020 to $111 as of Monday morning March 30th. This is a 12% decrease in stock price during a time period of abnormally high demand for Company X’s products. It seems reasonable to me this is a price dislocation. In my mind, it is not logical or rational for a company with positive activity to have negative stock performance. However, in periods of uncertainty and confusion, price dislocations appear in every market. Price dislocations tend to last for a while, but not forever. Dislocations create opportunities – at least, for any investor willing to have the patience to wait for stock prices to increase.
What causes price dislocations?
Most investors own their investment products as mutual funds or exchange traded funds (ETFs), rather than owning many different stocks individually. Remember that mutual funds and ETFs are products that pool together many dozens or hundreds or thousands of other securities (securities being stocks and bonds). For example, the S&P 500 is made up of 500 different stocks. Company X is one of the 500 stocks. If an investor wants to sell their S&P 500 fund, it isn’t possible to discriminate between which of the 500 stocks to keep or sell. When selling the S&P 500 fund, all of the stocks are sold…including Company X. In reality, when there is uncertainty and confusion (call this the “fear of the unknown”), investors who decide to sell are extremely unlikely to consider the actual companies whose stocks they will be selling. When there is no discriminating between the stocks to sell and the stocks to keep, everything is sold. When too many investors want to unload all their stocks, prices drop in every sector of the market…and price dislocations appear.
What causes the stock market to be volatile?
In short, fear and greed. Most investors spend most of their investment life simply holding their investments, selling some shares every so often when they need money or buying some shares every so often when they have extra money to invest. Stock prices are supposed to reflect our consumption of products and services, and most of the time consumers have predictable spending habits. However, we know that emotions – whether positive or negative – are a very real part of investing. When stocks skyrocket or decline quickly, it is almost certainly due to emotions taking control over logic. Fear of an uncertain future has definitely influenced some of the selling over the past month.
How do stocks tend to perform during times of crisis?
Historically, the stock market tends to drop before the severity of a crisis is obvious. Stocks tend to be volatile during a crisis as investors digest information. Information changes quickly, often leading to more questions than answers. This offers no clear path out of the crisis and causes a loss of confidence. Stocks also tend to increase before there are clear signs the crisis is fading.
An example of an expert being wrong
You might recall a letter I sent out during the December 2018 market selloff. One of the points of the letter was to assure you human beings are generally terrible forecasters. I’ll use a well-known tech stock, Company Y, as an example of a terrible forecast.
“It’s time to sell [Company Y].” This is an excerpt from the Wall Street Journal – on Saturday August 5, 2017. The article was making a case to sell shares of the companies with the largest market value as “eventually, large numbers start to work against you.”
On Friday August 4, 2017, Company Y traded at $156. On Monday March 30, 2020 – after declining by $77 per share since mid-February 2020, Company Y is trading at $250. Here is the math: despite losing 24% over the past month, Company Y has an annualized 17% rate of growth since the August 2017 WSJ article. In my opinion, this is a remarkable rate of growth for a company that should have been sold three years ago simply for having too large a market value.
An example of an expert being wrong about the stock market
“Whether stocks continue to fall ‘boils down to confidence’… without clear signs that the government stimulus and rescue packages are working, investors have little incentive to buy.” That sure sounds like a headline from the past few days. But it isn’t. This is another excerpt from the Wall Street Journal – on Monday March 9, 2009. This also happens to be the same day the stock market bottomed out from the 2008-2009 financial crisis. Of course, on March 10, 2009 no one knew the stock had bottomed out the previous day…that is exactly the point: none of us will know exactly when the market will bottom out, stabilize and then grow. Markets do tend to increase before there are any clear signs that the crisis has faded.
Some additional headlines from the March 9, 2009 Wall Street Journal:
- “Dow Falls, Now Down 25% for Year”
- “Stock-Market Pullback Isn’t Just ‘Financial’ Now”
- “Mortgage Bailout to Aid 1 in 9 U.S. Homeowners”
These headlines were compiled in a WSJ article published on the 7th year “anniversary” of the March 9, 2009 market bottom. The author was reflecting on how the world, the economy and markets had endured over the previous seven years and survived. I found the last comment from the author of the March 9, 2016 article to be the most meaningful: “The reality of March 2009 remains a good reminder that no one rings a bell when the market bottoms.”
Remember in the coming days and weeks that none of us – not a single journalist, blogger, reporter, financial analyst, hedge fund manager or financial advisor (including me) has the slightest idea what will happen with the markets an hour from now or a day or a week from now. We will not know when the market has truly bottomed out until long after it has happened. The news will almost certainly continue to be negative, pessimistic and anything but optimistic. Consider the last sentence: it is an accurate assessment of the news even in the best of times. Remember in the coming days there might seem to be no hope that this situation will become better. However, eventually, all crises end.
If you want to talk, I’m available.