March 26, 2020

Excerpted from a letter to clients sent on March 26, 2020. Anyone can sign up for our quarterly updates here.

We hope you are staying healthy and safe. We have thoughts to share on several topics, but in the interest of not overwhelming you, we’ll break it up into a few emails. In this letter we’ll cover the following:

  • The government’s economic response to the crisis (huge and unprecedented)
  • Distinguishing between the pandemic’s short-term effects on the economy (likely severe) and its potential impact on the stock market’s underlying fair value (probably not very significant)
     
The government steps in

We won’t rehash what you can read in any newspaper, but we want to emphasize the enormity of the government’s efforts to fight the downturn.

Congress is finalizing a stimulus package worth about $2 trillion – the largest stimulus package in modern history, and over twice as much as during the Global Financial Crisis (GFC). (1) It includes direct payments to individuals, increased unemployment, small business loans, and corporate bailouts.

Meanwhile, the Federal Reserve has already made dramatic changes. They have lowered rates, stabilized money market funds, and begun purchasing US government debt and mortgage-backed securities in huge quantities – all of which they did during the GFC. But they are also using newly created money to lend directly to corporations and municipalities, and even to buy corporate bond ETFs! This is totally unprecedented and would have been unthinkable a couple months ago. It shows that the Fed really is adopting a “whatever it takes” attitude to stem the crisis.

Importantly, the consensus view on stimulus during this crisis is quite different from the post-housing bubble period. Back then, many people were opposed to bailouts in the aftermath of a speculative bubble that had been characterized by a lot of financial recklessness and fraud. This time around, we are dealing with an external shock to the economy. There is no “moral hazard” of rewarding bad behavior like there was during the GFC, and there is widespread support for fiscal and monetary stimulus from across the political spectrum. For this reason, if the efforts to date aren’t sufficient to pull the economy out of crisis, we expect that there will be more to come.

 
A bad economy doesn’t mean stocks are a bad investment

We mentioned in our last letter that we have been rebalancing into the panic and even slightly adding to stock exposure on the big down days. We want to make sure you understand that this is not because of some naïve view that the economy will be fine. We realize that the fight against COVID-19 will continue to inflict serious short-term damage to the economy, and that employment and economic activity have already dropped with a speed that is unprecedented.

But one doesn’t buy stocks as a claim on the short-term economy. They are the claim on a long-term stream of dividends and earnings that can be expected from the companies whose stocks you own. So the question becomes: how will this crisis affect that long-term income stream?

The answer is, “probably not very much.” Consider the below chart of global economic growth, which we will use as a proxy for global corporate earnings:
 


There have been ups and downs along the way, but the upward trend has always resumed. To better illustrate that long-term resilience, here is the 10-year average size of the global economy (rather than yearly as in the graph above). This is a decent representation of what you are buying into when you invest in stocks:
 


Taking a 10-year view, the global economy has risen quite smoothly, and the underlying value of the global stock market has followed along. A lot of scary stuff has happened along the way, but it was never enough to budge that gentle upward slope of long-term value. Even the Global Financial Crisis of 2008-9 – the worst economic downturn since the Depression – is imperceptible when averaged in with the surrounding years.

Can the coronavirus do what the GFC could not? Probably not to any significant degree, once we consider the unprecedented government and central bank intervention described above. Additionally, while the economic impact is more sudden than during the GFC, it’s likely to be more short-term in nature. This time, we are not dealing with a huge bubble that could take years to unwind. We are dealing with a pathogen that will at some point be sufficiently contained that economic activity can start to normalize (the fact that this has already happened in some countries, such as South Korea, shows that it can be done).

Another way to approach this question is to look for similar situations in the past. In this case, the best precedent is the Spanish Flu Pandemic of 1918-1919, which is estimated to have infected one-third of the world population and caused a staggering 50 million deaths. (2)

Ben Inker of GMO examined the Spanish Flu’s impact on stocks’ fair value (shown in the below chart as the value of future dividends and earnings investors ended up receiving over the long run) and found limited impact:
 

S&P 500 Fair Value


There was a decline in fair value between 1911 and 1918, a period which included both the Spanish Flu and World War I, and was followed by a depression which further damaged future earnings. Yet between these three devastating events, the market’s fair value only fell by 1%. (Granted, had it followed the long-term trend it would have grown 8% over that period, so a more severe interpretation is to say that fair value grew by 9% less than one might have expected. Still, even that number pales next to the market declines we’ve seen in the past couple months).

If this period – which endured a major pandemic, a world war, and a depression – could inflict only minor damage to stocks’ fair value, is reasonable to assume that COVID-19’s impact on value won’t be worse than that.

To summarize: while the pandemic’s short-term economic impact might be very severe, it seems unlikely to have a significant impact on long term economic activity and earnings – nor, as a result, on stock market fair value.

While we think this is an important concept to understand, we also realize that people primarily care about price, not fair value. They want to know what they could sell this stuff for. And it is certainly the case that prices can diverge dramatically from their underlying values.

In fact, this is the main premise behind the value-focused investing approach we utilize. Value investors seek to take advantage of these dislocations between price and value in either direction: by avoiding overpriced investments (which protects from long-term losses) and seeking out underpriced ones (which improves expected returns, especially when adjusted for risk).

But that topic really deserves its own writeup. In the next letter, we’ll further discuss the relationship between price and value, and we’ll also survey current stock market valuations and return forecasts.

Watch for that letter next week, and in the meantime, please let us know if you need anything.



1 Source: NY Times, Quartz
2 Source: Emerging Infectious Diseases