Reopening: Buy or Sell?
Instead of a historically grim economic outlook decimating the stock market, the S&P 500 yielded a 31% increase since its trough on March 23. With the 2020 S&P 500’s high tallying just less than 3400, the market is making considerable progress back towards January highs. Never-before-seen volatility scared many investors into keeping much of their capital in cash, unaware of the extent to which COVID-19 would affect the future. This unprecedented event forced nearly all investors to continually question the bottom’s location. As states begin to reopen, it is worth questioning if buying stocks is the right move. Could the market be overpriced before the country reopens? Certain statistics are worth examining to determine a proper investment thesis regarding future long or short positions.
When attempting to determine if a stock is overvalued, the Price to Earnings (P/E) ratio proves one of the best metrics. The P/E ratio dictates how much investors are willing to pay for one dollar of a company’s earnings. The best way to determine if a specific equity is over- or undervalued is to compare its P/E ratio to a peer group. Comparing it to other P/E ratios of companies in the same industry with similar market caps, one gains an understanding of the company’s values. One gains an understanding of a company’s valuation when comparing their P/E to the industry average and potentially to similar sized companies within the industry. According to Barron’s, “The PE ratio of the S&P 500 has averaged 15 to 16 for decades. It is now above 20 times estimated 2020 earnings. What’s more, if earnings keep falling because of COVID-19, the market multiple could top the levels seen when the dot.com bubble burst” (1). The market’s P/E ratio listing roughly 20% higher than it’s historical average signifies that a second correction could be near. Noting that the S&P ‘s P/E is even in the realm of the dotcom bubble’s crash should flash red lights. In 2000, the market became incredibly overvalued due to a surge of funds into nearly every technology company.
In addition to valuation multiples signifying an overvalued market, earnings reports also sound alarms. As expected, a month of mandatory lockdown orders decimated consumer demand for nonessentials. Shrinking aggregate demand spared nearly all industries, as few companies met earnings per share expectations. Logically, the primary fundamental driving stock price is earnings; the goal of the stock market is to raise funds for business investment while returning profits to the owners (shareholders). However, this direct relationship has inverted in the past 4-6 weeks. As stock prices increase, earnings decrease.
Another indicator of market sentiment is the Volatility Index. The VIX defines the level of instability within markets. One scholarly publication written by Malcolm Baker and Jeffrey Wurgler explains:
The Market Volatility Index (“VIX”), which measures the implied volatility of options on the Standard and Poor’s 100 stock index, is often called the “investor fear gauge” by practitioners. Whaley (2000) discusses the spikes in the VIX series since its 1986 inception, which include the crash of October 1987 and the 1998 Long Term Capital Management crisis (Investor Sentiment in the Stock Market).
Though the VIX has dramatically decreased from historic heights in April, it still stands at more than double its level before the crash.
Comparing the present situation to past events proves insightful. When examining market crashes throughout history, one must discern event-based crashes from non-event-based crashes. An external force, such as a natural disaster, volatile political climate, pandemics, etc.,causes event-based crashes; these are also referred to as “exogenous” crashes. Internal forces within the market cause non-event-based crashes, such as surplus of bad credit, asset or sector bubbles, etc. According to Forbes.com, exogenous crashes tend to have a bottom of a 30% decline, exactly what the US economy realized in March. These crashes also have an average of a fifteen-month recovery period and last for nine months, considerably different from the current circumstance with markets giving back the entirety of the crash in just one and a half months (2). While it sounds pleasant that exogenous crashes turn green much quicker than endogenous crashes, the current market has made back its gains in about 20% of the time that the average exogenous crash takes. Not only is the country awaiting recession once Q2 GDP is announced, but the country also experienced a bear market. A bear market is a drop in 20% of the stock market, and takes an average of 24 months to recover, according to CNBC (3). There is one major difference between past recoveries and the current recovery: the threat that caused the crash in the first place still looms. While investors that bought stocks as they plummeted cheer this run on, sustainability seems nonexistent to logical thinkers. How could it be that a crash induced by the greatest external threat the market has ever seen recovers so quickly?
There is only one possible driver of a booming market given the conditions: narrative. The effect of narratives on the market becomes greater as people place higher emphasis on the media. An event like a pandemic glues the public’s eyes to every piece of information the media receives, due to the unknown nature of the virus. Nobel Prize winning economist, Robert Shiller conducts a 2017 study on narrative finance, in which he declares, “The human brain has always been highly tuned toward narratives, whether factual or not, to justify ongoing actions, even such basic actions as spending and investing” (Narrative Economics). The key to this quote is placing emphasis on factual or nonfactual. At times, the brain justifies its behavior even if based on irrationalities. Given the overweight of the stock market, 2020 could be the most significant case of narrative power. Shiller studied the effect of epidemics and narratives. One fact is insightful in explaining current market status, “During an actual epidemic, public attention tends to focus on the number of infectives, seen here as a bell-shaped curve skewed to the right” (6). If this principle is applied to the contemporary stock market, its movement seems justified. As the infection curve flattened, where the majority of the attention is directed, the markets increased.
With 40 million people out of work, no treatment, and no vaccine, it is difficult to understand how the stock market surged. Studying the power of narratives on the market seems to justify its recent increase. Considering that the market should be depressed based on its real financial status and it is enjoying a purely narrative driven run, investors should approach buying stocks cautiously. The unsustainability of these conditions given that narratives cannot drive the market permanently suggests that at some point it will be forced to return to its true fundamental valuation. A second correction seems necessary. While there are still some gains to be made back to restore the DJIA and S&P to their January all-time-highs, long-term investors should proceed with caution before allocating large amounts of capital. Speculators willing to take higher risk that markets will recover to their January highs may find now a suitable time to invest. However long-term investors would be better off dollar cost averaging small amounts of funds, and waiting for a second correction in the near future.
References:
1. https://www.barrons.com/articles/stocks-expensive-valuation-wall-street-jargon-pe-ebitda-earnings-51589225609
2. https://www.forbes.com/sites/jamescahn/2020/03/27/covid-stocks-and-the-three-bears/#10142b36d97d
3. https://www.cnbc.com/2020/02/27/heres-how-long-stock-market-corrections-last-and-how-bad-they-can-get.html
4. https://www.marketwatch.com/story/goldman-sachs-analyzed-bear-markets-back-to-1835-and-heres-the-bad-news-and-the-good-about-the-current-slump-2020-03-11
5. Baker, Malcolm, and Jeffrey Wurgler. 2007. "Investor Sentiment in the Stock Market." Journal of Economic Perspectives, 21 (2): 129-152.DOI: 10.1257/jep.21.2.129
6. Shiller, Robert J. 2017. "Narrative Economics." American Economic Review, 107 (4): 967-1004.DOI: 10.1257/aer.107.4.967
