August 12, 2020
These last few months have been difficult for everyone, but for many,
worrying about one’s portfolio hasn’t been the most serious concern.
Nevertheless, whether you look at your savings or retirement account, life goes on and decisions must be made, including doing nothing.
To the extent possible, avoiding having to sell stocks or mutual fund holdings when markets are tanking should be priority #1. This means having enough liquid savings to rely on as a cushion. This may require reducing one’s stock portfolio and therefore the potential for gains. The difficulty here is that it is easy to lament, on a weekly or monthly basis, not participating in rising markets, forgetting that crashes are rare but can cause permanent losses.
Once this liquidity cushion is achieved, holding a widely diversified portfolio with very low annual expenses seems the best choice for anyone holding a full-time job job and with little time to follow companies and their performance. Very low-cost mutual funds that mimic the S&P500 come to mind here.
The power of compounding and staying invested are key to good long term performance: $100 invested in a bond paying a 3% coupon will yield a terminal value of $181 in 20 years[1]. If $100 is invested in a stock whose price and dividend grow by 4% p.a., the end value jumps to $387.
When markets crash as they did in March, it is tempting to sell and bail out (if market induced stress was too high, you probably had invested too much in stocks and need to adjust); if you are an extraordinary trader, this may work. But for most of us, long-term compounding beats trading.
When faced with financial crashes such as that caused by Covid-19 you should ask yourself the following before bailing out or investing more money:
Is this (i) a life changing event, or (ii) do I expect this crisis to be resolved within a few months or years, and the economy to recover within 5 years at the most? If it is (i) you may well want to sell; if it is (ii) you may want to be less drastic. So far, I haven’t lived through what I would call a life changing event;
· Am I invested in great companies that can survive a crisis? If the answer is yes
and I sell now, how will I know when to get back in?
·
Do
I hold so-so stocks which looked like easy speculation when I bought them? If the answer is yes, I should sell and take
my losses.
·
If
I am invested in an industry which is particularly hard hit, am I invested in
the #1 company (i.e. best competitive position, strongest client relationship,
strong financials and management) or in the #3, 4 or 5? And if I sell #3, 4 or 5, do I buy #1 or not?
·
Are
there high-quality companies offered at fire sale prices which may recover within
3 years? If the answer is yes and I have
$100 to invest, why not put $30 to work and start buying them? It is a lot easier to gauge whether a great
company is priced cheaply than to guess whether markets have hit bottom.
This Covind-19 has been very taxing; it has caused markets to plunge some 30% very quickly, and just as quickly these have rebounded to their historical highs (S&P500) or very close to (Nasdaq, Dow Jones). They may still behave erratically.
Clearly, by mid-March, a buying opportunity arose to buy great companies (as defined above) when they were selling at attractive valuations. If one believed that the economy would return close to normal within the next 3 years and so would earnings, then the likes of General Motors (p/e multiple of <4[2]), Microsoft (p/e of 18[3]), Facebook (p/e of 18[4]), even Exxon (p/e of 8-9[5]) seemed quite attractive and worth putting some money into. Such money to come from cash in investment accounts, not the liquidity cushion.
Even then, since predicting market bottoms is impossible, had you bought stocks around mid-March, you could still have taken a 8%-10% paper loss within a week; if you had bought Southwest, that loss would have reached 25% by mid-May after Warren Buffett announced he had sold all of his airline stocks. You then would have asked yourself: Do I sell? Do I stay put? Do I buy more?
People like to quote the famous Rothschild quip: “Buy when there is blood in the streets”. They forget the last two words:”..including yours.” That makes it a lot tougher.
What now? GM, Microsoft and Exxon now sell at approximate p/e multiples of 5.5, 27 and 11 respectively; higher, but not crazy high. Other stocks, particularly in the high-tech and biotech sectors have soared: Facebook’s p/e multiple went from 18 to 34; Apple’s went from 18[6] to 36, Tesla went from 60 to 222[7], and Zoom Video from to 640 to 1,400[8].
The difficulty in making buy/hold/sell decisions in this environment is that, as in most situations, several forces weigh on stock prices and their prospects are either unclear or unknowable. As Yogi Berra, or was it Niels Bohr, once said, “it is tough to make predictions, especially about the future”.
Perhaps the biggest factor is real (after inflation) long term interest rates; what return can you earn taking little risk, if any? For the decade before the 2008 Great Recession, real yields on 10 Year Treasuries averaged around 2% p.a.
After the Recession, as the US and the world recovered, most market actors expected interest rates and inflation[9] to normalize (i.e. rise). That didn’t happen. From 2009 to 2019, inflation averaged 1.6% p.a. and 10 Year Treasurys averaged 2.7% p.a. for a real 1.1% p.a. average real return. Today the nominal yield is 0.67% p.a. and with inflation falling to 1% p.a. in July, the net return has turned negative.
Park your money in US Treasurys and, at current rates, it will shrink in real terms. With the Federal Reserve pumping more money into the economy and with unemployment not expected to return to 3.5% any time soon, risk-free investments are likely to remain value traps for some years to come (yet they should be part of an investment strategy seeking to maintain a liquidity cushion).
The $64,000 question is: what is an acceptable p/e multiple for stocks when Treasury real returns are zero or negative? A lot is the answer, as long as that lasts.
Today, the p/e multiple of the S&P500 is 29, which results in an earnings yield of 3.45% p.a. (1/29). For the Nasdaq, the multiple is 23.5 and its earning yield is 4.25% p.a. Subtracting the nominal return on Treasurys gives us an equity premium of 2.8% and 3.6% for S&P500 and Nasdaq respectively[10]. This looks low. But wait, analysts often refer to 15-17 as a “normal” p/e multiple range for the S&P500; if 3% is also a "normal" nominal yield for 10 Year Treasurys, then we derive more “normal” equity premia of…2.9 to 3.7%? Today’s equity premia no longer look crazy.
Will yields and inflation remain that low for long? So far, forecasters have been wrong. Eventually, there will be a price to pay for the huge issuance of government debt, but this doesn’t seem likely before 2022 or so.
Another factor impacting stock valuations is corporate growth prospects. For most companies, particularly the mature ones, earnings growth will track economic growth over a multiyear period. Covid-19 has wrecked employment and I have doubts that all the people who were furloughed or dismissed will easily find new jobs, and if they do, at the same pay level. This means that we may have mid to high single-digit unemployment for several years, maybe 3 or more. The other side of the coin is that productivity may experience a lasting boost as corporations make do with fewer employees and offices. At the macro level, net-net, the impact of this crisis could be negative: higher unemployment resulting in lower demand resulting in lower corporate profits despite higher productivity levels; the p/e multiples may remain where there are, but if earnings do not recover and grow, stock prices should fall.
In the auto industry, demand is relatively easy to forecast, players are well established and competition is fierce but predictable. Earnings are likely to be fairly stable and p/e multiples rarely get into double digit territory. But what about game changers? Companies that will change the way we live? Companies that develop a new demand and quickly dominate new markets? Apple has been such pioneer with the iPod, the iPhone and the iPad. Facebook is another, as is Google. With huge gains of scale and brand recognition, their pricing power is immense and so are their profits. Is Netflix one of them? Is Tesla?
New markets also create opportunities for new entrants, which complicates the job of investors. Netflix and Tesla have had a strong head start, but they now face competition from powerful but less nimble behemoths: Comcast and Disney for the former, GM and Volkswagen for the latter. These trailblazers may eventually preserve their leadership thanks to their outstanding management, innovative culture and strong product lineup, but many aspiring unicorns will crash and burn. Toyota, the preeminent global auto manufacturer has a market value of $220 billion vs. $294 billion for Tesla. If all goes perfectly and real interest rates remain very low or negative, Tesla’s valuation may prove correct, but in a world of uncertainties it looks high for now. So does the valuation of Zoom Video.
To conclude here, picking companies that will change the way we live is a good strategy and has been proven correct by this health crisis which has crystallized lifestyle changes which heretofore were not evident. The question is how to separate the winners from the ephemeral market darlings? If one could do so consistently, the price paid for the winners would not be a concern. But since nobody strikes .1000, a better strategy is to buy into a basket of innovators or wait for a market crisis to buy an established life-changer at a depressed price.
By curtailing mobility and social contacts, and by raising fears of the future, Covid-19 (and the massive government assistance programs) has boosted the propensity to save; people have postponed air travel and vacations, have reduced entertainment expenses, and generally have saved much more than in the past. These savings have been parked as bank deposits but they have also been invested thereby putting a floor under the market once the March panic subsided.
Finally, human psychology has and will continue to play a role in how financial markets fare. Humans, and their programmed machines, tend to react emotionally, whether selling en masse, trying to ride momentum waves, resisting taking losses or feeling itchy to put investable cash to use. None of us is immune to that.
I would summarize the current market conditions as follows:
I don’t see the two green arrows disappearing soon. I think that we are optimistic on the economy and vaccines: I believe unemployment may stay in the 8%-5% longer than we hope; I believe that we will get vaccines, but it will take months to distribute them, many people may refuse to take them and they may not protect us fully.
It seems to me that now is a good time to sell stocks of mediocre companies which have been carried by the rising tide, or stocks of speculative “high tech” or “biotech” companies which have done well but whose prospects are unclear. I am more hesitant to sell the likes of Apple, Microsoft and other leaders which have AAA balance sheets; sure, they may be ahead of themselves, but their business prospects look good, and if I sell now, when do I get back in?
I would not try to jump onto the momentum bandwagon of hot stocks. Most of the money is made at the time of purchase and buying high almost guarantees a loss. There are still a number of laggard stocks in the banking, transportation and manufacturing sectors but they are not that cheap; these companies are also capital intensive and have comparatively high fixed costs which make them more vulnerable.
Should one be reluctant to sell the crown jewels yet want some downside protection or the opportunity to make some money in case of a future correction, buying put options on the S&P500 when this index sets new highs can be considered. For me, it has always been secondary to keeping a liquidity cushion and to stock selection.
Finally, I would sit on whatever available investable cash. If I didn’t deploy all of it during the March lows, too bad, but I didn’t lose money that way. There will be other opportunities.
In the end, how we manage our financial affairs is a personal decision.
[1]
Pre-tax, assuming a sole annual dividend or coupon payment and that the
coupon/dividend is reinvested.
[2]
Adjusting for net cash of $5billion (the 12/31/19 number) and using EPS
of $4.5 for FY2022.
[3] Adjusting for net cash of $73
billion and using EPS of $7 for FY2022.
[4]Adjusting for $55 billion of net cash
and using a no growth EPS of $7.
[5] Assuming an EPS of $4 for FY2022.
[6]
Adjusting for $75 billion of net cash and using no growth EPS of $12.
[7] Using a conservative flat EPS of $7.
[8]
Estimates.
[9]
Consumer Price Index.
[10]
Using real earning yields and real bond yields would give the same
results.
