There's some surprise, among clients and commentators, at the recovery of financial markets as the economic shock of the Covid-19 situation unfolds. Much like the disease itself, the headline data points are somewhat misleading, but we need to consider several key aspects of the data.
This article was originally published in News24
The "market" is not the economy
The economy can be viewed as yesterday's consumption in data form. The current market index price is today's expectations of future earnings. In this way, the market is a discounting mechanism to bring the expected future cashflows into today's values. So, with that in mind, it's perfectly normal to see the two drift apart from each other, and that is especially true in the current climate.
Also misleading is the concept of "the market". Many indices make up this global stock market and much news flow focuses on the S&P 500 in the US. We feel the MSCI All Country index to be far more useful, but any measure has its limits.
At the moment, any headline index is a tale of a thousand stories. Those stories are, however, radically dispersed in content and effect. Dispersion is a measure of the gap between winners (winning stocks and sectors) and losers (losing stocks and sectors). When dispersion spikes, we know the market is dealing with large amounts of uncertainty. This uncertainty is being magnified by the solvency vs liquidity dynamics of this crisis.
Radically different sector stories
Within the headline index price level recovery lie the different stories of the different sectors and how they have been affected by the global shutdown. Clearly the worst hit are airlines, but not far behind are energy, hospitality and property.
E-commerce retailers like Amazon, along with technology and health/pharma sectors are almost back at pre-crisis price levels.Our view is that mega tech and large cap health/pharma look considerably overpriced relative to the economic backdrop. The rest of the broader indices look well-priced on a five-year view. To see this better, we should consider the "factor" lens view.
Value factor at record levels relative to growth
Factor investing is a game of harvesting tiny differences between factors and the index and compounding over time. Therefore, big differences between factors and the index are unusual and usually not persistent. Our portfolios overweight value, small cap, ESG and profitability factors. The value factor is at levels not seen before and this follows almost 10 years of underperformance.
Companies that meet the value factor metric are ones that are below fair value on a price-to-book-valuation basis. This is one of the oldest forms of investing and was made famous by the Sage of Omaha himself.
It accounts for much of the Berkshire Hathaway's underperformance over the past decade. The value premium is the expected additional return available from such companies vs the index. It is not unusual for any factor to have long periods of underperformance. However, current levels are new records.
What type of crisis? Solvency vs liquidity
What looks like good value depends on how one sees the crisis playing out over time. Scenario planning becomes less useful when your best and worst scenarios are on the opposite ends of the extreme.
A key variable in these economic scenarios is the possible second wave of infection and subsequent second lockdowns. A 5% or 10% drop in GDP over a year are radically different outcomes with very different implications for recovery. PwC in the UK has offered the following scenarios for the UK showing a second wave of infection as doubling the impact on UK GDP.
The large fiscal measures being applied by the US, UK and Europe are essentially liquidity stopgaps. However, the damage really begins if the crisis lingers on and becomes about solvency. The pricing opportunity in the value premium available now is reflecting this high degree of uncertainty.
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