We have received a lot of client questions about why the performance of the “paper economy” (stocks, bonds, mutual funds, etf’s, etc.) seems to be diverging from what we are experiencing in the real economy, both in person and anecdotally from reports on unemployment, consumer confidence and GDP.
The first answer to this is that the market is a forward discounting mechanism. This is a technical way to say that the value of a company, as reflected in the stock market, is not its current liquidation value but it’s future value based on expectations of its future profits the and the subsequent profits on those profits. (Buffet’s 7th Wonder of the World, compound returns) An analogy might be, what would we pay you today if we could buy 10% of your income in perpetuity. The value would not be 10% of your current salary or even 10% of your salary this year and for every year you were expected to live. The value would have to account for raises over your lifetime, we would have to make a calculation for any additional income you may receive from investing a portion of the income you retain, we might want to make a calculation on your life expectancy based on health. The truth is, to determine the current value of your income there are many variables we would need to estimate and calculate. There is one certainty though, the valuation of your future income has very little to do with what you are earning right now. This is the same with a company. As an example, if you had to buy United Airlines and all you got was today’s economic value you would say the company has a negative value. You would be getting a company with no revenue but still significant expenses and debt service. However, if you look forward you can make an estimate of future flights and load factors and costs and figure out what you think the company is worth. (This is still an inexact science and part of the reason that a company’s value fluctuates in the short term as the market disagrees on these variables.)
For readers who think this sounds theoretical we can turn to a recent real-world experience in the oil market to get a picture of current value vs. future value. The oil market is a physical asset market, unlike the stock market. When oil is bought in the physical market it is to be delivered on a certain date to a user. Unlike the stock market, which is projecting a future value, the oil spot market is determined by the amount of supply and demand on that day at that location. At the end of April, because of the huge decrease in oil demand precipitated by the stay at home orders, there was no demand from the market for oil and nowhere to store new oil being delivered. Therefore, at that moment and in that place, oil had a negative value. The cost to take it was greater than the value you could get for it and this was reflected in oil trading as low as negative $40p/bb. (People who had a contract to buy oil and had nowhere to put it were paying others $40 p/bb to take that obligation to receive oil off their hands) However, at the same time oil to be delivered in that same place but two or three months in the future still had a value above positive $20 p/bb. It may still come to be that there is no demand in August or September or that it is much lower than in previous years but for now the market thinks the future value is greater than the current value. This is the same with stocks, investors asses that the future value is greater than the current value and so the “spot” value of the company is not relevant to how the stock is trading today.
This takes us to our next point. In 2008/2009 the GDP fell about 5% but the equity market fell over 50%. In this current situation the GDP is estimated to be down 20% but the large cap equity markets are down only 10-15%. How does this make sense? The answer goes back to our discussion above on forward discounting. In 2008, as the financial crisis developed, there were no day to day statistics indicating the decline might be abating. When investors discounted the future, they were discounting one 5% decline and then another and assumed no quick resolution. In this case, however, investors are seeing daily data that appears to indicate the current outbreak is slowing, they can begin to reasonably discount growth rather than contraction.
Also, at least so far, the initial estimates for infection rates and fatalities appear to have been aggressive, particularly in the center of the country. While the death’s that have occurred are tragic, this “beating of expectations” is generally bullish for markets in the short term.
Another potential driver of the varied performance between the “paper” economy and the real economy is that it is much more difficult for the Federal Reserve to impact the real economy in an immediate way. To get involved in the paper economy the Fed can create money and use that money to directly participate on the bid side of various asset markets. The injection of $100 or $200 billion dollars into the paper economy is a relatively simple and frictionless process.
Injecting money into the real economy, on the other hand, is a much more difficult endeavor. You need Congress to write and pass legislation, you need a bureaucracy to administer and distribute funds, you need oversight and fraud protection and a laundry list other unforeseen issues will likely occur. We have seen this in the initial Payroll Protection Plan (PPP) program where there has been ample evidence of erroneous funding.
The Fed hopes that by stabilizing the paper markets the positive repercussions will reverberate in the real economy. However, that takes time. The initial, and most obvious, effect of the Fed’s actions will be in the paper economy.
Another factor to consider is the importance of the 5 largest stocks in the index to the performance of the S&P500. Microsoft, Google, Facebook, Apple, and Amazon make up over 25% of the S&P500. This decline has been different then 2008/09 in that the market is perceiving that some companies are benefitting from the stay at home order. Microsoft, via its collaborative software and cloud infrastructure. Amazon, with the explosion in home delivery for groceries and other products. These companies also have ample cash and little debt making their future more predictable. The fact that these “benefitting” companies are such significant drivers of the total index is contributing to the spread in results between the “equity market” and the “real economy.” Another indicator of this is that market indexes that do not include the five big tech names or are equal weighted vs. cap weighted are down much more than the S&P500.
None of this is to say that we are highly confident that we will not see further declines in equities as we get individual company and financial reports over the next few quarters, but we thought it would be of interest to lay out catalysts for the current move to improve our client’s understanding.
There are still many unknowns regarding how both the markets and the economy will perform in coming months. As you know, we do not try to time market entries but are generally more bullish equities when valuations are lower and less so when they are higher. With the significant bounce in equities we are pleased with recent buys but are now more circumspect at current levels. We do, however, continue to be selectively active in the market. We believe that replacements for traditional bonds are going to be very important to maintaining client’s long-term financial plans and are active in sourcing attractive replacements.
As always, we welcome any questions or comments. We also continue to encourage you to friend us on Facebook and connect with us on LinkedIn or to find other previous writings under Resources then Insights at www.sterneckcapital.com.