Coronavirus panic, and volatility explained. What's next?
Well - we certainly don't have any more good news since my last email - but I wanted to share a bit about WHY stock prices have dropped so much - and why the fluctuations are so extreme. I want to share some insight into the minutia of stock valuations - hopefully without too much detail that I lose everyone.
When you value any stock (of which the "stock market" is just a compilation of 30 individual stocks in the case of the Dow Jones Industrial Average, or 500 stocks in the case of the S&P 500) - you are ultimately putting a present value on their future profits and/or cash flows. The first input into this calculation is the expectations of what those future profits will be. Companies and stock analysts constantly publish estimates of what future profits may be.
From these estimates - there are two main factors that will influence how you convert future expectations into a current value. Obviously - a dollar today is worth more than a dollar tomorrow (think "a bird in hand is worth two in the bush"). But how much more? The first factor would be current interest rates. If banks were paying 10% interest on a 1-year CD - you would want AT LEAST $1.10 in expected profits a year from now to be worth $1 today. (Keep in mind though - we aren't just looking at one year of profits -we are adding up ALL future years' profits to get a "fair" stock price.") But what this does mean is that as interest rates go DOWN - current values of future profits SHOULD go up (with all else being equal.)
So you may have noticed - interest rates have actually plummeted the last few weeks - with 10-year treasury bond rates going from over 1.5% to as low as 0.5% at the lows of Monday.
But stock prices obviously haven’t gone up – why is that? Obviously, expectations for THIS year’s earnings have come way down – but future earnings estimates haven’t changed much. What has changed is the CERTAINTY of those future earnings. If there is less confidence in the certainty of future estimates – that will lead to a drop in current value of those future earnings. We use what is called a larger DISCOUNT RATE to convert those future dollars into today’s dollars. So while overall interest rates have come down – which would be a positive for stock prices – the uncertainty has gone up – which pushes the discount rate we use up – reducing stock values.
So – what needs to happen for stock prices to stabilize? More than anything – we need this uncertainty to pass, or to get to a point that we EXPECT it to pass at some point. If you remember the 2008-9 financial crisis, the market recovered WELL before the economy recovered – the markets improved when we just started to see that there was a light at the end of the tunnel. I would expect the same thing here – not that we have to get past Coronavirus, just to a feeling that WE WILL get past it.
Think about this in comparison to a rental home. If you had a rental property that could generate $1000/mo in rent, that would be $12,000/year. (Let’s just ignore other costs and say that $1000/mo is net of all costs). Based on a $12,000 income stream – we would assign a value to that home. Let’s say $200,000 – making $12,000 a 6% rate of return (in addition to potential appreciation.) So what would happen if an outside event occurred that made that home unrentable? The value would certainly decrease, but how much? That depends entirely on how long the disruption was expected to occur. If it was just a shortterm interruption and rent of $1000/mo would resume soon – it probably would have very little impact on the value. But if it was a permanent issue like a loss of a major employer in the area – maybe the long term rent rates would decrease as well, causing a larger drop in value.
So comparing this to the stock market, how long do we expect this disruption to company earnings to last, and will it be permanent? The reason for the extreme volatility is that we just don’t know yet – so based on the news and mood of the day – we have very large swings in how much value we put on stocks. We are almost certainly going to have a recession – that is already priced into stocks (in my view.) The economic data for the foreseeable future will be bad – that is already expected. But if we can get to a point that we see the light at the end of the tunnel – stocks would likely be in position for a recovery. Unfortunately – I can’t tell you exactly when that will happen - but from past experience, I would tell you that stocks will recover AS it’s happening – not AFTER it happens. This is why timing the market is so difficult – stock prices can respond instantaneously to news and expectations – not allowing us time to process that information and make decisions before prices move. For this reason – as long as the money we have in stocks (and stock funds) has time to work through this disruption – I don’t recommend panic. I certainly expect life will be “normal” again someday – hopefully sooner rather than later. If 12 months from now, Coronavirus is looked at no differently than SARS, Ebola, MERS or numerous other past epidemics, and future company earnings expectations are just what they were before Coronavirus – it’s quite possible stocks will be back to where they were (All else being equal.) A 30% drop in stock prices would need a lot more than a short-term disruption to make sense (Yes, it’s quite possible other factors are at play as well). But history has shown us that markets often overreact in emotional times – and that as things settle down, markets recover. Obviously, I can’t guarantee anything for stock prices – but that is the reason that stocks have historically provided higher returns. If future earnings and stock prices were very predictable and stable – their returns would be more comparable to lower risk investments.
I could go on for another page about bonds and the risks in bonds, but I’ll save most of that for another day. I will say that anyone investing in bonds needs to be very cognizant and knowledgeable about the risks in bonds. While a bond held to maturity only has the risk of the ability of the issuer to pay – bond values can and do fluctuate prior to maturity as interest rates move. While bonds have been very good investments for the last 30+ years, their risks must be understood. If I am managing your portfolio – I choose funds based on the current circumstances. But the problem for inexperienced investors is that bond funds may show great past returns right now, even in stock market drops, but still have considerable risks. There are funds that own nothing but Treasury bonds that have fallen over 10% this week alone as rates recovered from the lows on Monday. If you’d like a review of any funds you own elsewhere, please let me know.
In closing, I certainly hope everyone stays safe and healthy. I hope your lives are not too disrupted – especially in seeing and spending time with family and friends. And I expect that we will all get back to life as usual in the not too distant future. Please do not hesitate to call if you have any questions or concerns you’d like to discuss.
Ryan R. Roloff, CFP®, ChFC®, CLU®, CMFC®, NSSA®
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing