What is the recent market strength telling us?
If the recent market rally has taken you by surprise, you’re not alone. Since hitting a low around 23 March, the S&P/ASX200 Index has rebounded almost 20 per cent, despite a steady flow of grim health and economic news coming out of Europe and the US. So does that mean the market has bottomed?
For our part, we certainly expected a few weeks ago that markets were more likely to step down than up, and in the intervening period have adopted a generally cautious stance while trying to take advantage of selected opportunities in particular stocks. We certainly did not expect a record-breaking rally to appear, absent any significant good news.
So, what to make of the recent market strength and the potential future direction?
There are a couple of observations that can be made here, and the first of them must of course be to highlight that we have very little ability to predict market direction, certainly in the short term, and we need to acknowledge that a wide range of possible scenarios exist.
We can, however, point to a few factors that may shape which of those scenarios are more likely to emerge.
One of these is future news flow, and its scope to surprise the market. In terms of the human tragedy currently unfolding, we certainly expect further bad news in coming weeks. However, we also expect that markets are now fully aware of this and that scenes of COVID-19 victims being wheeled out of hospitals for the last time, while harrowing, will be met with a sense of sorrow, rather than one of surprise. Markets – for better or for worse – are driven by the latter and not the former.
Separate from the human tragedy are the economic impacts that follow it, and on this front we anticipate that there may be more scope for negative surprises. The sudden shutdown of economies around the world is something beyond the experience of any of us, and in a world of complex supply chains and interlinkages there is enormous scope for unexpected consequences and second order effects that no one can yet predict. It is unlikely that many of these surprises will be the good sort.
At the same time, we also believe that good news will come, though perhaps on a slower timeframe. It will come in the form of innovations that improve our ability to effectively combat COVID-19. A vaccine is perhaps the most obvious possibility, but before that arrives there are countless other possibilities in terms of improved testing, treatment and tracking of COVID-19 cases. In managing the virus, the world began 2020 as an absolute rookie. It will surely end 2020 with vastly improved understanding, technology and techniques to deal with it, and should be taking strides back towards some sort of normality well ahead of the expected 12-18-month timeframe for a vaccine.
The path forward then in terms of news flow is difficult to predict. We might reasonably be cautious in the near-term, but with legitimate expectations that things could improve from there.
Another factor that may shape market behaviour is value
It is hard for markets to fall much past the point where value becomes obvious to a large portion of investors, and so it is useful to consider the impact to aggregate market value of a severe, but time-limited, disruption to corporate earnings.
On this front, the picture is perhaps a reasonably positive one, and may shed some light on the recent market strength. The critical point to bear in mind is that a temporary disruption to a stream of cash flows has a vastly smaller impact to value than a permanent disruption. In simple terms, a loss of one year’s earnings for a company has a value impact equal to the discount rate used to value those earnings, and in a world where interest rates are vanishingly small, that can work out to a surprisingly small number. You could think of the earnings stream as being still intact, but simply deferred for one year.
Of course, it may be unrealistic to think that earnings will recover 100 per cent of their previous level, but to the extent that they do recover within a reasonable time frame, the market falls we have already seen could be more than enough of an adjustment to underlying value.
A final consideration is risk. It is stating the obvious to say that markets are volatile and uncertainty is high, and experience tells us that volatility tends to be followed with more volatility. For risk averse investors, even the presence of apparently reasonable value may not be sufficient compensation for the uncertainty involved, and there is ample scope for good buying opportunities today to turn into even better buying opportunities tomorrow.
In thinking about how to approach the current market then, unfortunately it is easier to identify questions than answers. Given the broad range of possible outcomes, it is probably wise to adopt a position that you can live with through any and all of these outcomes, rather than relying too heavily on any one of them emerging. This may mean striking a balance between being invested now at prices that could seem like very good value five years down the track, while keeping enough in reserve to accommodate your risk appetite, as well as the possibility that the real bargains are yet to appear.
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Tim Kelley has retired from Montgomery Investment Management, effective 30 September 2021. Tim’s final project has been drafting our investment guidelines to integrate environmental, social and corporate governance (ESG) considerations into our...