Equity markets are struggling to factor in how long the pandemic will last, how severe it will ultimately prove to be, the likely effectiveness of the policy response, the trajectory of earnings growth in both collapse and recovery, and the savage cuts to dividend distributions.
There are a number of factors we will be following to get a sense of whether the market is finding a bottom and how strong a rebound is then likely.
In the short-term
- Most obviously the infection and recovery rates, especially in countries early in the curve notably China, Italy and Spain. This will determine the speed at which lockdowns elsewhere can be eased and a sense of normality begin to return. A real danger would be re-infection in China.
- Liquidity in the credit markets and the banking system. This has been avoided so far by the swift and decisive action of the authorities, but with the likelihood of defaults rising the continued functioning of the credit markets is essential to keep the flow of money around the economy and people in work.
- Sentiment surveys and early data to show the severity of the recession and the likely effectiveness of the policy response. A secondary round of stimulus should be expected and needs to be delivered.
- Over time, stocks are valued on earnings and cash flow, and this relationship will eventually return. Valuations are optically cheap but this is misleading until there is a better sense of the massive hit to global earnings. When this is more apparent, and if equities are still inexpensive, this will be very positive if coupled with improving pandemic and economic data.
I’ve written in my weekly market update notes of the need for stock markets to find a floor. One of the great challenges has been the roller-coaster daily moves which preclude this ‘floor finding’ mechanism. Prices are ‘where buyers and sellers’ meet; in the first few weeks it was one way traffic as the stock markets fell by a third but latterly there have been some large buying as well. This does not show that we are necessarily past the worst; we have seen some of the biggest daily price rises ever in the major indices but we also did in 2008 well before the bottom of the market in March 2009. Same as well in 1929 but I’m the only one old enough to remember that, or at least it certainly feels like it! These moves are just a sign of huge uncertainty, not yet a returning sense of calm.
In a market update note a few weeks ago we wrote how the stock market recovered from the ‘flash crash’ of 1987, the dot.com collapse of 2000/3 and the great financial crisis of 2008. Vanguard Asset Management have taken this analysis further, with their chart showing the magnitude and duration of bull and bear markets over the last century and highlighting:
- The average length of bull markets is 7.9 years but that of bear markets only 1.3 years
- Stock markets have always recovered from bear markets and gone on to produce ever stronger returns, averaging a real (i.e. after inflation) return of 5% per annum
Our stance remains that however painful it feels, long term investors should remain invested and not ‘cash out’ of the market and, depending on individual circumstances, may consider a programme of phasing in outstanding cash. Missing out on the bull markets is what really hurts portfolio returns.