The real reason stocks fell so dramatically

  • Describe some of the challenges over valuations of stocks
  • Explain the impact of valuations on stocks following the outbreak of Covid-19
  • Identify the importance of valuations on long-term performance
The real reason stocks fell so dramatically

A few months ago, investors were likely smiling.

Major equity markets made a strong start to the new decade, with US equities up more than 10 per cent, continuing a bull market run that started more than a decade before.

But now, in a striking volte-face, the tide has turned as investors adapt to the current risk-off environment.

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This change in sentiment is generally attributed to the economic impact of Covid-19.

Key Points

  • Covid-19 has exposed the overpricing of stocks
  • One gets more value from underpriced stocks
  • Now is a buying opportunity

While the rise of this horrible disease represents a genuine global tragedy, for investors it is a little too easy to attribute the market falls to the novel coronavirus.

From there it is just a short leap to believe that, had Covid-19 not materialised, investors would still be riding high, collectively trillions of pounds richer than we are today.

So, to what extent did the coronavirus expose existing market weakness, rather than cause it?  

Explaining market movements

Market pundits quickly and easily offer explanations for each day’s rout.

But what is often left unsaid is that these are suppositions, if we are being polite (guesses, if not).

No time is given for research and testing – no time is available, given the short deadlines of not just daily press but the instant online press.

In this realm, plausibility carries considerable weight.

So it is with some trepidation and considerable humility that I suggest a cause for market downturns that does not get as much airtime as each day’s explanation.

That cause is valuation and – concomitantly – mean reversion.

Mean reversion is the concept that asset valuations tend toward a long-term mean, or average.

When market valuation measures get very stretched, the snap-back can often shoot right past the centre and into stretched territory on the other side.

We have seen this in individual securities like stocks, as well as in sectors and entire markets.

And I believe we have seen that lately in major stock markets around the world, as well as in bond markets too.

Whenever you see near-zero or negative interest rates, you can bet the market has moved into a stretched position.

These situations create opportunities for fundamental investors – those that take the time to estimate an asset’s fair value and believe it matters. 

‘Underpriced’ assets tend outperform as they become fully priced, while ‘overpriced’ ones tend to underperform as they fall back to fair value, that is, they both tend to revert to the mean.

In the short run, these movements are never predictable.

That is, one can never say” ‘Overpriced asset A will decline by X per cent on Thursday’, or even within the next month, or year.

But we can talk about these things probabilistically: asset A appears overpriced, so we do not like its prospects over the next market cycle (of about a decade’s time).