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

In order to access these opportunities, investors must have a process for comparing the potential reward-for-risk profile of one asset to another, as well as evaluate an asset’s attractiveness across time.

Such a framework cannot be built swiftly in response to a crisis, but must be established in advance.

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Those lacking such a framework are naturally less able to take a longer-term perspective and are more tempted to make near-term predictions of market movements.

The catalyst

Leading up to the recent market collapse, we had believed for some time that many stock markets had growth overpriced, none as much as the US market.

Prices of US stocks made sense to us only in the rosiest of all possible worlds.

That does not mean we predicted the decline, only that we expected future US stock performance to be much weaker than its performance of the recent past (the S&P 500 notched a 31.5 per cent increase in 2019).

The market probably did not need much to spook it out of its belief in US stocks.

Yes, the US economy was stable, and investors seemed confident (the S&P 500 had risen more than 10 per cent in early 2020 before it began its long fall).

But I do not believe that the market bulls were fully considering valuations.

As prices become increasingly detached from a reasonable assessment of the fair value of an asset, the probability of a significant fall increases and consequently the more vulnerable prices become to any period of economic weakness.

We did not get minor economic data, but a rare, massive upset to the global economy.

And arguably, we got two of them – the virus and the oil sell-off. That said, this virus came in like a lamb.

Recall that in the early days of the spread of Covid-19, no one was predicting we would all be stuck at home, unable to meet with friends, go to work, or spend holidays abroad.

Some investors sold out early, but for most it was a minor concern.

Then came a dispute between two of the world’s largest oil producers that sent the price of crude tumbling, bringing stocks down with it.  

The fact that markets fell before the oil dispute suggests that early news on Covid-19 was enough to blur the rosy picture investors were relying on to support high valuations.

Looking at two stock markets through the valuation lens, I think we will find some cause to believe that Covid-19 exposed market weakness (in the form of overpricing), which led to selling, which in turn drove down all global markets.

Overpriced stocks exposed

Going into the market downturn, UK stocks offered one of the best valuation-based opportunities among world markets – developed or emerging.