February 5, 2020
Excerpted from a letter to clients sent February 3, 2020. Anyone can sign up for our quarterly updates here.
After a year of sizable gains, the global stock market has dropped about 3.5% since news of the virus outbreak in China came to light.(1) We’ll discuss the virus scare momentarily, but first we want to share some thoughts on another worry we had recently been hearing a lot about.
For several months we’ve frequently come across headlines and comments about all-time highs in the stock markets. The topic has often been framed as a reason to worry, as if new highs suggest that a decline must be near.
But as we see it, record high market prices are neither particularly newsworthy, nor a cause for concern.
Consider the below chart of global economic growth over nearly 60 years. While there have been slowdowns and pullbacks along the way, the long-term trend has very much been upward. Even the 2008-9 Global Financial Crisis looks like a blip in this long-term history:
The point is that with very few exceptions, the size of the global economy has almost continually cruised along at its then-all-time high. Why shouldn’t stocks do the same?
That they don’t is, in our view, a result of the market’s tendency to overreact. Stocks represent ownership of a very long-term stream of earnings. Yet investors seem to disproportionately focus on near-term events and to be driven by emotions such as fear and greed. As a result, prices move around a lot more wildly than the quite steady underlying trend of economic growth would suggest.
Markets really do overreact
One could argue that investors aren’t overreacting, but are rationally discounting expected changes in long-term earnings. History suggests otherwise. In the chart below, the red and green line shows the estimated fair value for the S&P 500 over the long term based on actual earnings achieved along the way. The blue line shows the S&P 500 price. The fact that prices have been over 17 times more volatile than fair value is a strong indication that investors have, in fact, tended very strongly to overreact to short-term news and to get caught up in cycles of fear and greed. (A deeper explanation of this chart can be found here).
To sum it up, if markets acted rationally, then they would be at all-time highs a lot more often than not! So on those occasions when they do actually hit new highs, we don’t think it’s anything to be worried about.
Of course, it does make sense to worry about whether a market is significantly overvalued. But the price by itself doesn’t provide that information – valuation is determined by price in comparison to estimated fair value (which in the case of stocks largely comes down to the likely long-term earnings stream we mentioned above).
To summarize our stance on current valuations: we believe the US stock market to be significantly overvalued, developed international and emerging markets to reasonably valued, and some areas of developed and emerging markets to actually be undervalued. We take those valuation measures, and their implications for future returns, quite seriously. But we don’t concern ourselves with whether or not markets are at all-time highs.
(By the way, Rich was recently quoted in a Union-Tribune piece about record high prices in the San Diego housing market… unfortunately, his attempts to downplay the significance of all-time highs didn’t make it into the article. ? )
The Virus Scare and Similar Past Crises
In the past couple of weeks, fears have turned to the Chinese virus outbreak. It is legitimately a big story that involves human suffering and uncertainty about what will happen next. But viewed purely from the standpoint of investment markets, there is reason to believe that the long-term impact will be minimal.
It’s a big planet, and the fact is that there is almost always something scary going on. This may include disease scares as well as geopolitical crises, natural disasters, oil shocks, trade wars, actual wars, and more. The human impact can be substantial, but financially speaking, these crises almost always end up looking like blips in the long term.
The two charts above, showing long-term economic growth and stock prices, took place against a backdrop of nearly continual “headline” crises. Yet in spite of the barrage of troubles, the global economy stands at its biggest ever, with stock markets just below record levels. The world economy and markets are simply too big to have been influenced for long by these one-off events, no matter how consequential they were to those involved.
To focus on disease outbreaks in specific, this next chart shows the biggest scares in recent decades, plotted against the global stock markets. It doesn’t look like any of them had a lasting effect on markets.
Source: Marketwatch (click graph for a larger version)
There’s a chance that this time could be the outlier, and that the economic or market impact could be greater than any of those prior events. The odds of that seem low, given the historical record, but we have to acknowledge the possibility.
Even were that to happen, though, the world would come out of it. Consider that first graph, showing long-term global economic growth. That time period consisted not just of headline crises that turned out to be blips, but also of major economic downturns and even the worst financial crisis since the Great Depression. Yet the economy overcame it all in the end, and eventually resumed its upward march.
In short, past disease outbreaks and headline scares strongly suggest a limited lasting effect on financial markets. Even if this outbreak turns out to be a very rare outlier with much more impact than similar events in the past, the global economy should recover in due course, along with the portfolios of value-aware investors.
Know Where You Stand
We can’t know the timing of declines or the events that will trigger them, but there will almost surely be significant stock market downturns again in the future. What we can know, to a reasonable degree of certainty, is the range of volatility that you are likely to experience in your portfolio. If your portfolio volatility level is too high for your comfort, you will be more likely to get stressed out and make poor decisions based on emotion. To help prevent that kind of reaction, we have multiple investment models and do our best to ensure that each client is invested in the appropriate model that will prove to be tolerable when those tough times occur.
Markets have sold off over the past couple of weeks, but that came after a great year, and they still aren’t far from their highs:
If you have any doubts about your risk tolerance, now is a good time to revisit it. You may decide that you are exposed to more volatility than you can tolerate, or perhaps that you could comfortably take on more volatility than you are now (which would increase your expected long-term returns). Either way, we can help you figure it out. Please let us know if you’d like to run through a quick risk reassessment.
It’s also advisable to get a good sense of whether you’re on track to meet your financial goals. If your chance of financial success is a mystery to you, that can result in a feeling of unease that will likely be exacerbated by market downturns. We have great financial planning software that can help remove the mystery. It determines your probability of success by analyzing 1,000 different scenarios that include good outcomes, bad outcomes, and everything in between. A plan that has a high chance of succeeding is one that is built to withstand most, if not all, of the bad outcomes. The peace of mind that comes from knowing where you stand can allow you to endure downturns more easily, worry about money less, and enjoy life more. And that is our ultimate goal.
1 – Source: stockcharts.com, performance of Vanguard Total World Stock ETF (VT)