The world continues to grapple with the Covid-19 pandemic, but you wouldn’t know it by looking at financial markets. The recent cheerful market mood is a huge turnaround from the complete panic and despair that reigned just four months ago.
During the panic, we were adding to our stock exposure. We described our reasoning in detail at the time, but the very short version boils down to this:
- The pandemic didn’t seem likely to seriously damage long-term fair values.
- Valuations had gotten very attractive, with some areas of the markets even cheaper than they were at the low in 2009.
- Buying (reasonably valued) investments while everyone else is panic-selling can be painful in the short run, but it usually works out well in the end.
So, we bought some stock and braced for more potential pain. Instead, we got a powerful rebound rally that saw stocks gain several years’ worth of expected returns in just a few months.
That leaves us in a very different situation than the one we were facing in March.
Pricing in the best-case scenario
Our optimism in March wasn’t based on the belief that the pandemic isn’t so bad. (It’s bad). What gave us confidence was the fact that most markets were already pricing in the expectation of an extremely bad outcome. That means that if we actually got an extremely bad outcome, it shouldn’t further depress prices, as it was already expected. And a merely less-bad outcome would be a positive surprise.
Markets are no longer pricing in such a dire outcome. In fact, some stock markets seem to be pricing in something closer to a best-case scenario.
We can hope for the best-case scenario, and we might actually even get it. But it doesn’t seem like the most probable outcome. It will take a lot of good fortune to quickly get the economy back to its former level. And even if it gets 95% of the way there, that could still be bad for financial markets, as most corporate profits and cash flows tend to happen at the margin.
Much more so than usual, the near-term outcome is highly uncertain. Markets are not acting like this is the case.
Our current positioning
We still feel like the long-term fair value of stock markets is unlikely to have changed too much. We are more skeptical of the idea that the market has suddenly started to focus solely on the long term. It seems like there is an unusually high chance of another selloff if the stock market doesn’t get the best-case outcome that it seems to be pricing in.
More importantly, valuations just aren’t nearly as good as they were a few months ago. While some areas of the global markets are still priced for very good returns, nothing is as cheap as it was in March, and a few areas have gotten expensive again.
Between the less-attractive valuation environment and the unusually high near-term uncertainty, we chose to reduce our stock exposure as markets continued to recover. (Note: We were a little early on this. In hindsight we could have made a bit more money if we’d waited until now to reduce our exposure, but given the powerful rebound we’d already gotten alongside the uncertain backdrop, we wanted to err on the cautious side. With valuations now having risen further, we feel even more comfortable with the current positioning).
We still have significant exposure to the well-valued areas of the global stock markets, and we will continue to participate if they keep rising. But now we have room to add more if markets do end up deciding that the best-case outcome isn’t a sure thing after all. We feel like this is a good balance between staying invested in good long-term opportunities, and being ready to take advantage should there be another market disruption.