Prices for stocks, bonds, commodities and other assets have become disconnected from fundamentals. They will need to fall much further if the coronavirus crisis continues for longer than expected, resulting in a deep downturn and a slow recovery.
Markets largely assume that the crisis will be short-lived, a rapid economic recovery will ensue, and policy makers are in control. In truth, the public health crisis from COVID-19 may continue in some form, and for some time. A vaccine is not imminent and may never be found. Even if a vaccine is produced, global vaccination takes time. Even with a vaccine, the virus may mutate, as with influenza or the common cold, starting the cycle again.
Moreover, if one country contains the virus, there will be hotspots and without rapid 100% testing, the ability to move freely, especially internationally, risks new infection waves. The probable scenario is some relaxation of national lockdowns but continuance of travel restrictions and limits on certain activities. Periodic re-introductions of strict controls if there are new outbreaks cannot be discounted.
Ignoring this possibility, current forecasts assume economic activity is restored quickly. Forecast earnings and dividends fall by 25%-50% in 2020 but then return to normal. Valuation models assume a short-term interruption in earnings and cash flows, insignificant over a 10-year investment horizon.
But if the lockdowns persist, then large sectors of the global economy face negligible revenue, losses, no dividends and insolvencies. Significant rises in bad debts are not incorporated in valuations. Without cash flow, risky assets, such as stocks, residential and commercial real estate, and infrastructure, will be worth much less. Investors have failed to grasp that most businesses right now are in survival mode.
Weaknesses in the economic structure mean that any recovery may be tepid at best. Economic activity may stabilize at levels substantially below normal levels. Lower growth, falling incomes and demand, as well as excess capacity, may place deflationary pressure on prices of certain products. Forecasts and asset values do not countenance this possibility.
Investors nowadays are being seduced by false narratives. Price/earnings ratios are predicated on profits. If you assume sharp falls in earnings, then the recent recovery in prices means that multiples are at the same level as when the S&P 500 SPX, -0.52% was at its all-time highs in February 2020. If you assume that stock prices should track earnings, then a 50% fall in profits would correspond to a halving in share prices.
Parallels are drawn with the September 11, 2001 terrorist attack, an unconventional shock which disrupted the real economy and impacted airlines, tourism and hospitality. But this comparison is unhelpful, as economic activity then resumed quickly. The downturn was localized, not global. Stock valuations were lower then because of the earlier dot-com crash. The scope for central bank action was greater because interest rates were higher and balance sheets less stretched.
Policy makers now, in contrast, are increasingly at the limits of their powers and resources. Their actions are designed to prevent a worse downturn, rather than reflate the economy or prices. Besides, additional action may not assist financial assets.
“ Investors currently are experiencing a black hole illusion ”
If current initiatives prove ineffective, then the final option would be for central banks to buy stocks and for governments to take over large parts of economic activity. There would be de-facto partial or total nationalization and a rewriting of economic relationships. At a minimum, this would dilute existing shareholders. In the extreme case, conventional markets would mutate into something closer to Soviet-styled command economies, altering the values of financial assets.
Investors currently are experiencing a black hole illusion. When flying at night, a featureless terrain can mislead pilots into thinking they are at a higher altitude than they are. Consequently, they fly dangerously low and crash. In the same way, markets are ignoring the consequences that may emerge if the COVID-19 crisis is not short-lived.