Saturday, February 10, 2018

Testing Times: Market Turmoil and Investment Serenity

The last week has been a roller coaster ride, though more down than up, and investors have done what they always do during market crises. The fear factor rises, some investors sell and head for the safer pastures, some are paralyzed not knowing what to do, and some double down as contrarians, buying into the sell off. In the last week, I found myself drawn to each of three camps, often at different points in the same day, as the market went through wild mood swings. These are my most vulnerable moments as an investor, since good sense is replaced by "animal spirits", and I feel the urge to abandon everything I know about investing, and go with my gut, never a good idea. I know that I have to step back from the action, regain perspective and return to what works for me in markets, and it is for that reason that I find myself going through the same sequence, each time I face a market crisis.

Step 1: Assess the damage and regain perspective
The first casualty in a crisis is perspective, as drawn into the news of the day, we tend to lose any sense of proportion. The last week has been an awful week for stocks, with many major indices down by 10% since last Thursday. If your initial investment in stocks was on February 1, 2018, I feel for you, because the pain has no salve, but most of us have had money in stocks for a lot longer than a week. In the table below, I look at the change in the S&P 500 last week and then compare it to the changes since the start of the year (which was less than 6 weeks ago) to a year ago and to ten years ago.

S&P 500 on date
S&P 500 on 2/8/18
% Change
I know that this is small consolation, but if you have been invested in stocks since the start of the year, your portfolio is down, but by less than 3.5%. If you have been invested a year, you are still ahead by 13.25%, even after last week, and if you've been in stocks, since February 2008, you've not only lived through an even bigger market crisis (with the S&P 500 down 38% between September 2008 and March 2009), but you have seen your portfolio climb 90.48% over the entire period, and that does not even include dividends. That is why when confronted by perpetual bears, with their "I told you so" warnings, I try to remember that most of them have been bearish since time immemorial.

Returning the focus to the last week, let's first look across sectors to see which ones were punished the most and which ones endured. Using the S&P classification for sectors, here is how the sectors performed between February 2, 2018 and February 9, 2018;
Not surprisingly, every sector had a down week, though energy stocks did worse than the rest of the market, with an oil price drop adding to the pain.  Continuing to look at equities, let's now look geographically at returns in different markets over the last week.
While the S&P 500 had a particularly bad week, the rest of the world felt the pain, with only one index (Colombo, Sri Lanka) on the WSJ international index list showing positive returns for the week. In fact, Asia presents a dichotomy, with the larger markets (China, Japan) among the worst hit and the smaller markets in South Asia (Thailand, Indonesia, Malaysia and Philippines) showing up on the least affected list. 

While equities have felt the bulk of the pain, it is interest rates that have been labeled as the source of this market meltdown, and the graph below captures the change in treasury rates and corporate bonds in different ratings classes (AAA, BBB and Junk) over the last week and the last year:
The treasury bond rate rose slightly over the week, at odds with what you usually see in big stock market sell offs, when the flight to safety usually pushes rates down. The increases in default spreads, reflected in the jumps in interest rates increasing with lower ratings, is consistent with a story of a increased risk aversion. Here again, taking a look across a longer time period does provide additional information, with treasury rates at significantly higher levels than a year ago, with a flattening of the yield curve. In summary, this has been an awful week for stocks, across sectors and geographies, and only a mildly bad week for bonds. Looking over the last year, it is bonds that have suffered a bad year, while stocks have done well. That said, the rates that we see on treasuries today are more in keeping with a healthy, growing economy than the rates we saw a year ago.

Step 2: Read the tea leaves
It is natural that when faced with large market moves, we look for logical and rational explanations. It is in keeping then that the last week has been full of analysis of the causes and consequences of this market correction. As I see it, there are three possible explanations for any market meltdown over a short period, like this one:
Market Meltdowns: Reasons, Symptoms and Consequences
Market Consequences
Panic Attack
Sharp movements in stock prices for no discernible reasons, with surge in fear indices.
Market drops sharply, but quickly recovers back most or all of its losses as panic subsides
Event or news that causes expected cash flows, growth or perceived risk in equities to change significantly.
Market drops sharply and stays down, with price moves tied to the fundamental(s) in focus.
Repricing of Risk
Event or news that leads to repricing of risk (in the form of equity risk premiums or default spreads).
As price of risk is reassessed upwards, market drops until the price of risk finds its new equilibrium.
The question in any meltdown is which explanation dominates, since stock market crisis has elements of all three. As I look at what's happened over the last week, I would argue that it was triggered by a fundamental (interest rates rising) leading to a repricing of risk (equity risk premiums going up) and to momentum & fear driven selling. 
  1. The Fundamentals Trigger: This avalanche of selling was started last Friday (February 1, 2018) by a US unemployment report that contained mostly good news, with 200,000 new jobs created, a continuation of a long string of positive jobs reports. Included in the report, though, was a finding that wages increased 2.9% for US workers, at odds with the mostly flat wage growth over the last decade. That higher wage growth has both positive and negative connotations for stock fundamentals, providing a basis for strong earnings growth at US companies that is built on more than tax cuts, while also sowing the seeds for higher inflation and interest rates, which will make that future growth less valuable.  
  2. The Repricing of Equity Risk: That expectation of higher interest rates and inflation seems to have caused equity investors to reprice risk by charging higher equity risk premiums, which can be chronicled in a forward-looking estimate of an implied ERP. I last updated that number on January 31, 2018,  and I have estimated that premium, by day, over the five trading days between February 1 and February 8, 2018. There is little change in the growth rates and base cash flows, as you go from day to day, partly because neither is updated as frequently as interest rates and stock prices, but holding those numbers, the estimated equity risk premium has increased over the last week from 4.78% at the start of trading on February 1, 2018 to 5.22% at the close of trading on February 8, 2018. 
  3. Implied ERP, by Day: January 31, 2018 (Close) to February 8, 2018 (Close)
    Date (Close)
    S&P 500
    T.Bond Rate
    Implied ERP
    Link to spreadsheet
  4. The Panic Response: Most market players don't buy or sell stocks on fundamentals or actively think about the price of equity risk. Instead, some of them trade, trying to take advantage of shifts in market mood and momentum, and for those traders, the momentum shift in markets is the only reason that they need, to go from being stock buyers to sellers. Others have to sell because their financial positions are imperiled, either because they borrowed money to buy stocks or because they fear irreparable damage to their retirement or savings portfolios. The rise in the volatility indices are a clear indicator of this panic response, with the VIX almost tripling in the course of the week. Just in case you feel the urge to blame millennials, with robo-advisors, for the panic selling, they seem to be staying on the side lines for the most part, and it is the usual culprits,  "professional" money managers, that are most panicked of all.
At this point, you are probably confused about where to go next. If you are trying to make that judgment, you have to find answers to three questions:
  1. Where are interest rates headed? There has been a disconnect between the equity and the bond market, since the 2016 US presidential election, with the equity markets consistently pricing in more optimistic forecasts for the US economy, than the bond markets. Stocks prices rose on the expectation that tax cuts and more robust economic growth, but bond markets were more subdued with rates continuing to stay at the 2.25%-2.5% range that we have seen for much of the last decade. As I noted in my post at the start of this year on equity markets, the gap between the US 10-year T.Bond rate and an intrinsic measure of that rate, computed by adding inflation to real GDP growth, has widened to it's highest level in the last decade. The advent of the new year seems to have caused the bond market to notice this gap, and rates have risen since. If you are optimistic about the US economy and wary about inflation, there is more room for rates to rise, with or without the Fed's active intervention.
  2. Is the ERP high enough? Is the repricing of equity risk over? The answer depends upon whether you believe the numbers that underlie my estimates, and if you do, whether you think 5.22% is a sufficient premium for investing in equities. The only way to address that question is to examine it in the context of history, which is what I have done in the picture below:
    Download historical ERP data
    With all the caveats about the numbers that underlie this graph in place, note that the premium is now solidly in the middle of the distribution. There is always the possibility that the earnings growth estimates that back it up are wrong, but if they are, the interest rate rise that scares markets will also be reversed.
  3. When will the panic end? I don't know the answer to the question but I do know that it rests less on economics and more on psychology. There will be a moment, perhaps early next week or in two weeks or in two months, where the fever will pass and the momentum will shift. If you are a trader, you can get rich playing this game, if you play it well, or poor in a hurry, if you play it badly. I choose not to play it all.
Is there a way that we can bring this all together into a judgment call in the market. I think so and I will use the same framework that I used for my implied equity risk premium to make my assessment. You will need three numbers, an expected growth rate in earnings for the S&P 500, you estimate of where the 10-year treasury bond rate will end up and what you think is a fair equity risk premium for the S&P 500. For instance, if you accept the analyst forecasted growth in earnings of 7.26% for the next five years as a reasonable estimate, that the the T.Bond rate will settle in at about 3.0% and that 5.0% is a fair value for the equity risk premium, your estimate of value for the S&P 500 is below:
Download spreadsheet
With these estimates, you should be okay with how the market is valuing equities at the close of trading February 8, 2018; it is slightly under valued at 3.90%. To provide a contrast, if you feel that analysts are over estimating the impact of the tax cuts and that the historical earnings growth rate over the last decade (about 3.03%) is a more appropriate forecast for future growth, holding the risk free rate and ERP at 3% and 5% respectively, the value you will get for the index is 2233, about 16% below the index level of February 8, 2018. If you want put in your own estimates of earnings growth, T.Bond rates and equity risk premiums, please download this spreadsheet. In fact, if you are inclined to share your estimates with a group, I have created a shared google spreadsheet for the S&P 500. Let's see what we can get as a crowd valuation.

Step 3: Review your investment philosophy
I firmly believe that to be a successful investor, you need a core investment philosophy, a set of beliefs of not just how markets work but who you are as a person, and you need to stay true to that philosophy. It is the one common ingredient that you see across successful investors, whether they succeed as pure traders, growth investors or value investors. The best way that I can think of presenting the different choices you have on investment philosophies is by using my value/price contrast:
To the question of which of these is the best philosophy, my answer is that there while there is one philosophy that is best for you, there is no one philosophy that is best for all investors. The key to finding that "best" philosophy is to find what makes you tick, as an individual and an investor, not what makes Warren Buffett successful.

I see myself as an investor, not a trader, and that given my tool kit and personality, what works for me is to be a investor grounded in value, though my use of a more expansive definition of value than old-time value investors, allows me to buy both growth stocks and value stocks. I am not a market timer for two reasons.

  • First, the overall market has too many variables feeding into it that I do not control and cannot forecast, making my valuations inherently too noisy to be useful. 
  • Second, I see little that I bring to the overall market in terms of tools or information that will give me an edge over others.  
The truest test of whether you have a solid investment philosophy is a week like the last one, where you will be tempted to or panicked into abandoning everything that you believe about markets. I  would lying if I said that I have not been tempted in the last week to time markets, either because of fear (driving me to sell) or hubris (where I want to play market contrarian), but so far, I have been able to hold out.

Step 4: Act consistently
During every market crisis, you will be tempted to look and ask that ever present question of "What if?", where you think about all of the money you could have saved, if only you had sold last Thursday. Not only is this pointless, unless you have mastered time travel, but it can be damaging to your future returns, as your regrets about past actions taken and not taken play out in new actions that you take.  My suggestion is that you return to your core investment philosophy and start to think about the actions that you can take on Monday, when the market opens, that would be consistent with that philosophy. I am taking my own suggestion to heart and have started revisiting the list of companies that I would love to invest in (like Amazon, Netflix and Tesla), but have been priced out of my reach, in the hope that the correction will put some of them into play. More painfully, I have been revaluing every single company in my existing portfolio, with the intent of shedding those that are now over valued, even if they have done well for me. If nothing else, this will keep me busy and perhaps stop me from being caught up in the market frenzy!

YouTube Video


  1. S&P 500 Intrinsic Value Spreadsheet
  2. Google Shared Spreadsheet of Intrinsic Valuations


Anonymous said...

Dear Professor Damodaran,

This blog post is probably by some way the most sensible, balanced and well thought out thing I've read all week. Forget all those opinionated journalists and "Twitterati" pontificating in an incoherent and thoroughly subjective manner about what the market is doing and what its going to do next.

P.S. Thank you also Professor, for not abusing the term "investor" like so many do. There are too many people using investor as a synonym for trader.

George said...

I thought that CAPM is an equilibrium model. However I see that you use 10yr rate. Why?

Aswath Damodaran said...

Your understanding of what comprises an equilibrium model must be deeper and more nuanced than mine, but what the heck does it have to do with whether you use a 10-year rate as your risk free rate?

George said...


Unfortunately I don't have a good understanding of the CAPM model and that is why I asked; to confirm and learn.

To my knowledge, CAPM uses the current short-term rate to be consistent with beta estimation/calculation based on regression analysis. Build-up models use the long-term rate. 10yr rate is used because bonds of this maturity are (or perceived as) the most liquid.

Perhaps I'm wrong and would appreciate if you could clarify what risk free rate should be used for CAPM?

RustMore said...

Pretty optimistic GDP forecast, especially when inflation reaches 3+ % and the Fed must cool off things a bit.

Unknown said...

Wonderful article professor.The key is how many of us act rationally. Most of us run away with fear of loosing money.

Rahul Anand said...

Dear Professor Damodaran,
Thanks for sharing your thoughts so transparently. It is amazing to see how the model changes with one's biases of T bond rate, earnings growth and long term growth!
One question: our earnings estimate we are using is based on dividends and buybacks, is that an underestimate (a consistent one at that), because it excludes companies like Amazon and Google that do not pay dividends or buybacks but have still contributed to the S&P50 growth? Or does that get captured in some other way?

Dan said...

Dear Professor ,

on a rising rate environment usually financials tend to outperform . have you built any DCF model which takes into account changing fed fund or ECB rates as well as 10 year bonds to evaluate financial stocks ?
won't it be sensible to check this and take this in account when doing a DCF, especially in Europe where ECB rates are negative and may soon change .



Aswath Damodaran said...

Fed funds and ECB rate changes can affect the short term rates, but the only way they affect intrinsic value is if they have an impact on economic growth. I don't believe that central banks have as much power to change the trajectory of growth in developed markets, as they once had or we think that they do. I would rather focus on inflation and real growth than watch the Fed.

Aswath Damodaran said...

All economic models are equilibrium models. So, that means very little. The CAPM is often derived as a one-period model, but the period can be a minute, a day, a year or 10 years. Using short term treasuries as risk free rates is meaningless if you are valuing a long term string of cash flows, which is what you are doing in valuation.

George said...


Thank you for the clarification. I see your point. Perhaps you can comment on a few other items.

First, since CAPM in a single-period model and we can use 10yr forward rate, should we also use 10yr of historical data to calculate beta used in the model?

Second, we project CF ad infinitum. And in comparison with infinity both 10yr and 3m are very small intervals anyway. It's because the difference between 3m and 10yr is significant from any human beings perspective we may perceive 10yr as a long-term and 3m as a short term. But from mathematical perspective they are still the same on the grand scale of things. And then why not to use 20yr or 30yr? These bonds may be less liquid, but their terms are better aligned with the long-term approach we use in valuation?

Aswath Damodaran said...

On your second point, you are right. Cash flows go on forever, but we stop with 10-year rates, because the other inputs that you need for the model get more difficult to estimate with 30-year betas and the term structure also flattens out. On the first, how you estimate a beta is completely unaffected by what tenor you use for your risk free rate and how you estimated your equity risk premium. In fact, I think regression betas stink, no matter how you finesse them. Look at my corporate finance class on my website for an alternative.

Anarchus said...

I wonder if the S&P 500 growth rate going forward is going to be large enough to support the market near these levels.

If you use nominal final sales (% change, year-over-year) as an estimate of the long-term growth rate of the economy, you get the following chart:

The two substantive differences between the S&P 500 earnings growth rate and nominal final sales would be: (1) while S&P 500 revenues compare closely to nominal final sales, on balance the typical S&P 500 member has a large proportion of overseas revenues that aren't captured in nominal final sales, and (2) S&P 500 earnings obviously vary from revenue growty by the change in profit margin.

However, given that the S&P 500 operating margin is near historic peak levels, I don't think it's reasonable to expect S&P 500 EPS growth to outpace revenue growth over the next decade.