Monday, March 16, 2020

A Viral Market Meltdown III: Pricing or Value? Trading or Investing?

This is the third, and I hope the last, of my viral market updates, reflecting how much change a week can deliver, and last week delivered more change than most investors could handle. Not only did we see two of the worst market days in history, in absolute terms, we also saw the worst single day in US market history since October 19, 1987, in percentage terms. In fact, the price change this week has been so dramatic that it makes the tables that I provided last week on market damage, across sectors and regions,  seem dated. In this post, I will update those tables, but I want to focus on a much larger question of how investors should craft a response to the market meltdown, and how that response cannot be one-size-fits-all.

Price versus Value
I have long drawn a distinction between price and value, two terms that get used interchangeably in both academia and practice, but with very different drivers and implications. As we watch stock indices around the world gain and lose trillions each day, it is worth remembering that markets are pricing mechanisms, not value mechanisms, or as Ben Graham would put it, they are voting machines, not weighting machines, at least in the short term.

The Drivers
To draw the contrast between price and value, I will use a picture that I have used many times before, where I outline the drivers of value and contrast them with the determinants of price:

Note that the drivers of value are cash flows, growth and risk, familiar ingredients in both intrinsic value and fundamental analysis. The determinants of price are both less complicated and more powerful, demand and supply, and all of the forces that drive them. While rational investors may use only fundamentals in setting demand and supply, we know, both from research and experience, that fundamentals are drowned out in markets, by mood and momentum. Markets have always been pricing games, with the degree of weight put on fundamentals ebbing and flowing over time, with less weight assigned in good times, and more after market corrections. During periods like the last three weeks, the market is all pricing all the time, with fundamentals not even on the radar. That does not make markets wrong, but it does make them difficult to decipher and tricky to navigate.

The Differences
If you accept the distinction between price and value that I have drawn, it can be used to draw out why price and value diverge, and frame investment philosophies around those divergences.

1. Price has no upper or lower bound. Value does.
Since price is determined by demand and supply, and there is nothing that constrains those buying and selling in markets, at least in the near term, it follows that there is no upper or lower bound to prices. In short, the prices of stocks can move towards infinity or towards zero, depending on where mood and momentum take them. Value on the other hand has both upper and lower bounds, with both bounds being set by expected cash flows, growth and risk. The upper bound is set by those who are more optimistic about a stock and what they forecast the fundamentals to be (high cash flows, high growth and low risk) and the lower bound by those who are most pessimistic about that same stock, in terms of future expectations or liquidation value. It is true that reasonable investors can disagree about where these bounds lie, but they should not disagree about the existence of these bounds. It is possible, for some stocks, especially early in the life cycle and with substantial uncertainty about the future, for the lower bound on value to be zero, but stocks collectively cannot have that lower bound. For equities collectively to be worth nothing, you would require an apocalyptic scenario, one in which there is little point thinking about investments anyway.

2. Price is reactive, Value is proactive!
Information is the lubricant for market movements, but information works differently in the pricing and value processes, on two dimensions:
  1. Incremental Information versus Fundamental Information: If pricing is driven by mood and momentum, those forces can take information that, at least at first sight, seems insignificant, from a value perspective, and cause price changes that are disproportional. Thus, when the mood is upbeat, small pieces of good news can result in big jumps in stock prices, but if that mood turns sour, small pieces of bad news can cause large drops in stock prices. To illustrate, the 10% plus drop in US stocks on Thursday (3/12) was supposedly caused by the Trump Administration's decision to bar flights from Europe for thirty days, and the almost equivalent jump the next day (3/13) by its decision to declare an emergency. 
  2. Reactive versus Proactive: Since pricing is determined entirely be demand and supply, and there is no value center to it, it is, by its very nature, reactive. Put simply, traders react to the incremental information to adjust the price, and put little thought into whether the starting price itself has a basis to it. Thus, a starting price that is too high (low) will only get higher (lower), if the incremental news that comes out is good (bad). On the other hand, value is driven by expectations of cash flows, growth and risk, and incremental information has to be used to reassess those expectations, a more difficult task, but one that forces you to separate the wheat from the chaff. 
In periods of pricing tumult, like the last three weeks, it is both futile and perhaps counter productive to try to explain big pricing moves, especially on a day-to-day basis, with the language and tools of value. If I could make a suggestion to the financial news channels now, here is what it would be. Remove all the talking heads (including me) from the screen, and just show the stock indices in real time. This is a market that needs no commentary!

3. Equity prices may never converge on value (at least in your lifetime or mine).
Old time value investors live by the adage that prices can go up and down, with little relationship to value, but that they eventually converge on value. That sounds reasonable until you consider what "eventually" means, at least in the context of equity in a publicly traded company. Absent a catalyst causing the convergence, it is true that price will not only diverge from value in the short term, but it could do so for very long time periods. Put simply, assuming that you will be rewarded for being right on value can be a pipe dream, and Keynes was correct when he said that the "market can stay irrational longer than you and I can stay solvent".  So what is it that keeps investors toiling at the fundamentals, hoping to get rewarded? The answer is faith, faith that they can estimate value and faith that the price will adjust to value. It is faith because I can offer you no proof for either proposition, and it is faith, because its strength will be tested by markets like this one.

An Investing Game Plan
If you are wondering what all of this discussion of price and value has to do with how you should react to the market drop, I will argue that your response has to be tailored to (a) whether you have faith in investing (b) how much liquidity you have or need and (c) where you see yourself as having the biggest edge over the rest of the market.

Do you have faith?
In the abstract, most market participants describe themselves as long term, patient and believers in value. Books about Warren Buffett outnumber those sold about any other market player, by ten to one, but I think one of his pithier sayings comes to mind, when evaluating whether people mean what they say about being long term value investors. Buffett once said that it is only when the tide goes out that you can tell who’s been swimming naked, and it is only when the market goes into crisis mode that you can tell the investors from the traders. So, if you came into the February 2020, describing yourself as a believer in value, do you still believe? If yes, what have you done or not done during the last three weeks that is consistent with that faith?  My faith in value and price adjusting to value is strong, but it is not absolute. I have found myself questioning my own beliefs at times during these weeks, just I did in 2008, and I believe that is not only natural, but healthy. My faith still holds, but I have a feeling that there are more tests to come.

Are you selling or buying liquidity?
There is no stronger resource to have during a crisis than a cash cushion, since investors seek out liquidity and are willing to pay handsomely for it. That said, whether you can buy or sell liquidity may not be in your control and is affected by outside forces:
  • Income Predictability: If you are feeling a little less secure about your income prospects after the last three weeks, you are not alone, and while this will pass, it does affect how much cash you need to conserve, just in case.
  • Cash Needs: Virus or no virus, house payments have to be made, credit card bills paid and unexpected costs covered, and a shakier economy make all of these obligations more onerous.
  • Personal make up: I believe that the key to picking an investment philosophy that is right for you is to make sure that you can pass the sleep test, with it. Put simply, if you lie awake at night thinking about your portfolio, you’ve failed the test. If you are naturally impatient, your time horizon is shortened, and no lecture on the importance of long term investing or data backing up that it works, can change that.
If you add mortality to this list, and the fact that if you manage other people's money (in a mutual or hedge fund), it is their time horizon that may matter, not yours, it is easy to see why what is perceived as liquidity in good times very quickly dissipates in bad one. If you are sitting on a cash cushion, you are already in a much better spot than those who do not have that luxury, but there are two uses that you can put the cash to, one passive and other active. The passive response would be to hold on to the cash, preserve your sanity and pass the sleep test, as markets stay volatile. The active response is to use the cash to take positions, though what you will invest in will depend on whether you believe in value or price, and within each of these, where you think that market is mistaken. If you are in the less enviable position of needing cash quickly, either to meet a liquidity crunch or to stop failing the sleep test, you should sell some of your holdings, though what you sell will reflect again your beliefs about market mistakes.

What is your edge?
To succeed as an active market player, you have to bring something to the table, and recognizing the edge that you bring is key to success, and that is true whether you are an investor (who believes in value) or a trader (who plays the pricing game).
  • As an investor, your skills may lie in assessing the entire market, sectors or individual stocks, and this crisis has brought those all into sharper focus. 
  • As a trader, you can be good at riding momentum or detecting shifts in it and making money from reversals, and the opportunities for both have expanded, as market volatility has expanded.
In either case, you will get an opportunity in the coming weeks to plot your own path through this crisis, and as I mentioned at the start of this post, it will not be one size fits all. 

Choosing your Game Plan
In the picture below, I have outlined how your faith or its absence, liquidity or lack thereof and your perceived edge will all come into play in determining what is your best path of action.


I have never believed in offering investing frameworks, without being open about the choices that I am making, not because they are the “right” ones, but because they are the ones that work for me. I believe in value, and I am lucky enough to have liquidity. I believe that I can bring more to the table, when valuing individual stocks, than I can, in assessing sectors or markets. 

What now?
I know that this post has meandered and I am sorry, but in this last section, I will come back to the numbers, by first updating my valuation of the S&P 500 and then moving on to both update the tables on market damage from March 6 to reflect the last week's market action. 

Valuing the Index
While some of you will view this as a futile exercise, I revisited my S&P 500 valuation spreadsheet that I created two weeks ago, and updated it, to reflect an expectation that the earnings damage this year is likely to be larger than I initially estimated. Rather than provide a single value estimate for the S&P 500, I have run a Monte Carlo simulation around the four key inputs: earnings drop this year, the percentage that will be recouped by 2025, the percent that will be returned as cash flows and the equity risk premium:

Download spreadsheet & Simulation results
Note that on the earnings drop and subsequent recovery, I have used distributions with more downside surprises than upside, reflecting my belief that there is a chance of significantly greater damage than expected, albeit with small probabilities. The median value of 2750 is marginally higher than 2011, the level of the index on Friday, March 13, but this is not an investment for the faint of heart. 

Valuing Individual Stocks/Sectors
I have held back on individual stock valuations for the last two weeks, but I will start looking, and to help decide where to start, I created this very simple structure for thinking about what companies are most affected and least affected by the virus:

Using this framework, firms that sell non-discretionary products, are non-travel related, have low leverage (operating and financial) and are cash flow positive should be least affected by the virus, and discretionary product/service or travel-related companies with high fixed costs and debt, should be most affected. In the table below, I have updated both my sector and industry tables that I had posted last week, to reflect the additional damage from last week:
Download spreadsheet
The ten industry groups that were affected most and least by the market turmoil are below:
Download spreadsheet
Updating the regional tables to include the last week’s data:
Download spreadsheet
I also rechecked the momentum and PE tables, and while every decile of each lost money last week, there was no discernible pattern in either. Finally, I broke firms down by debt ratio (as percent of total market value of the firm), to see if firms with more debt were being punished by the market more than less indebted firms, and see only a mild relationship. You can download all of this data by clicking on this link. Collectively, global equity markets have lost a staggering $18.65 trillion in market capitalization, with US stocks accounting for $7.6 trillion in those losses. Note that the market damage lines up well with our priors, which is what makes investing tricky. In fact, there are two perspectives that you can bring to surveying these stocks, leading to contradictory strategies.
  • If you believe that markets have over reacted, your best chance at finding value might be to look in the rubble, the worst affected regions, sectors and companies
  • If you think that markets have not fully incorporated the economic damage from the virus, you should look at the regions, sectors and companies that are more protected.
The first two stocks on my radar for in-depth intrinsic valuation are Zoom, one of the few stocks that has benefited from this crisis, and Boeing, a stock that has lost more than half of its market capitalization, as its high-leverage, travel-focused business is put to the test by this virus. Implicit in both these valuations will be my own views on the macro and timing effects of this virus, but that is something that I cannot avoid taking a point of view on. Stay tuned!

YouTube Video


Spreadsheets/Data

  1. Spreadsheet to value S&P 500, March 13, 2020
  2. Simulation Results for S&P 500 (Run using Crystal Ball)
  3. Market Capitalization Changes, February 14- March 13, 2020

10 comments:

Anonymous said...

Outstanding Aswath..thank you.

Unknown said...

Based on today's market decline, I presume there will be a Part IV. HF, especially relative and volatility strategies should perform well assuming their Prime Brokers are able to provide liquidity. Within your spreadsheet can you also post companies (best/worst performers) within each sector?

Thank you.

Anonymous said...

This is a great posting. May you stay healthy dear prof.

Anonymous said...

It would be great if u can use GoogleSheets instead of Excel.
That way you can keep the sheet updated with current data/ formulas (=GoogleFinance(AAPL, today()-90 etc) & easier for us to follow you.
Now I have multiple excel files downloaded from you with different data (old)

Anderson said...

Should I consider the fact that I've read all the 3 articles a sign of hope or despair?
Thanks for your view on the market for these days.

Unknown said...

Thank you very much for your posts!

how can i generate the data myself? do you have post on that?

Once again, Thank you. I enjoy reading your posts very much.

Houman said...

Thank you very much for the post.

I will be waiting for your valuation posts, a question I have is how do you factor in macro outlook into the valuation, if at all. If the airline industry is going to have to ground half of their fleet (e.g. Lufthansa) for more than 6 months, how much would this affect the aviation segment of BA?

Many thanks,

Anonymous said...

Hi Professor,

May i ask where the sources for the data came from? I'd like to recreate my own w/ different dates.

Thank you!

Unknown said...

The range of values shown in the chart "Valuing the S&P 500 Index: March 13, 2020" are for 5 years out, correct?

B Gorsiya said...

Dear Professor,

Firstly thanks for taking time out and putting such a detailed note especially with the workings on where we stand in terms of S&P valuation.

Although I largely agree on the valuation metrics you have used, I wanted to draw your attention to the fact that the equity risk premium that you may be using might be considerably low in the period of such uncertainity, especially when the spreads of the Investment grade bonds & high Yield bonds (https://fred.stlouisfed.org/series/BAMLC0A0CM) have widened considerably and a ERP of 5.7% might be causing you to err on the expensive side whilst valuing S&P.

Thanks again and look forward to your valuation for Boeing and Zoom.

Kind regards.