18 June 2020
FOMO vs. Oh-No
Chasing equities
by Frank O’Nomics
“The sky is falling! The sky is falling!” screamed Chicken-Licken.
“So sell the sky”, reasoned the investment banker.
Stock markets are fickle. The last quarter has seen the full gamut of investor emotion; initial panic selling, then a hunt for bargains, followed by piling in regardless for fear of missing out (FOMO). After all, equities always go up eventually, right? Then, last week, came concerns that trading levels were supported by nothing more than hot air. To give some context to last Thursday’s 6% fall in the S&P, this represented a $2trn loss of value to investors. It is not hard to imagine those who had panicked in March, piled back in well into the rally, only to bail again last week. This is an expensive way to manage your savings.
I recently wrote about the importance of remembering why you save (“Don’t trash your golf clubs”, Shaw Sheet 16/4/20), counseling against knee-jerk liquidation. That is a very different sentiment to buying regardless -putting fresh money to work when the market has rallied, 30% requires careful consideration. An examination of the reasons for last week’s sell-off highlights the risks. First came a particularly dire economic outlook from the US Federal Reserve, who warned that the path to recovery would be long with most of the Fed Governors expecting interest rates to remain near zero until late 2022. The market, previously supported by the prospect of continued Fed support, has had to realise that this only exists due to the bleak outlook. Then came news of a fresh wave of Covid-19 infections in areas, such as Texas and Arizona, where lockdowns had been loosened. A second wave would make a significant difference to the expected economic damage from the pandemic.
Just how expensive are equities? Standard valuation tools looking at dividends and earnings may not be ideal, given that dividends are being cut and future earnings are uncertain. However, a big picture review can give some perspective. Perhaps the most surprising indicator is the level of the NASDAQ Composite index in the US. This closely followed index is heavily weighted towards information technology companies and, ahead of last Thursday’s fall, had not only rallied 46% from its March low but had also hit a new all-time high. Many tech companies may come out of the crisis stronger, but it is a huge leap of faith to suggest this as true for all when the length and extent of the pandemic’s impact is so uncertain.
As for the UK, the FTSE 100 does not look cheap. A standard way of valuing equities is to look at the share price divided by the companies earning per share – the lower this ratio the cheaper the stock. Overall, the current FTSE 100 price-earnings ratio (PER) stands just below 15; attractive compared to a high of just below 18 before the crisis, but similar to the level of this time last year. Are we really saying that the outlook has not changed in the last 12 months? The worst economic environment in a generation has so far only seen the FTSE PER hit a low in March of 11, yet the 2008 financial crisis produced a level of 7.5. What makes this potentially worse is that the forward PER is likely to look a lot more demanding – most companies are unlikely to generate earnings anything close to those previously reported. Estimates of the forward PER for the S&P 500 are in the mid-20s, which makes US equities look as expensive as the early-2000s.
Such a focus on valuation levels may, nevertheless, be missing the point. For many the sell-off just seems to have been yet another opportunity to buy, and much of last week’s fall has already been eroded. Worries regarding central bank growth predictions have again been countered by fresh announcements of central bank support. Low interest rates make it easier for companies to weather the storm and, more importantly, vast additional amounts of quantitative easing are tremendously supportive for equities. The Fed announced late on Monday that part of its latest £250bn stimulus package would include direct purchases of corporate bonds, the Bank of Japan announced that it would increase similar purchases from Y75trn to Y110trn, and the Bank of England is widely expected to increase its programme of government bond purchases today. Put simply, higher PERs than in 2008 are justified by lower interest rates and central bank support. Further, the use of standard valuation techniques may not be appropriate. A low PER may indicate a stock that is risky rather than cheap. The more highly valued stocks currently seem to be those seen as having the greater growth potential. The PER for Amazon for example is around 125, up from 80 at the end of last year, with the stock price at an all time high.
Once again we should remember that the level of the stock market and the health of the economy are two very different phenomena. Last week’s equity market fall would in most years be seen as significant. This year, however, it might be just a reflection of a new normal of greater volatility. At this stage, all the move looks like is a modest correction to a major rally. The 6% fall in the S&P came after a 45% bounce from the lows of late March, and the more modest 4% fall in the value of the FTSE 100 corrected a 30% up move. It was not unreasonable for traders to take profits. However, the setback has not been extended and the rising market is again leaving those traders wondering where to put their money. FOMO is winning out, but only for as long central banks maintain support or until the global economy stabilizes. At that stage we might have to return to looking at concepts of value.
