COVID changed our lives and the economy. Unemployment surged almost as fast as coronavirus infections spread.
And yet even with the recent pullback, the U.S. stock market is up about 6.0% as of Sept. 9 as measured by broad total stock ETFs like the iShares Core S&P Total U.S. Stock Market ETF (ITOT) and the Vanguard Total Stock Market ETF (VTI).
Both are slightly higher than the high hit on Feb. 19 before the COVID crash hit. And this comes after a decade-long bull market where many thought stocks were due for a fall. What gives?
I don’t buy the typical reasons. Though the market is forward looking, COVID certainly hasn’t improved the long-run outlook as a whole.
The market, of course, has been led by a few mammoth players that benefit from our new virtual world of business, entertainment and shopping, but overall consumption outlooks aren’t any better. A vaccine will hopefully be here soon, but that would just get us back to where we were before.
And I don’t buy that stocks are the only game in town now that bonds pay so little. Real (inflation-adjusted) after-tax rates were far more negative in 1980.
My 2 Reasons
Reason No. 1: Discount rates fell more than cash flow projections
When you buy a stock (or stock ETF), you are buying a claim to future corporate cash flows for as long as that company stays in business, or until you sell. Because every company has risk, and because money today is more valuable than money in the future, we discount those cash flows each year.
If a stock has average risk, we discount it each year by the risk-free rate (arguably the 20-year Treasury bond) plus the market risk premium, which is the extra compensation investors want for taking on the risk of stocks. Arguably, let’s call that 6% a year.
With these assumptions, we started the year with a 2.39% risk-free rate, so we discount cash flows by 8.39% annually (risk-free rate plus the 6% risk premium). If ABC company started the year with the following cash flow projections, we estimate its value at $17.12 a share. I used a terminal perpetuity value assuming $1.35 per share cash flow with 2% annual growth—the Fed’s inflation target.
Fast forward to today: ABC’s business was decimated and is now projected to earn nothing in the next year instead of making the original forecast of $1 per share. Furthermore, cash flow next year is only half what was originally projected, and it is now estimated to take four years for ABC to get back to the original pre-COVID projections. Below are the new analyst projections:
Note that cash flows have only decreased in the near term and haven’t increased in the long term. Yet the estimated value of ABC has increased from $17.12 to $19.27 per share. That’s because the risk-free rate declined from 2.39% to 1.25%, meaning that these lower cash flows are now discounted at 7.25% annually instead of 8.39%. Further, the discount rate was the only assumption that changed in the terminal value calculation
This is to say that lower cash flows are worth more, because discount rate declined by more than the cash flow projections. The same is true for the stock market as a whole. Overall long-term earnings projections haven’t increased; they have merely shifted from companies like brick-and-mortar retailers to Amazon.
Only time will tell if the market has called the long-term Treasury bond correctly. The market thinks inflation will be tame. Is the market right? The way I learned economics was that printing more money to chase the same amount of goods is inflationary. Yet we’ve seen little signs of inflation in Japan, which has a much greater amount of debt relative to its GDP.
Reason No. 2: The market always fools us
I know this isn’t a very satisfying answer. Certainly, the more common explanations in the beginning of this article have greater intuitive appeal. But those intuitive explanations fail when held up against facts and logic.
My intuition told me to sell, sell, sell all of my stock funds and run for the hills in March. I chose to ignore that intuition and instead bought more stock index funds—twice, in fact. Admittedly, facts and logic offered little emotional comfort when I hit that execute button, as it still hurt like a gut-punch.
When I bought back then, I hadn’t done updated valuations using the lower discount rate. I merely did it to stick to my stock asset allocation. That’s the same reason I sold last month when I was above my target allocation when stocks recovered.
The stock market is a very complex system that perhaps no one understands. I know I don’t. One has to reach to try to explain its past performance, and most explanations are merely explaining away events that are truly random. If we can’t even explain the past, just think of how futile it is to predict the market’s future.
The two assumptions I’m making are:
- Both capitalism and the U.S. government will survive.
- It’s better to buy stocks when they are on sale (after a plunge).
None of us knows the future, and acknowledging that is one of the keys to being a successful investor.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.