Have some financial asset prices bounced back too far and too fast?
This is never simple to evaluate, as current prices for rates and risk assets have a behavioral component, and appropriate price levels may only be obvious in hindsight.
In past cycles, equity bear markets and subsequent recoveries have unfolded over months, not weeks. This more recent volatility event was different on that front. Compared to how trading was conducted decades ago, the current flood of news through electronic sources, institutional algorithmic trading systems, and fast (and now largely free) retail trading has generated higher volumes. By adding low-cost market, factor, and thematic exchange-traded funds to the mix, the ease in implementing exposures may also be exacerbating the day-to-day volatility markets experience. This has created a few hiccups more recently in bond markets, where underlying bond holdings are far less liquid, causing the fewer offered exchange-traded products to act as a ‘safety value’ for price discovery and liquidity. This function has also added to volatility, and no doubt was a factor in the Fed’s decision to provide liquidity and buying power to these markets—a validation of their widespread usage and growing importance to financial market health.
In terms of pricing today, many market strategists are in agreement that where we go from here remains heavily dependent on the medical landscape. This makes the situation more fluid and more of a wildcard than we’ve been used to. In normal downturns, even if economic forecasts aren’t perfect, some modeling can be done to provide a rough framework for recovery. In this case, the depth and length of the downturn is likely very much dependent on the spread/waning of the virus. The possible scenarios have been broken down into ‘shapes’ of the expected graph of economic growth:
- The general consensus view is that a ‘V-shaped’ recovery (economy re-opening quickly and activity getting back to normal soon) is less feasible as a best-case scenario. China and South Korea have experienced a relatively rapid recovery, but societal differences and technology have played a stronger role in targeted medical tracking that may not be as palatable for Americans or Europeans. In addition, the risk of a second wave remains, as with many prior pandemics.
- A ‘U-shape’ appears to be the most common currently-accepted base case—a deep trough which may take a few months or even quarters to plough through to ensure a more thoughtful reopening. This scenario assumes a bottoming in Q2, with a resumption of activity in Q3 and Q4, as well as into 2021.
- A trickier set of conditions is the ‘W-shape’, which is a sharp bounce-back, followed by a second wave of infections and shutdowns in future months, and, finally an eventual drawn-out recovery. This would no doubt try everyone’s patience from a societal and economic standpoint, but, unfortunately, isn’t an uncommon outcome based on prior pandemics in which a second or even third wave has unfolded. Some compare the current case to the 1918 influenza pandemic. Despite being perhaps useful on the epidemiological front, this period was less relevant from an economic standpoint, as the Fed was only a few years old and untested. That era predated the modern Fed’s usage of monetary policy, economic data was far spottier when available, not to mention other carryover effects from the conclusion of World War I, all of which complicate the analysis.
- The dreaded ‘L-shape’ represents a sharp economic downturn, with a permanent loss of some activity and jobs. This is not considered to be a base case by mainstream economists, but if the current shutdowns persist for an extended period, the chances of this scenario rise as businesses shutter and temporary job losses turn permanent. Fears of this outcome have been the force spurring politicians and businesspeople to fight for faster re-openings, even in spite of higher medical risks. It could be said that the Great Depression in the 1930s was an L-shape, although there were policy errors that likely exacerbated its length and depth. Avoiding repeat of those mistakes explains the use of extreme fiscal stimulus today.
Valuations today appear neither extremely cheap nor outrageously expensive, and price in an optimistic economic and earnings recovery next year, which of course is possible. However, an important pitfall to avoid at times like this is pricing for a very narrow and ‘perfect’ path. Last week, a handful of hedge fund managers (many of whom are known to take and could benefit from volatility and negativity) claimed the U.S. equity market was overvalued, while other portfolio managers expressed the opposite sentiment. This reflects the uncertainty and disagreement in possible economic paths going forward. This year’s earnings have been written off completely, with those for 2021 expected to get back to $160-170 on the S&P. Bond yields are anchored by very easy Fed policy, and lower inflation expectations in the mid-term. (The long-term expectations are up for debate, due to the now massive fiscal budget deficits.) As always, starting yields have been a decent indicator of future fixed income returns, which is less inspiring for savers and more conservative investors.
As they were a decade ago after the financial crisis, many bond investors may be pushed to take on more risk to earn higher income in high yield corporates, emerging markets, etc. For equities, only a small proportion of earnings inputs into cash flow models depend on the coming few years, rendering the Covid outbreak hopefully a small blip on the historical chart. However, sentiment in the near term can be powerful, and could well depend on medical news.