As stock prices in April continued their March pattern of wide daily fluctuations, both up and down, and amidst the financial media’s ongoing reporting of the severe negative economic impacts from the global responses to the coronavirus, we have been looking for a word or phrase to capture what is happening. The word that comes to mind is random. And the investment icon most associated with that word and idea is Princeton Professor Burton Malkiel, who wrote the investment classic A Random Walk Down Wall Street (first published in 1973). The basic thesis of the book (paraphrased from the book’s Wikipedia entry) is that:
Asset prices typically exhibit signs of a random walk so that no one can consistently outperform market averages… Actively managed, diversified stock portfolios, whether using individual stocks or mutual funds, following fundamental or technical analysis, and/or relying on past performance, are likely to produce inferior results compared to passive strategies. Using past performance for mutual funds is a problem because outperformance in one year is often followed by underperformance in years following their success, with results regressing to the mean. Over the long term, the benchmark index for that investment category is likely to outperform. [Emphasis added.]
In October 2003, right around the time of Park Piedmont’s founding, our Monthly Comments quoted directly from Malkiel’s book (8th edition):
“[t]he problem is that there is no persistency to good performance; it is as random as the market. If a manager beats an index in one period, there’s absolutely no guarantee that the performance will be repeated in the next… The top funds of the sixties had dismal performances in the seventies…the top funds of the seventies badly underperformed the market in the eighties, and the top funds of the eighties underperformed in the nineties… Yesterday’s genius turned into today’s disaster… It is true that there are always some funds that beat the market… [But] there is no way to choose the best managers in advance.” Malkiel, A Random Walk Down Wall Street, pages 128-130 [Emphasis added.]
Next is a sample of Malkiel’s advice in times of crisis, written two weeks after the September 11, 2001 terrorist attacks on America. (Our note: Could it be that some of this discussion is applicable currently? The figures are different but the ideas resonate. Presumably, time will tell). The title of the article is “Don’t Sell Out,” (WSJ, 9/26/01):
“The horrific events of late have focused the attention of the world on the U.S. stock market and the potential influence it will have on the likelihood of a global recession. As of yesterday’s close, the Dow is more than 10% below its level prior to the terrorist attacks and consumer confidence has collapsed. While more than a $1 trillion loss in market value was punishing enough, many commentators have expressed concern that the market is still overpriced and that the potential for further declines is large. Simply put, the worry-warts argue that with today’s price/earnings ratio (P/E) still in the low 20s (well above its long-run average of about 15), stocks are overpriced and corporate earnings are greatly overstated, making the actual P/E dangerously high. While stocks may continue to fall in the short-run, investors should reject such a negative view.
There is no reason to believe that 15 or any other number is the correct earnings multiple at which the market should sell. Two important factors influence the ratio. The first is the level of long-term interest rates. And when long-term interest rates are very low, as they are today, higher P/E ratios for the market are warranted. The appropriate P/E for the market also depends on the risk premium (the extra return over safe bonds) demanded by market participants. One very good proxy for the risk perceived by equity investors is the recent inflation rate. The normal relationship today, based on bond yields and inflation, is for the S&P to sell at about 22, not 15. Bond yields are low and inflation is well contained, so it is perfectly appropriate for the S&P to sell at a level above its long-run average. The market today appears to be fairly valued.
But do the tragic events of September 11th throw all the historical analogies out the window? I think not. I have looked at previous shocks to the economy: the Gulf War, the crash of 1987, the resignation of President Nixon, and the U.S. bombing of Cambodia in 1970, among others. While one can discern temporary market perturbations, there do not seem to be any long-run deviations from the prediction line. Even if I extend the analysis back in time to the Korean War and Pearl Harbor, I find only temporary effects. Of course, it is always possible that this time is different, but history suggests that investors who make an emotional decision to sell during times of crisis are unlikely to derive any benefit.
Yes, earnings are likely to decline in the coming quarters, but there has always been a tendency for P/E multiples to rise during recessionary periods. And even if we do have a recession, the market is likely to look beyond depressed current earnings and to capitalize earning power during the following recovery. While the market today seems reasonably priced, no one can make a short-term prediction of where prices will go in the future. Certainly, the world is a much less stable place than it was before September 11th, and risk premiums should be higher. Moreover, if irrational exuberance characterized 1999 and early 2000, unreasonable anxiety could influence prices over the next several months. Indeed, figures released yesterday showed the biggest monthly drop in the consumer confidence index since 1990. But history tells us that anyone who sells stocks today in the hope of getting back in at just the right time is likely to be making a large and costly mistake.”
Turning now to these April 2020 Monthly Comments, the extreme negative impacts of the coronavirus on people’s health and their ability to conduct normal activities continues. This in turn continues to present major economic issues for businesses around the world, which have had to curtail or shut down their operations, generating high levels of unemployment and creating all sorts of problems for those consumers and businesses dependent on their goods and services. And yet the S&P 500 stock index gained 12.7% in April, with many days up or down more than 2%, even with days of no apparent new news, giving rise to our observations about stock prices being random. Here is evidence of “randomness,” based on the recent extreme price movements of the S&P 500 index:
- from the February 19th high to the March 23rd low, down from 3,386 to 2,237, a decline of 1,149, or 34%;
- from February 19th to March 31st, down from 3,386 to 2,585, a decline of 801, or 23.6%; the gain from the March 23rd low was 348, or 15.5%;
- from February 19th to April 30th, down from 3,386 to 2,912, a decline of 474, or 14%; the gain from the low was 675, or 30%.
The information in the chart below makes a similar point:
|Daily Up Average; %
|Daily Down Average; %
||Daily Average; %
|Feb 19-Mar 31, 2020
|April 1-30, 2020
|Totals Feb 19-Apr 30
Note: All % measured from Feb 19th all-time high of 3,386, unless otherwise indicated.
Also, a few additional reference points: The S&P 500 index at the end of 2018 was 2,507; compared to the April 30, 2020 figure of 2,912; the change is +405, or 16%. For all of 2019, the S&P 500 was up just short of 29%.
In our March Comments, discussing the stock price volatility from that month, we wrote: “what if this same result occurred with an even decline each day of 28 points, or 0.83% of the index (801 divided by the 29 trading days)? At some point you would have noticed, but the reactions would likely be much more subdued.” Factoring in April’s surprising positive result, the overall result is even more muted, even with all the continuing bad news and frightening events. Over 50 trading days, there is a net decline of 474 points, which, if spread evenly, would be just under 10 points a day, or (0.28%). Hardly worth much of a reaction. It would seem as if the volatility/randomness of the daily price changes has been much more frightening than the 50 day start-to-finish numbers.
And to what can we attribute the April stock gains? Does the Federal Reserve’s maintenance of ultra-low interest rates, and their calming of the bond market, carry enough weight in the financial markets to explain these stock price results? “The Federal Reserve said the US economy has deteriorated due to coronavirus and pledged to take aggressive action to support an eventual recovery” (WSJ 4/29/20). When interest rates are close to zero, investors cannot earn a reasonable yield from their bond holdings, and the price gains from declining rates are pretty much over, so many investors are forced to turn to the far more volatile stock markets in hopes of earning a positive return. Another possible explanation for the April result is that some market participants are already anticipating an economic recovery from the impacts of the virus, but that would certainly fly in the face of the media’s mostly downbeat reporting. It is also an open question where daily trading activity comes into play to impact stock prices, as distinguished from the presumed lack of activity from long-term buy-and-hold investors. We simply do not know and continue to be quite concerned about the near-term health and finances of all.
As we wrote in March: the danger of this kind of extreme short-term price volatility in the markets is that it gives investors a reason to “do something.” If in fact your long-term goals have not changed, the likely best action is to do nothing, relying on the history of stock price recoveries from bear markets, some even deeper than this one. Of course, a health pandemic with no clear finish line presents major uncertainties for all. But reacting to the risk by following and acting on the day-to-day extreme (often random) ups and downs in the stock market does not seem to us (or Malkiel) to be that useful. And remember, your asset allocation away from stocks to bonds, tailored to your particular situation, provides risk reduction and a source of money as needed so that stocks need not be sold during periods of steep declines.
BONDS: (from March Comments):
“Bonds are designed to provide a buffer for your investment portfolio, normally generating income and much lower price volatility as compared to stocks. Typically, the older people get, the more their investment portfolio allocation should be tilted towards bonds, even with some stock allocation providing a potential for growth in case they live a very long time. Currently, bond price fluctuations are considerably lower than they are for stock prices. But interest rates are also very low for bonds, so the tradeoff between price stability and price volatility is particularly stark. Bond prices have come under pressure recently, even as interest rates have declined, because of perceived credit risks. The Federal Reserve has made it clear, however, that it is ready to support the bond market in a variety of ways (NYT, 4/1/20, page B1). Bonds also provide a source of cash for everyone who needs to be using money currently, so that stocks need not be sold in periods of decline. This is a very brief discussion of a complex topic, but we believe the allocations away from stocks and into bonds, established in more normal times based on each client’s particular situation, are doing their job as intended.”
While searching for the Malkiel quotes in our Monthly Comments archives, we came across the following set of our personal observations from September 2001. They seem pertinent again now.
“Beyond the figures and the history and the media reports, there are some other, more personal thoughts we would like to convey… We find that there is more reason for additional engagement with the rest of the world, and that our own well-being is interrelated with people and places far away. Since the demise of the Soviet Union, and the Gulf War, we achieved increased prosperity for ourselves and other developed areas, while at the same time we seemed to have reduced our interest in the less economically developed and troubled parts of the world. Thomas Friedman’s excellent book, The Lexus and the Olive Tree, previously discussed in the Comments of March, 2001, highlights some of the implications of the increasing divergence between the “haves” and the “have nots”, and those willing to break with tradition and those clinging to tradition.”
Finally, although the world as we knew it for the last number of years has changed irrevocably, it should also be clear the world has not, as the expression goes, come to an end. In the post 9/11/01 world, we are likely to be, for some time, more insecure, less confident, and less financially well-off. But the world is still out there, and we still have our lives to lead in this world. As we get used to these new circumstances, we all need to, in our own time, overcome our feelings of sadness, depression, even despair, and move on to productive lives. On both a personal and a national level, these productive activities will get us to a better place.”
STAY SAFE AND TAKE CARE.