One of the most frequently questions I get asked these days is – Why aren’t the Stock Markets crashing ? It is a fair question to ask considering when the COVID pandemic hit us in 2020, it made worldwide markets tank initially. Subsequently, they recovered in a one way sharp V shape recovery. You can notice the sharp movement of Sensex in the chart below.
Post April 2020, it looks like that the stock markets have convinced themselves that the COVID crisis is materially resolved and the economies are in healthy shape. However, the ground reality is that it is far from over, rather getting worse with each passing day. In Mar 2020, when the markets broke their back, the number of new daily COVID positive within three digits. In sharp contrast, today daily new COVID positive cases are ~400,000 and growing. We aren’t even seeing signs of peaking. The chart below.
Many states are imposing their localized movement restrictions which range from a weekend restriction to a daily restriction. This has an immediate impact on the economy hit by the restrictions and would (should) directly or indirectly impact their earnings, eventually the stock prices.
And hence the obvious question – why aren’t the markets reacting the way they did in March 2020. At the time of writing this blog, there is barely even a 10% correction from the highs of 52K made by Sensex. I can sense a lot of investors waiting impatiently on the sidelines as they had missed the bus or got off from the bus in the 2020 panic. They would obviously feel cheated and would like to get on onboard the investment journey once the markets correct.
Markets Hate Uncertainty and Love Hope
This is one of the golden rules of stock markets and perhaps was the key reason for the knee jerk correction in Mar 2020. When COVID hit our economies, no one understood it. We didn’t know the scale of damage it could cause and if it could be one of the painful sci-fi movies which we have watched. Knowing very little and having no visibility of the medical help at hand, the markets tanked.
As the scientists understood more about the virus, bit by bit, the cloud of uncertainty materially reduced. Vaccines got invented in record time and are under production round the clock. Markets love this as it reduces the uncertainty and adds to the hope that COVID will no longer be the threat which was concived initially. Hence, despite of exponential rising COVID positive cases, markets aren’t feeling very uncertain. They have learnt about the transition path which western economies have taken and the effectiveness of the vaccines. India too is gradually getting vaccinated, but it could take some time before we get our material population vaccinated.
Why Markets Went Up Higher Than Earlier ?
A fundamental answer to this question will require one to understand how stock valuations are determined. One of the common methods is by summing up the expected future earnings of a business and then discounting it to its current value (Present Value) using a suitable interest rate. We will explain this concept of Discounted Cashflow (DCF) in a future blog post. If the interest rates are low, the current value of a business will be much higher versus if the interest rates are high.
Recent fall in interest rates across the globe have hence a big role in increasing the ‘spreadsheet’ valuations of business. For instance, back in 2019, the 10 year Indian government bond yield (rate) was quoting above 8%. It has dropped to around 6% mark in 2021.
If we use the same for US, the 10 Year US government bond yield (rate) fell from around 3% to around 0.5% and is currently at around 1.6%.
These are massive reductions in the interest rates and has a tremendous positive impact in bumping up the fair value of the businesses, i.e. their stock prices, atleast on a spreadsheet. Though, the reverse is also true & may arrive some day. But that is for a later date.
Atleast, we have some reasoning behind why markets started their upward journey with no abatement.
How Much Fall is Justified
A corollary to the above heading, if owing to COVID, one year of a business’s earning is wiped off, it may impact around ~10% of its current value. Hence, any more than that may be ‘mathematically’ unjustified, keeping all other assumptions as constant. If the viability of a business is materially impacted, e.g. hospitality, airlines, entertainment, etc, they would have a significant erosion in their business’s long term earnings, even pushing them towards bankcrupcy. On the contrary, some other businesses like Pharmaceuticals & its ancilliary industries may see immense positive benefits owing never seen demand for their products.
What Does It Mean for An Investor ?
For a long term investor it doesn’t change the investment thought process. An investor’s action should be governed by the investment objectives, the timelines required to achieve it and the overall asset allocation.
An investor must not put all eggs in one basket. There has to be a fair diversification which should protect from one or more investment options being impacted in all at the same time. This also means, diversifying geographically within the same investment type to avoid the risks of the same country hitting in a go. For example, we can see at this point, US as a country recovering far quicker considering their actions, versus the current situation in India. To read more about Geographical Diversification, you may visit our post > Geographical Diversification – A Key Risk Management Strategy
Another good strategy in most times is to gradually investment over a period of time to avoid getting caught at the peak and taking opportunity of ongoing market corrections. See the chart below where in past 40 years, markets always had a correction within a year. The scale of corrections were different depending upon the severity of the economic crisis at that time. Also it is a great idea to have some extra liquidity at hand to take opportunity when the markets have sharp corrections. This significantly boosts long term returns. But an approach to sit only with liquidity and investing only when markets fall adversely may not always work well.
With that, I wish you all a safe transition out of this second wave of COVID. I am sure like others, this too will pass. For a long term investor, beyond a point, it doesn’t materially matter (see chart below). Stay safe.