On Monday March 9th, 2020 stock trading was halted for the first time since 1997 and the S&P 500 ended the day down 7.6%. It was a rough day for markets which had lost almost 20% from the all-time highs of late February. This followed multiple other recent big moves in the market including the three biggest daily gains by points in history on March 2nd (+136.01), 4th (+126.75), and 10th (+135.67).
How do we make sense of such huge swings in stock prices? It helps to get back to the basics of value and price. As Warren Buffett puts it, “Price is what you pay, value is what you get.” This quotes makes the claim that price and value may not always match. Most recently, we’ve witnessed Coronavirus and energy market news drive price swings. But what about longer-term value?
Value is harder to observe. We think it should be based on both the cash flows that a business will generate in the future and the risk of the firm. More cash, greater value. More risk, lower value. Simple enough.
However, investors are constantly processing information to help form estimates of value and there is a lot of data out there. Even worse, we don’t really know what will happen in the future. We can only form an educated guess based on careful analysis.
Panic or Legitimate?
The big price swings of early March 2020 tell us the market is having a very tough time processing Coronavirus news. This is not surprising as it reflects the general global uncertainty on this issue. Most people want to know if these market swings reflect changes in value or price.
If the swings are related to short-term panic rather than long-term fundamentals, then we might rest a bit easier with our investments. If big movements reflect longer-term problems including recession, then it might be prudent to act accordingly as investors and managers.
On the question of how much these price swings reflect reality-based decision making versus panicked responses, I unfortunately don’t have any answers. Clearly there will be lost cash flows for many businesses which will result in a genuine loss of value. The question is how much of this loss will just be postponed and how much will be permanent. The big price swings we are seeing are the market’s attempts to judge this difficult question.
Narrative and Numbers
As we move forward through this volatile period, I find the concept of narrative to be particularly useful. Narratives, or popular storytelling, reflect the ways that average people learn about and communicate financial thinking.
Nobel Prize-winning economist Robert Shiller identifies narrative as a driver of economic events. In his book Narrative Economics he notes some famous narratives that proved to have major consequences such as “housing prices can only go up.”
Narratives are appealing to us because they simplify complex issues into more relatable and digestible forms. The downside is of course that narratives may not reflect reality. Many stories are now circulating about the Coronavirus and many experts are weighing in with predictions. I lack the expertise to tell the difference between reality and myth on this issue.
What I do believe is that the prevailing narrative will drive market responses in the short-term, regardless of the accuracy of the underlying story. As a result, price changes may or may not be meaningful.
Navigating Volatile Times
I certainly listen to other people’s narratives on the market, but it is important to form our own ideas and to challenge the wisdom of the masses. It’s best not to get too worked up about day-to-day market movements. Panicked decision making is not ideal.
The best bet is to look for numbers and other evidence that might point us to a clearer understanding of longer-term value. Some areas I’ll be watching closely in the coming days and weeks are announcements on fiscal policy, potential firm earnings revisions, and debt market movements.
Each one of these events has the potential to impact the prevailing narrative which I would describe currently as “confused.” My prediction, and it isn’t much of a prediction, is that markets will remain volatile until we get a clear narrative. When the clear narrative will come or what it will be when it arrives is not clear to me.
Although this era is relatively unprecedented in many ways, the fundamentals stay the same. As managers and investors, the long-term financial focus is on generating cash and managing risk. Uncertainty is inherent in business and business leaders have proven many times in the past to be more than up to the task of managing it.