I’ve gotten a few texts and emails from readers asking for my take on the present market turmoil. If you listen to the pundits on cable channels, recent market falls are caused by everything from the fear of the Ebola virus to worries about global growth to worries about the Fed tightening.
The fact is, however, that while all of these issues are factored into market participants’ thinking, it is ridiculous to apply some causal connection between these (or any factors) and the market falling.
What’s really going on in the markets? It’s falling a bit and there doesn’t have to be a reason. One of the research articles that sparked my love of the markets was a paper by Larry Summers that investigated the attribution of causal connections to the 50 largest stock market movements. In the majority of cases, he found no evidence of any connection between an identifiable “external” shock and a market movement.
Perspective Setting
Here’s a chart of the S&P 500.
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The S&P 500 hit an all-time high of 2011.36 on September 18 and is now about 6% lower than that. While everyone would very much like the equity market to keep ratcheting on up a little bit every day, that simply doesn’t happen. 6% is not, in the grand scheme of things, very important.
Volatility has risen, but was scraping along almost ridiculously low levels. Again, this is not a news story, no matter how much the cable news channels want to make it such.
With that out of the way, let’s take a brief look at the selection of risks and issues that face the market right now.
Growth
The growth of the world economy is indeed a risk. Europe and China both look to be teetering a bit, both for their own reasons. The U.S. is posting some very strong numbers showing a recovery in the job market, but there are reasons to worry about its long-term growth trajectory as well.[1]
I have acknowledged this risk for the past few years, and have bought into PIMCO’s “New Normal” framework. The way I express this is by lowering my assumptions for medium-term and terminal growth rates–the latter having a particularly large effect on valuations.
There are some complex and multiply intertwined trade and financing relationships between different countries, and it is impossible to say with certainty how a slowdown in one nation or area will affect other nations or areas. Growth may slow, but as far as I can see, I have built these slower growth scenarios into the worst-case revenue scenarios for the companies I’m valuing.
In general, that is an approach that seems sensible to me. Forecasting is impossible. Understanding complex international goods and money flows is impossible. Understanding the demand environment for a certain company’s products or services and estimating a best- and worst-case scenario for how that demand translates into profits? That’s possible.
Ebola
It is a terrible problem for West Africa. It is a human tragedy for the people here and in Europe who have contracted it. It is not material to the valuation of virtually all the companies that readers of this blog would consider (unless you’ve got your heart set on being the owner of a West African regional air service).
Is it an investing opportunity? Some companies may do well short-term by supplying needed gear, medication, or services to doctors and agencies treating and studying Ebola. I’m not sure about the valuations of any of these and tend to think that any fad investment like this falls under the class of speculation. Speculation is the realm of the goddess of fortune (Tyche), with whom I’ve had less luck than the goddess of wisdom (Athena).
Fed Tightening
The Fed has been very loose for very long. It may tighten. There are different market historians that can give you the statistics about what happened to equity prices in each of the cases the Fed has tightened in the past. I don’t think these history lessons matter very much from a statistical standpoint because there are so few observations in the sample and because each case is highly idiosyncratic.
If the Fed announces a tightening, the market may fall. If it does, look for good opportunities to sell puts and otherwise get solid economic exposure to companies creating value for their shareholders.
Notes:
[1] Longer term, I think the weakening of the U.S. middle class will be something that will have to be resolved. Jobs are being created, but median earnings have been stagnant for a very long time even as the things the middle class cares about most–education, medical care, etc.–have been increasing in price. This is not, historically, the recipe for a strong, vibrant economy.