With March's brutal sell-off still fresh in peoples' minds and the economy in a dire state, many investors may be wondering why the stock market is doing so well right now. Is this recovery likely to endure or will the lows seen in the first quarter of 2020 be re-tested?
They're good questions, but there might not be clear-cut answers for those who want certainty. For those weighing up whether now is the time to invest, here are three key things to consider:
1. Markets Are Unpredictable in the Short Term
This point is perhaps obvious, yet there seems to be no end to the appetite for predictions from investment managers. But this isn't just something that happens in the investment world: anyone who watches sports on TV (when it's on) fully knows that a) the unpredictable seems to happen a lot, b) humans' ability to predict any short-term outcome is very limited, and c) we still love to hear and make predictions.
In the short term, one should be prepared for a wide range of outcomes in markets. Yet, we are often surprised at what markets do. Being surprised implies a level of confidence in our expectation that is probably misplaced. So, not only are markets unpredictable in the short term, we are also overconfident in our or others' ability to predict.
With investments, we try to keep a humble confidence about the long-term path of markets. History has shown time and again that market declines are eventually repaired by rebounds and that the general direction of stocks in aggregate is up, as long as their underlying companies are profitable and managements continue to allocate capital so that its growth compounds. The path, however, is far from smooth and even.
We do find that market prices will depart from market fundamentals, or the aggregate cash flows produced by companies. When a price is below what we think a stock is worth, all else being equal, we'll typically find that to be an attractive investment. This doesn't require accurate short-term predictions.
2. Markets Predict the Economy
Bill Miller, the famous value investor who was chairman of Legg Mason Capital Management and later founded Miller Value Partners, observed that markets predict the economy rather than the economy predicting markets. Economic data is historical (it's backward-looking) while markets are forward-looking. This explains why markets typically rebound before a recession is over, but it certainly doesn't mean markets are always right.
Is it true today? Have markets correctly seen that the economic impact from the coronavirus will be less than thought in March? We just don't know.
We do believe, however, that buying assets when they're attractively priced is usually well-rewarded. Also, doing so removes the need to be right about predictions. Even if markets test new lows, we think they'll eventually recover and assets bought at attractive prices will do well - regardless of whether they were bought at the most attractive price or not.
3. A Market is More than an Index
The idea of "the market" is a tricky one, and what we say about a market can depend on how it's defined. So, it's important to understand what's within an index before you talk about it - or invest in it.
The chart below illustrates how the headline performance number for an index that's meant to represent US stocks, like the S&P 500, doesn't tell the full story about the investable universe. Small-cap value stocks have lagged large-cap growth stocks by a wide margin year to date, and the S&P 500 has well outpaced international stocks, represented by the Morningstar Global Markets ex-US Index.
Exhibit 1: Divergent YTD Returns for U.S. Large Growth, Small Value Equity Indexes
Source: Morningstar Direct. Data as of May 15, 2020.
Also, the S&P 500 itself is an of other markets, one that changes over time. The composition of the S&P 500 has become increasingly dominated by stocks that are doing well in the current environment because they benefit from work-from-home consumers or are Internet-related, have strong balance sheets, benefit from globally diversified revenues, or their businesses are defensive by nature (meaning demand for their products is less dependent on the strength of the economy).
Most other stocks are down, some by a lot. So, while it feels like some parts of the market are doing too well currently, other parts are pricing in some negative outcomes for energy companies and banks and outright disaster for airlines, hotels, and cruise lines.
What Does this Mean for Portfolios?
While we will never have a satisfactory answer to the question of what is driving the market, we do think one can respond to the prices and opportunities presented.
The market is facing a wide range of possible economic outcomes with more uncertainty than usual. In the wisdom-of-the-crowd model, accuracy is driven by the diversity and accuracy of individuals' guesses. We don't see anything to suggest a greater diversity among guessers, and most investors would say their guesses have a wider range than normal, so the average accuracy may be much lower than normal.
This means the market's accuracy may be hindered, and the crowd's wisdom may have lost a few IQ points. We think it also could mean opportunity for investors willing to be different from the crowd.
In our opinion, market-timing is not possible, however, we think the returns for value, international, and energy stocks at current prices look attractive for the long-term investor.
Daniel Holland is a stock analyst at Morningstar Investment Management. This article originally appeared on Morningstar Canada.
