If you are puzzled about the market and why or how it works, this is a good explaining risk. Take a minute to read this and use it to help you understand the present situation.
(This was written by a guy that knows and understands the markets. He has a 30 year history)
This piece is about as good an explanation of the fundamentals driving the stock and bond market as any I’ve seen recently. If you focus on the risk of uncertainty premium that’s baked into stock prices now, you can understand why the markets are dropping so significantly. Corporate earnings remain fairly strong, so, while stocks should drop due to corona virus and oil price disruptions, they should not decline to the levels we see now. The decline is accelerated because uncertainty premiums have been significantly increased. (If you price a stock’s future cash flows at an 8% after tax discount rate in ordinary times and that rate includes an ordinary uncertainty premium, you need to add to that rate in extraordinary times, bringing the discount rate today to say 15%. The added 7% is the additional uncertainty premium.) In other words, corona and oil price risk is easily assimilated by the stock market just like SARS, MERS and oil price disruptions were in the past. Today’s risk is significantly greater, I think due to election year uncertainty, for the more detailed reasons noted below, and thus warrants an additional premium.
The changes in fiscal, tax, regulatory, judicial and economic policy proposed by the current Democrat party candidates are so radically different from the current administration’s policies on each of these items that the impact on corporate earnings will be profound. So these proposed changes have to be estimated and adjusted by the probability that the Democrats will win a sweep of varying degrees in November (all three branches, just the house and senate, just the house or senate, just the executive, or none of the above).
The risks Campbell hints at but does not identify are cultural and political. Younger people are panicking because they have not experienced downturns for some time, if ever. They, and other investors, are being fed a “sky is falling” narrative by certain politicians, some elements of the media and the class of traders known as short sellers (these folks benefit when stock prices decline). Each of these classes is pushing an agenda. The politicians want to help their candidates sweep the house, senate and executive branches in November. They want to return to power. The market knows this turnover will be bad for economic growth and thus for corporate after-tax earnings.
The media knows that fear drives eyeballs to their broadcasts and publications so they will always tout the worst case scenario regardless of merit. Short sellers will serve as “experts” for the media narrative because they stand to make money on a downturn in markets.
Market participants tend to discount the media and short seller narrative, but need to remain aware of the potential success of all these narrative inputs and, as a result, are adding a much higher risk premium into the rate they use to discount future cash flows from stock ownership. They are also imputing much higher risk of tax rate increases due to a change in administration into their calculations and this further reduces stock valuations.
Variability in securities markets is normal and baked in to prices. The duration of this current experience of excessive variability is unknown. But this does not seem like the time to panic. We saw much worse in 2008 and the market recovered, albeit slowly. I would guess a 50/50 allocation of high quality debt securities (including government issues) and blue chip stock is a good bet for the current environment. You should be able to sleep at night knowing the you are insulated from a total stock market collapse (This is very, very unlikely.) and won’t miss out on all the benefit of a rapid bounce back in stock prices.
Good luck to all of us. Vote carefully in November.
(See my last post for a printout of the article on the Risk Yield Curve.)
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