Valuing Equities in an Economic Crisis or How I Learned to Stop Worrying about the Economy and Love the Stock Market

Having spent the last decade decrying stocks as overvalued despite what has generally been an extremely benign economic backdrop, some of our clients are a bit bemused to find us more bullish than many of their other managers today. After all, isn’t this the worst economic crisis since the Great Depression? If we could hate stocks when times were great, shouldn’t we hate them even more when the world seems to be going down the drain? But given our basic set of beliefs – mean reversion happens, the economy is driven by the skills of the workforce and the physical and intellectual capital of companies, equities are long duration assets – both stances are completely consistent. To us, the true value of the stock market changes very slowly and smoothly. It is the myopia of investors that causes market prices to vary so wildly.

In their recent panic, investors have driven U.S. equity valuations down below fair value for the first time in well over a decade. This is not particularly surprising given the economic environment, but we should not confuse a predictable event with a justifiable one. Given that we are in an economic crisis, investors were apt to overreact to the bad news and drive the market down, but we believe that this is not warranted given the underlying fundamentals of the market.

John Templeton’s famous line, “The four most dangerous words in investing are ‘This time it’s different,’” is usually taken to apply to New Era bull markets. But it is just as applicable in a bear market. Because the economy is a mean reverting system, things have never been as good as they appeared in the booms, and have never yet been as bad as they appeared in the busts. We believe that this time will not be different, and history, at least, is on our side.

Given our assumptions, fair value for the S&P 500 is around 900. Long-term investors in stocks should therefore do well if they invest at current levels. An investor who correctly guesses that the market will bottom at 600 and waits until then to invest will do even better. But that investor is taking the risk that investors overreact less to this crisis than they have in previous crises and, in waiting for the perfect entry point, may miss the best opportunity to buy equities in over 20 years.

Link to the Paper