The partial lockdown of the United States is already hurting many business sectors. With the country entering a recession, many companies of all sizes have already announced plans to lay off some of their staff in a bid to reduce operating costs. Some of the largest recruiters in the country, including Alphabet Inc. (GOOG), have taken steps to pull back on hiring for the remainder of the year. As a result, the initial jobless claims have skyrocketed to record highs.
Source: Department of Labor/The New York Times.
From the look of it, this is very bad news for investors. As the level of unemployment increases, consumer spending will come to a halt, resulting in a drop in sales for many industries. Lower earnings, on the other hand, will reflect negatively on the market price of companies affected. To the surprise of many investors, however, empirical evidence suggests that this might not be a reason to worry.
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="An investing lesson from the history books” data-reactid=”28″>An investing lesson from the history books
Whether or not history will repeat itself is up for debate, but past performance often provides insights into the expected returns from equity markets. From 1928 to 2018, the S&P 500 Index has provided better returns in the years following a spike in the unemployment level to historic highs.
Source: Pension Partners/Charlie Bilello.
There seems to be an anomaly between economics concepts and the performance of equity markets. A low level of unemployment is associated with a booming economy, which in turn is expected to boost stock prices over a prolonged period. However, as evident from the table above, the opposite has been true.
The differentiator is the valuation levels of equity markets. Investing is about identifying undervalued companies and betting on them to converge with their intrinsic value. During times of economic growth and low unemployment, valuation multiples tend to reach historic highs, leading to disappointing returns in the coming years as a correction takes place.
Source: Pension Partners/Charlie Bilello.
The sentiment of investors plays a major role in determining the direction of stock prices. A persistently low level of unemployment creates a false sense of security about the outlook for the economy, which leads to an expansion of earnings multiples, often to levels that are not sustainable. The data from the above table confirms this theory.
A spike in jobless claims, therefore, should not push investors away from equity securities.
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="The market, however, may still be overvalued. Many investors look up to the likes of Warren Buffett (Trades, Portfolio) to gauge a measure of how gurus are reacting to a market melt-up. Even though stock prices have collapsed since the beginning of the year, the Oracle of Omaha has not announced a major deal. On the contrary, Berkshire Hathaway Inc. (NYSE:BRK.A)(BRK.B) slased its stakes in The Bank of New York Mellon Corp. (BK) and Delta Air Lines (DAL). The Buffett Indicator, on the other hand, is still above 130%, which is an indication of a possible overvaluation of equity prices. As many value investors should be aware, Warren Buffett (Trades, Portfolio) is a fan of buying stocks when this ratio falls below 100.” data-reactid=”50″>The market, however, may still be overvalued. Many investors look up to the likes of Warren Buffett (Trades, Portfolio) to gauge a measure of how gurus are reacting to a market melt-up. Even though stock prices have collapsed since the beginning of the year, the Oracle of Omaha has not announced a major deal. On the contrary, Berkshire Hathaway Inc. (NYSE:BRK.A)(BRK.B) slased its stakes in The Bank of New York Mellon Corp. (BK) and Delta Air Lines (DAL). The Buffett Indicator, on the other hand, is still above 130%, which is an indication of a possible overvaluation of equity prices. As many value investors should be aware, Warren Buffett (Trades, Portfolio) is a fan of buying stocks when this ratio falls below 100.
Source: GuruFocus.
Many investors were expecting Berkshire to surprise the market in its annual meeting scheduled for May 2 by revealing a few major deals. However, in an interview with The Wall Street Journal on April 17, Charlie Munger (Trades, Portfolio) denied this, saying:
“Well, I would say basically we’re like the captain of a ship when the worst typhoon that’s ever happened comes, we just want to get through the typhoon, and we’d rather come out of it with a whole lot of liquidity. We are not playing, Oh goody, goody, everything’s going to hell, let’s plunge 100% of the reserves into buying businesses.”
The guru went on to add that nobody has a clue of what is happening and when this will end, resulting in increased uncertainty. As evident from these remarks, Berkshire is still waiting on the sidelines for a better opportunity to put its $128 billion cash pile to work. This is not good news for investors, but there is another side to this story as well.
Berkshire Hathaway is a company that specializes in investing in traditional business sectors such as energy, insurance and financial services. The company started investing in the likes of Apple Inc. (NASDAQ:AAPL) and Amazon.com Inc. (NASDAQ:AMZN) in recent years. Therefore, the inactivity of Berkshire might not be a good indicator to determine whether tech stocks are cheap or not because the conglomerate is unlikely to bank on any opportunities in this sector even if attractive opportunities emerge.
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Takeaway: investors should cautiously sift through the market to find winning stocks ” data-reactid=”69″>Takeaway: investors should cautiously sift through the market to find winning stocks
Even though the market might provide attractive returns in the coming years based on empirical evidence related to the unemployment level, an investor should not let this conceal the dire situation the economy is currently in. If mobility restrictions remain in place for a prolonged time, consumer spending in the country will drop drastically. This will be a direct hit on consumer discretionary companies such as Apple. However, the company is in a strong financial position, which should help it weather the storm and come out of this chaos stronger. The best way forward is to identify such companies and use a technique such as dollar-cost averaging to slowly but steadily invest money.
Some of the well-known gurus are not investing still, but others such as Ray Dalio (Trades, Portfolio) and Seth Klarman (Trades, Portfolio) have doubled down on the opportunity to buy high-growth companies at attractive valuation multiples.
Once-in-a-lifetime opportunities could surface in the coming weeks due to the increased volatility in markets. An investor, therefore, cannot relax. Continuously looking for market anomalies is the best course of action. As Munger once famously said:
“It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it – who look and sift the world for a mispriced bet – that they can occasionally find one.”
In searching for such bets, however, an investor should pay close attention to the balance sheet strength since a cash-rich company with a low level of debt would be in a better position than a company in poor financial health to emerge stronger when business activities resume.
Disclosure: I do not own any shares mentioned in this article.
Read more here:
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