The markets continue to ping-pong – up 1,000 / down 1,000 – rattling the nerves of investors and bystanders alike. Each day is a mirror of the previous. Everyone seems to be trying to handicap the impact of the coronavirus on the global economy. Throw in a price war over crude oil (usually a positive for the markets) and things get really interesting. Instead of a rationale repricing of the market, I think we are being whipsawed by computer traders and algorithms that are moving in lockstep – big move up one day – big move down the next.
So why do I think these moves are irrational? For more than 100 years, investors have used mathematical models to value companies. Those models estimate the intrinsic value of a company by forecasting future cash flows and discounting them to today. These models are not based on one quarter’s, or even one year’s, cash flow, but rather the combined cash flow of a company over the next 30 years. If 2020 cash flows for the entire S&P 500 dropped all the way to zero, a discounted aggregate value of the market should only fall by 4%-5%. Therefore, the proper question to ask when analyzing the coronavirus (or any emerging macro risk) is “How much will this affect the long-term cash flows of businesses?” I doubt very much that the owner of a profitable business would accept a 20%+ reduced offer for the entire company today versus two months ago simply because of virus fears.
While it is too soon to answer the long-term cash flow question with certainty, we can look back at prior “epidemic” fears to see the impact they had over time. SARS, bird flu, Ebola, and the West Nile virus are all examples of exogenous medical emergencies that the market faced over the past two decades. In all cases, world economies adjusted to the threats without seeing significant impacts to long-term cash flows. In all four of those cases, the S&P 500 index exceeded its pre-outbreak high within two months of the initial concerns. I am not making a prediction that will happen, but use these historical comparisons to support my contention that these market moves are overblown.
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