Volatility is here to stay

BMO’s base case acknowledges that COVID-19 will devastate global economic growth for the second quarter, and this slowdown might well extend into the third quarter

Ruth Saldanha 13 April, 2020 | 1:26AM

Roller coaster

Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

The COVID-19 pandemic has spelt pandemonium in the markets, with a bear market, followed by a market rally last week. The volatility has confused investors, leaving them wondering if they should take advantage of the opportunities in a recession,  whether fear-of-missing-out is justified, or if they should just do nothing for now, and stay the course

“Small wonder then, that many investors are running scared, and that fear has translated to highly volatile equity markets and a flight to perceived safe assets,” says Morningstar Investment Management’s Michael Keaveney.

It feels almost worse for Canadian investors, thanks to cratering oil prices that hit Canadian stocks. Canadian energy producers quickly cut capital expenditures, and Federal Finance Minister Bill Morneau promised support for the reeling sector through government-guaranteed credit.

“As investors, we are faced with a period of maximum uncertainty. Our base case continues to acknowledge that COVID-19 will devastate global economic growth for the second quarter. This slowdown might well extend into the third quarter. Current estimates for earnings are now out of reach. In addition, it will be almost impossible to forecast earnings without knowing when the pandemic will peak globally,” says BMO Private Wealth’s CIO and Head of Investment Management Lesley Marks.

How to value stocks?
If it is hard to estimate earnings, it is also impractical for investors to hold on to pre-downturn fair value estimates. How should investors decide if a stock price is attractive in these volatile times?

Morningstar’s director of investment research Ian Tam suggests price-to-book. As he explains, this valuation metric is particularly relevant today, when companies' earnings might be considered unpredictable, making price-to-earnings or the P/E ratio a bit less reliable.

The book value of a company's equity refers to the liquidation of the value of the company if they were to sell off all their assets and pay off all their debts. The remainder of assets minus liabilities is known as the book value of a company's equity.

“When we divide the price of the stock by the book value per share, we'll be able to get a good sense of what type of premium the stock is trading at, especially when we compare that price to book ratio of two stocks together, or a stock against its own history,” Tam says.

Marks agrees. “It will be difficult to forecast earnings for 2020, but investors can look at other metrics to value companies such as trailing price to earnings ratios which can give you a sense of the earnings potential of the business. Another way we can value companies is based on replacement value or book value as an attractive entry point.  A third way to decide whether a company is a ‘buy’ when there is a level of uncertainty around near-term earnings is to try to look over the valley and value the company on expected earnings two or more years out,” she says.  However, she warns that for some companies, it may take longer for a resumption of normal activity so even two years out, earnings will not resume their pre-COVID trend levels. 

At present, Marks’ asset allocation portfolios are underweight equities due to the recent underperformance of equities compared with bonds. 

“We recently rebalanced portfolios by topping up equity weightings to bring portfolios back into line with a neutral positioning.  Although it is difficult to call the bottom for equities, we felt that three conditions existed which led us to believe that equities could be transitioning from the sell-off phase to the bottoming phase.  These three conditions were fiscal policy support to help bridge the economic gap during the extreme shutdown, monetary policy measures to stabilize markets and help with liquidity and significant outflows from risk assets such as equities and credit into cash,” she explains.

Lessons from China
China was the first country to experience fallout from the new coronavirus, and Chinese equities were also the first to fall. China was the first to see business activity decline due to government-mandated shutdowns. Now, however, some citizens have been allowed to return to work gradually as the number of new cases in China approaches zero. China’s Ministry of Commerce says more than 80% of restaurants and 60% of hotels have resumed business.

Marks notes that Chinese construction activity, retail sales, factory output and home sales all sank during the first two months of 2020, sending March unemployment to a record 5.7%.

However, Chinese equities recovered.

“The world will now closely monitor what happens when social distancing measures are relaxed. Lift restrictions too quickly and a virus resurgence might flare up. Singapore and Hong Kong, which were initially heralded for their containment efforts, saw spikes in confirmed cases once citizens were free to visit bars and restaurants,” Marks says, adding that she believes that policy support (both monetary and fiscal) will help soften the virus’s impact on economic growth. “We continue to believe that when the number of cases peaks, the market will once again focus on longer-term fundamentals. These factors together will support equities over bonds,” she says.

What should investors do?
“We've seen volatile markets before, and they are often brought on by these types of shocks. The specific shock varies. It can be public health related, political, military, or even an embedded flaw in financial engineering that suddenly reveals itself. Periodic drawdowns are part of the market cycle and should not come as a surprise to investors,” Keaveney says.

For income investors, while dividends are popular, Marks warns that investors need to consider the likelihood of dividend cuts before they invest in higher yielding stocks because in some sectors like energy, she expects dividends to be at risk. “There are also opportunities within the credit space, both investment grade and high yield, but again default and rating downgrade risks must also be weighed against the enhanced yield,” she says.

Finally, as Morningstar’s Global CIO and President Daniel Needham says, it’s important to not overact. “Our research shows that those that sell out at the bottom and then buy back in, say a year later when they feel more comfortable, do much worse than those that stay invested. So, we think the most important thing is to actually not do anything and to talk to your financial advisor or your financial planner and really stick to the plan. That's what the plan's there for. In the short term, markets are going to move around a lot, and it's very important that you take a long-term approach to investing. Our view is that when we have periods of market volatility or where prices fall, it's often a time where you should be adding more to your investments rather than taking them away,” he says.     

  

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Ruth Saldanha

Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca

 

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