Acting rationally: Why equity markets have recovered
Unearthing the reason for market heights
Since the remarkable equity market reversal in developed countries in late March, many clients have asked whether markets have become irrational.
Given the extreme uncertainty surrounding Covid-19, record unemployment, and eye-watering declines in second-quarter GDP, how can the markets have flirted with all-time highs?
Possible answers range from "There's no alternative" to young investors' driving the market through new digital investor platforms.
Our investment strategy group, however, thinks that the answer is fundamental. And we do not believe that US equity markets are acting irrationally.
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Mathematics and value judgments
At their core, financial markets reflect assessments of the value of assets today based on investors' expectations for the cash those assets will generate.
This concept of net present value is more concretely applied to fixed income, where the known values for yields and coupon payments produce the price. Knowing two of the three values allows investors to determine the third.
The concept applies equally to equity markets. Price plays the same role as in fixed income; future cash flows equate to the coupon, and the required rate of return equates to yield to maturity.
The challenge for equities is the inherent uncertainty around future cash flows - the earnings that companies will reinvest in the business or distribute in dividends.
Much of the assessment of these future cash flows is related to current financial conditions. Because of the market's forward-looking nature, prices react to changing corporate and economic conditions faster than traditional economic data can.
Three telling events
Though Covid-19 remains a real risk to the global economy, three important things happened in recent months to cause equity markets to reassess return prospects after the fall into bear market territory.
Long-term bond yields declined steeply, the Federal Reserve cut its policy rate to zero, and already-low inflation expectations fell even further. These factors caused the required rate of return to plummet.
The present value of equities increases as the required rate of return decreases.
The future?
What does this mean for future equity prices? That depends. A higher fair value range now won't necessarily remain elevated or continue to increase. Nor does it mean that market prices will not deviate from fair value temporarily.
A normalisation in interest rates and inflation expectations would cause fair value to fall (all else being equal), but prices may not immediately follow because of other short-term factors.
Over longer periods, though, we would expect these deviations to revert to fair value as they have over the past 70 years.
Vanguard's global economics team does not expect monetary policy to normalise anytime soon. On the contrary, we believe the federal funds rate will remain near zero at least through 2021.
We also believe demand-supply imbalances will likely lead to lower (not higher) inflation in developed countries for the foreseeable future, despite unprecedented monetary and fiscal policy. This would suggest that fair value is unlikely to change significantly.
Better-than-expected news about the development of a vaccine or effective therapy could cause equity prices to deviate into overvalued territory.
Conversely, if these developments take longer or containment measures prove unsuccessful, prices could move into undervalued territory as market sentiment suffers.
Accurately predicting such surprises and untangling them from market prices is difficult at best.
We may not be able to predict the market's next move with any degree of confidence, but we can say that a reasonable basis exists for its current level.
Kevin DiCiurcio is senior investment strategist at Vanguard
