Large UK companies are multi-nationals, deriving considerable revenue outside the UK, yet the overall market was not immune to fears surrounding Brexit.
Prices were low relative to the strength of underlying cash flows, or so we reasoned.
In contrast, the US market was among the most overpriced of mainstream investments, in our opinion.
Driven largely by the high-flying tech names like Microsoft, Apple, Amazon, Alphabet (Google), Facebook and Netflix, US market prices seemed permanently buttressed by sentiment – belief, almost, that these companies’ stocks could move in only one direction: up.
Of course that belief is not true, and one needed only look back to the fourth quarter of 2018, when the US market declined –peak to trough – more than 19 per cent, to see evidence of the fragility of this market.
A fragility, we would argue, created by overpriced stocks.
That US stocks were overpriced was not a secret.
So I believe – and this is, of course, unprovable – that the growing fear about how Covid-19 might affect stocks got an early fillip from the knowledge that US stocks were already dear.
Their high prices gave them more room to fall, and the more they fell, the more global sentiment worsened.
Investors did not differentiate between reasonably priced markets like the UK and overpriced ones.
Thus, overpricing led to repricing, which dented sentiment, which led to selling and worsening sentiment.
Of course, the virus also spread during this time, as did awareness and new information on its potential economic impact.
We cannot decouple those forces.
But we can imagine a scenario where the virus was quickly contained and its impact minor, and in that scenario I believe stocks still would have fallen because of the chain above that begins with overpricing.
Later, stocks continued to tumble as the impact on economic activity came into sharper focus.
For example, a weekly unemployment figure in March in the US was nearly five times its previous record-worst level, as thousands of companies were crippled by stay-at-home orders.
Certainly, we can say that the economic impact from coronavirus is driving pricing today.
However, we would note that markets are extrapolating – they are pricing in today’s shut-in economy well into the future, when again we expect to see reversion to the mean.
As low as downturns go, they always seem to find a way back.
Valuation tied to future performance
If you group stock markets based on valuation – that is, price relative to fundamentals – you will find that underpriced stocks tend to outperform overpriced stocks in the long term.
We believe this is a key tenet for investing.
It is at the core of our investment process, and we believe it should be a financial adviser’s North Star, even if they hire someone else to build portfolios for their clients.
