Headlines today, and nearly every conversation, seems dominated by COVID-19. The torrent of unhelpful information and alarmism can be overwhelming, so I wanted to share some thoughts on where we stand in the market to hopefully add some perspective.
The spread of COVID-19 has driven breathtaking levels of market volatility, however there were already a number of market conditions which may have contributed as well. Most notably, the high price to earnings multiples of equities, particularly those in the United States.
The price to earnings multiple, commonly referred to as “P/E,” is a ratio which is used to determine how “expensive” equities are relative to their historical average. While not predictive of returns, and certainly not of the timing of market gyrations, historically investments made at lower, “cheaper” P/E levels have fared better on average than those made at P/E levels far above the long-term average. Since 1871 the average monthly P/E of the S&P 500 has been 15.8, while the average from 2018 – 2019 was 22.0.
This is not to say that the recent market pullback was predictable, because it most certainly was not. P/E ratios drift higher as exuberance and a rosy outlook appear on the horizon and drop in environments where there is an increased perception of risk. Although we do not yet have Q1 earnings information, by looking at prices and estimates we can see that we are much closer to average than we have been over the last two years, with a P/E ratio of approximately 17-18.
The two most recent market downturns prior to 2020 highlight the reason why reactive behavior rarely yields positive results when others begin to sell in panic. The month following the dot-com bear market yielded 15% alone, and 34% over the year that followed. In the two years after the height of the Great Recession in 2009 the S&P 500 rose from 676 to 1310, nearly 200%. No one can predict when equities will return to bull market territory, or the scale of impact this virus will have on the economy, but one risk that does exist is that of selling in fear and missing the upswing in prices that will likely occur once we begin to see good news reported rather than the barrage of negative headlines we have seen over the last two weeks.
There is no doubt that there are extraordinary risks posed by the spread of the COVID-19 virus. However, the proactive decisions that we see being made by individuals, organizations, and countries around the world to limit exposure should instill confidence that steps are being taken to mitigate any significant long-term impacts.