By the book

On June 1, Bloomberg's Matt Levine wrote:

Here's a simple model for stocks and the pandemic. The price of a company's stock is the present value of the company's expected future earnings. Earnings for the next while will be real real bad, since the economy has shut down.

Every company's earnings from, say, 2021 until perpetuity will be "normal" in some sense. The economy was growing in 2019, and in 2021 it will get back on that growth trend. ... If in 2019 you built a stock-price model that projected out 100 years of income, you will have to adjust one or two columns for 2020 and 2021, but after that everything can stay exactly the same.

Levine's model, of course, is that of fundamental investing. Don't sweat the current details, because ultimately, companies are worth what they will distribute to their shareholders over the ensuing years and decades. Granted, fundamental models typically discount expected cash flows rather than the accounting earnings that Levine names, but close enough. The concept is the same.

Levine continues:

This is all trivial and obvious, the simplest possible textbook model of how the stock market works, the one that every sophisticated person finds simplistic and naive. "Har har har stock prices reflect the present value of future earnings," people say knowingly when Tesla (TSLA) jumps around a lot for no reason.

A lot of people have spent years saying that the public stock market was focused only on next quarter's earnings and forced companies to prioritize short-term profits over long-term investment. ... And now, you know, here's a data point. Now next quarter's earnings will be bad for almost everyone, and the stock market has essentially shrugged it off. "Ehh, what does next quarter matter," the market basically said, "we're in it for the long term."

Looking ahead

This seems correct. People do complain, frequently, that stock investors overreact to current events, which inhibits corporate executives from investing properly in their businesses, while encouraging them to "manage" their quarterly results. However, this spring's events strongly refuted the accusation. In second-quarter 2020, global stocks rose sharply even as economies suffered record declines. Never mind overreaction; it seemed that covid-19 didn't even exist.

Investor myopia has never been as great as advertised. Back in the day, enough money managers invested on "earnings surprises"—that is, buying stocks that had released earnings reports that exceeded consensus expectations—to warrant some criticism. Adept corporate executives would lead Wall Street analysts by the nose, guiding them to forecasting quarterly earnings that were below what the company could report, if it tinkered with its accounting assumptions. Such was earnings management, and the tactic worked well.

Even then, however, there were plenty of exceptions to the frequent rule. Even as General Electric (GE) CEO Jack Welch garnered plaudits for working the system, other companies thrived without having any earnings whatsoever. In the 1990s, cellular telephones, cable television, and biotechnology firms achieved high stock-market valuations while consistently losing money. Investors were always willing to overlook current problems if a company's future appeared to be bright.

Their vision has sharpened with the New Millennium. For example, Amazon (AMZN) and Tesla have become among history's wealthiest companies never to pay a dividend. Nor, until quite recently for Amazon, have those firms posted significant profits (or in Tesla's case, any profits whatsoever). To be sure, many leaders of mature firms still pay close attention to their quarterly results. But that is because they fear that they cannot tell compelling stories about their long-term outlooks. If they could, they wouldn't worry about their 10-Q filings.

Tesla charging at a charging station

Amazon and Tesla have become among history's wealthiest companies never to pay a dividend.

Stocks' recent upswing, therefore, has not only matched fundamental investors' mental models, as noted by Levine, but also has aligned with the market's historic behaviour. Investors typically overlook today to concentrate on tomorrow. True, stocks take a beating during those occasions when investors cannot foresee what tomorrow will bring—as during the 2009 financial crisis and during the initial spread of covid-19—but once their vision clears, stock prices recover.

Whither bonds?

This much I understand. True, I miscalculated how quickly investors would discount the virus' economic effects. I expected that the marketplace would take several months, if not more, to assess how companies will fare when the pandemic passes. That estimate was incorrect, which made my assessment unduly pessimistic. However, I never doubted that at some point, the investment storm would pass, leaving stocks to be evaluated for their eventual prospects.

Which leads to the question: What about bonds? As we have seen, US stock prices have rapidly retracted their steps, placing equity prices very near their mid-February levels. But bond yields have not responded similarly. Ten-year Treasury notes paid 1.6 per cent when covid-19 first hit the United States. Their yields immediately plunged to 0.6 per cent, where they remain today. For its part, the 30-Year Treasury yield has dropped from 2.00 per cent in February to a current 1.25 per cent.

I can offer three explanations for why stock and bond quotes have diverged, none of which fully satisfies.

One is that although equity investors evaluate long-term cash flows, bond investors do not. Thus, while stock shareholders have already looked past covid-19's existence, bond investors continue to view their assets as they did when the pandemic arrived—as a place of safety during a pandemic. By this account, bond shareholders suffer from the myopia of which stock investors are often accused.

By that explanation, bond owners are remarkably stupid. I do not believe that this view is correct.

A second possibility is that stock fundamentals have remained intact, but bond prospects have been permanently altered. Because of covid-19's effects, purchasers of 30-year Treasuries will now be adequately compensated by receiving 1.25 per cent payments on their initial investments each year, whereas when 2020 began those same investors required 2.00 per cent.

That seems … highly unlikely. If you can tell a story about how corporate earnings will chug onward for the next few decades as if the coronavirus never struck, while inflation rates (and thus bond yields) have been greatly changed, please let me know. I cannot devise such an account.

The third narrative is that the Treasury market is dominated by noneconomic buyers. That is, Treasury investors own their securities for a specific purpose, ranging from holding US currency assets (for foreign central banks), to extending the duration of their portfolios, to obtaining the ballast of government securities. These are permanent decisions that are relatively unaffected by market prices. Whatever the cost, those buyers will maintain their positions.

This is the likeliest of the three scenarios, but even so, it seems a stretch. One would think that if the behaviour of stocks and bonds diverges so sharply, that arbitragers would enter on the other side of the trade, to move those asset prices more closely together. But perhaps there are limits to that arbitrage trade.

It's reassuring to think that equity investors responded rationally and calmly to 2020's market turmoil, recovering quickly from their initial confusion to focus on what really matters: business fundamentals. That does indeed seem to be what occurred. However, it is difficult to reconcile that comforting interpretation with the performance of high-quality bonds. The two stories do not appear to sum.

 

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.