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Perspectives

March 2020

Assessing Valuations in Volatile Markets


For many investors, March 9, 2009, may seem like a long time ago. It marked the bottom for stocks during the global financial crisis. Eleven years later to the day, the spike in volatility and continued sell-off across equity markets is likely to elicit similar concerns. The novel coronavirus COVID-19 continues to dominate headlines, and the impact on society-at-large should not be overlooked. While the number of confirmed new cases in China has decreased, many other countries, including Italy and South Korea, are reporting increases in new cases.  Both governments and private entities alike are taking significant measures in the hope of stemming the spread of this outbreak.

We are approaching “bear-market” territory (a sell-off of 20% from the last market high) and see the anxiety investors are experiencing reflected in a spike in VIX levels—a common measure of U.S. market volatility—and a tremendous flight to perceived safety. As of this writing, U.S. 10-Year Treasuries are hovering around 0.50% and the 30-year yield has dropped below 1%. But we believe it is important to consider some additional factors. The exact role COVID-19 is playing in market movements is unclear, but it appears the market is reassessing its growth and return expectations, and it is very likely the coronavirus outbreak was a primary catalyst. Stocks have seen an incredible run since March 2009, and alongside that run we have seen that valuation ratios have expanded significantly for certain parts of the U.S. equity market, as is illustrated in Figure 1.

Figure 1 | Valuations for U.S. Growth Stocks Have Increased Meaningfully Since 2008

Data for all charts from 12/31/2008 to 3/6/2020. Source: FactSet. Style and size represented by Russell indices.

For example, earlier this year, the price-to-earnings (PE) ratio for the Russell 1000® Growth Index peaked at over 28, compared to a historical average of 20.8 going back to 2008. Other ratios show similar patterns as shown in Figure 2. The difference in valuation ratios between large growth stocks and small value stocks has increased significantly, pointing to a higher expected value premium.

Figure 2 | The Difference in Valuation Ratios Between Large Growth and Small Value Stocks Has Increased Significantly

Data from 12/31/2008 to 3/6/2020. Source: FactSet. Style and size represented by Russell indices.

We are in a period of uncertainty and volatility not seen since the 2008 financial crisis. What is different about this period is that the major global banks are far better off financially than in 2008, which helps reduce concerns about the ability of the banking system and markets to weather the storm. A gauge on the outlook for U.S. companies in general before novel coronavirus concerns is the Russell 3000® Index hitting an all-time high on February 19. 

While the recent market volatility along with world events and health concerns may be unsettling, investors should find it reassuring that asset prices incorporate current expectations and investors’ demanded discount rate. We are likely in a period when investors are demanding high expected returns to take risk, as indicated by the 10-year U.S. Treasury yield falling below 0.50% illustrated in Figure 3, an indication of investors seeking safety and overall increased risk aversion. Where some investors see unwanted risk, others will see opportunity. For long-term investors, broadscale changes to a well-thought-out asset allocation are likely unnecessary.

Figure 3 | 10-Year Treasury Yield Falls Below 0.5%

Data from 1/2/1962 - 3/5/2020. Source: St. Louis Federal Reserve.

Glossary

Price-to-Earnings Ratio (P/E): The price of a stock divided by its annual earnings per share. These earnings can be historical (the most recent 12 months) or forward-looking (an estimate of the next 12 months). A P/E ratio allows analysts to compare stocks on the basis of how much an investor is paying (in terms of price) for a dollar of recent or expected earnings. Higher P/E ratios imply that a stock's earnings are valued more highly, usually on the basis of higher expected earnings growth in the future or higher quality of earnings.

Price-to-Book Ratio (P/B): Price per share divided by book value (net assets) per share.

Price-to-Cash Flow Ratio (P/CF): Price per share divided by annual opperating cash flow per share.

Price-to-Sales Ratio (P/S): Price per share divided by annual revenue per share.

 


 

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