The headlines appear more threatening every day. Increasing infections and deaths from Covid-19 are forcing quarantines at an unprecedented scale. The economic fallout is certain to be bad, and the timing of the recovery uncertain. Almighty corporations such as Boeing and Delta are seeking state-backed bailouts reminiscent of AIG and General Motors in the Lehman crisis.
Yet the one thing to do, neither intuitive nor obvious, is to buy stocks now.
Stocks reflect the long-term earnings potential of their underlying businesses. The American economy is contracting because of necessary measures to contain the virus, but the long-term potential of the American economic expansion is intact. In the past 100 years, America, backed by relentless dynamism, has survived a flu epidemic; the Great Depression; costly World Wars and numerous conflicts; an assassination and a resignation of her Presidents; hyperinflation and oil shock; Black Monday; savings-and-loans implosion; September 11; the dot-com crash; defaults of major economies; the Lehman and mortgage crisis; and the Eurozone sovereign crisis. Yet the S&P 500 increased from 18 to 3,231. There is little doubt that major corporations in the United States would set record earnings 10, 20 and 30 years from today.
So why now?
How do we know that stocks have bottomed? The truth is that there is no way to tell, despite what you hear from Goldman Sachs and CNBC. Steve Jobs said that “you can never connect the dots forward. You can only connect the dots backwards”, which means that we will only know the bottom with hindsight. Because you can’t be certain to buy at the bottom, you should only buy when you expect reasonable returns. Using 90-year averages for the S&P 500 as a benchmark, the investor can expect roughly 7% returns per year in the next 10 years (see Appendix at end of article for calculation), a reasonable return.
Why now when investors are hungry for cash and appear to be selling assets from stocks to bonds to commodities for cash? Cash pays next-to-nothing and loses value in an inflationary economy. The Federal Reserve and the ECB, the two most significant central banks, set policies to target positive inflation every year. You don’t want to bet against that. Yet investors demand cash now because of a lack of confidence in assets, even when cash is a depreciating asset. Stocks are almost certain to beat cash in returns over the next 10 years. So buy stocks before others regain confidence, as long as you are buying at levels that are likely to offer reasonable returns.
The case for owning a piece of the American economic expansion now is clear, yet there are other obstacles – psychological, economic or otherwise – for investors to pull the trigger. I do not purport to convince every person to own stocks and hold them for a sufficient duration for significant returns. Perhaps JP Morgan said it best – in bear markets, stocks return to their rightful owners.
Table above shows that S&P returned 5.9%/y for the past 90 years, comprising mostly EPS growth (5.4%) and a little PE expansion (0.5%). As of March 20, 2020, the S&P 500 traded at 13.3x forward PE. Using the 90-year averages as a benchmark, if the investor expects PE at 20x in 2030 (20x is the 1928-2019 average), this means that PE will grow from 13.3x now to 20x within 10 years, providing 4.2% return per year. Let’s assume that the return is reduced to 3.0% because of damage to confidence from the Covid-19 fallout. To estimate returns from EPS, the investor can use 5.4%, which is the 90-year average. Let’s assume that EPS returns almost halved to 3.0% because of the damage from virus containment. Summing the returns from PE (3.0%) and EPS (3.0%) result in 6.0% returns without the reinvestment of dividends. Say if we assume dividends add another 1% return conservatively (current dividend yield is about 2%), total return becomes 7%.