Finding A Reference Point for Assessing Value in Stocks

On Monday, I wrote that while stocks could be expected to hold onto most of the gains seen last week early in this week, the month’s, and therefore the quarter’s, end yesterday could prove to be a short-term turning point. The early evidence this morning, with Dow futures having indicated an opening seven or eight hundred points below yesterday’s close, suggests that I was right. If so, then a test of the March 30 low in the Dow of 18,213.65 looks like the most likely next move.

Assuming that is the case, a return to the lows will probably prompt a lot of investors to go value hunting, which leads to the question: What, if anything given the exceptional nature of this shock to the markets, can be considered value?

The problem with looking for value in a collapsed market is that in order to assess what is oversold, you first have to decide what represents fair value. That task is complicated this time around by two factors.

First, the levels from which we dropped are not, in most cases, a useful indication of fair value because even before this all began, valuations were distorted. The average Price to Earnings Ratios (P/Es) of all the major indices were well above their historical averages at the highs, even though it was becoming increasingly clear that that wasn’t supported by the available data.

As I pointed out several times earlier this year, we were at record highs despite three consecutive quarters of negative earnings growth for the S&P 500 to end last year. Even without a cataclysmic event such as this, that had to change.

There were several reasons why we were there. The world was awash with liquidity, as central banks around the globe had been pumping money into the financial system for a decade. Most had begun to tighten monetary policy somewhat, but last year the Fed, under enormous political pressure, had begun loosening again. Whether you believe that was justified or not, loose monetary policy distorts asset values.

Some reasons were more understandable. There was genuine optimism that growth, both global and here in the U.S., was on an upward trajectory, and there was a feeling among some that advances in technology and efficiency were pushing us into a new normal where average P/Es in the twenties were justified and sustainable.

Those projections in themselves weren’t unreasonable, but the market pricing them in completely while dialing down the risk discount in stocks almost to zero once again distorted value calculations.

That distortion occurred over time, but it really began to accelerate in the last quarter of last year when the Fed started to cut rates again, as the chart for the S&P 500 below, which runs from 4/1/2019 to just before the collapse started, clearly shows:

This isn’t an exact science, but that would suggest that fair value calculations for stocks should be based off the levels at that time.

If you do that, some interesting patterns emerge. Stocks like Apple (AAPL) which face no existential threat from this downturn, may have got to end of September 2019 levels at their lows, but have recovered to price in a fairly quick bounce back. Other big tech companies such as MSFT exhibit the same pattern, while some that may even derive long-term benefit from behavior changes that result from these crazy times, like Amazon (AMZN) for example, are significantly higher now than they were then.

That doesn’t mean that Amazon isn’t a good stock to own in expectation of a return to normalcy, it is just that if you are looking for something oversold, there are better options.

One word of warning. This doesn’t mean that all the hardest hit stocks are the ones to buy. Things like cruise lines and airlines face real, existential threats should consumers make long-term adjustments to their behavior, so a wait and see approach is best there. Similarly, buying highly leveraged energy companies risks a total loss should there be more bankruptcies, so is not advisable right now.

There are, however, some opportunities in hard-hit sectors. In energy, the likes of Royal Dutch Shell (RDS-A) or Chevron (CVX), integrated firms with decent balance sheets, look like value at 38% and 43% respectively below their levels at the end of September. They have the added advantage of juicy dividends in a low-rate environment.

Banking too has some opportunities. The large national banks, like Bank of America (BAC), will face issues with ultra-low interest rates and a possible rash of defaults on loans, but, as I pointed out on Friday, their balance sheets are in much better shape than in previous crashes and there are some offsetting pros as well as a long list of cons about this situation and the response to it.

BAC is available at a 31% discount to its 9/30/20 close, so, given that, is another that can be said to represent value.

There is no way for investors to know at this point how long this disruption will continue or what long-term damage it will do, but if you see an approach to the previous low as a chance to spend some available cash in your account it is worth considering what constitutes “value.” Referencing pricing at the end of the third quarter of last year may be a good way to make that assessment.