The US is due to relax restrictions to social distancing measures over the coming weeks, mainly in Trump supporting states, and Europe is finally seeing a slow decline in cases and death rates.
We’re consuming endless news and information about the lockdown and everybody has an opinion.
Financially speaking though I believe there are three “big thinking” graphs that place where we are in the economic cycle firmly into context.
How this compares to past crises
The first graph is a direct comparison between the stock market crash of 2020, what people now seem to be calling the “Great Lockdown” (a suitable moniker!) and previous stock market crashes.
Remember that counter-intuitively, stocks don’t tend to fall in a straight line. In every major crisis we have faced before there has been a slow and meandering road down to the bottom. Have a look at the left hand side of the graph (% fall from highs) versus the horizontal axis (length of time stocks fell):
The message here is clear: whether it was the Oil Embargo in the 1970s, or the Dot Com bubble in the 2000s, or the stock bubble in 1929, once equities hit a brick wall in the form of a crisis they tend to go down over a period of months with short, sharp rallies in between before sentiment hits rock bottom.
Yet the “Great Lockdown” (red line) seems extremely mild in comparison and suggests we could have a lot further to fall.
Shiller CAPE Index
The second graph has a lot of moving parts, but what it boils down to is how ‘expensive’ or ‘cheap’ stocks are at any given moment in history. This is a lot like panning the camera out way, way further back and looking across centuries rather than years.
Renowned Yale professor Robert Shiller created the CAPE or cyclically adjusted price-earnings ratio in order to show how over long periods of time, since 1881, stocks can go through periods of high valuation followed by periods of very low valuation.
The blue line is the ratio itself and the red line is where interest rates were over the same time period:
Great times to buy stocks were when the CAPE ratio sat around 10, in 1921, 1932, 1943-1945, 1980-82, 2009.
Conversely when the CAPE ratio is above 25 we see peak market values in 1901, 1929, 1966, 2000, and early 2020.
What this should warn us about is something fundamentally very simple: in every period in history when we’ve hit a peak, we have seen a “reversion to the mean” where stock valuations go lower.
Buffett Indicator
Warren Buffett has inspired a generation of stock market investors. He’s a household name and that doesn’t just mean in the US, either: Buffett is very famous in places like China.
As we covered earlier this week, there’s a good reason why Warren Buffett isn’t buying stocks.
Like the above graphs, though, there is one single measure that Buffett uses above all else to decide where stock valuations are at any given moment – it is called the Market Cap to GDP ratio:
What this represents is the total market capitalisation of the stock market (literally, every single stock in the United States) divided by the US gross domestic product (total productivity of the US economy). In other words it gives you a clear picture of how the entire universe of stocks is performing against the entire economy.
In periods like 1975-1990, the total market cap of the stock market was under-performing the economy. In 2000, 2007, and basically from 2013-2020, we’ve again seen significantly lofty valuations against the over-all strength of the economy.
Frugal Investors – what do we do?
Buffett’s business partner, Charlie Munger, probably has the best advice for what we should be doing right now:
There might very well be a second wave of infections within the next two months. The vaccine that humanity desperately needs, to stave off hundreds of thousands of deaths, may be delayed with tragic consequences. It is a tough old world out there and we all need to do our part to get through this crisis.
None of that directly impacts the investment cases for Unilever, Diageo, London Stock Exchange or Relx over the long term. Or a globally diversified dividend fund like the Vanguard All-World High Dividend ETF.
Neither does it stock you from investing in Coca-Cola, Stryker, Restaurant Brands International, Raytheon Technologies. Or the SPDR S&P Dividend ETF, or the Schwab US Dividend ETF.
Investing is a slow, steady process of doing nothing for long periods of time!
