Protest signs and artwork decorate the newly-erected fence around the White House
The crisis across the nation continues. The novel coronavirus hit our shores in February (perhaps earlier) and brought a biological threat that caused health authorities and government officials to strongly advise we socially distance ourselves from each other to slow the spread of the contagion. This forced us to remain at home for all but essential travel. It also resulted in the shuttering of much of the economy.
The economic impact was swift. In a matter of weeks, we went from record low unemployment to jobless numbers the country has not experienced since the Great Depression. We lost tens of millions of jobs. Economic output collapsed. Consumer spending plummeted. While the country is not technically in a recession, it surely will be.
Then the death of a black man, George Floyd, on May 25 in Minneapolis sparked protests that have transformed into a movement against racial injustice and discrimination. The demonstrations have continued every day in large cities and small towns on four continents. The reaction hearkens back to the social unrest of the 1960s, when we lost Dr. Martin Luther King and Robert Kennedy.
Over the weekend, a Wall Street Journal and NBC News poll indicated that 80% of Americans feel that the country is “spiraling out of control.” Even if you don’t feel that strongly, you are probably very concerned about what is happening.
Pricing a Stock – A Simple Example
Last week we noted the apparent disconnect between the economy and the stock market, and touched on what a stock price represents to understand this.
There a number of ways to price a stock. We’re outlining here the “discounted cash flow model” to show that the stock market is looking past COVID-19, the recession and the current social unrest.
Let’s assume that we want to know the value of stock in “ACME”. We need to know the following:
- The cashflow we expect from ACME in the next year.
- The expected growth rate of the cashflows over time.
- The number of years to discount.
- The overall cash flow beyond our last year. This an estimate and is known as the “terminal cash flow.”
- Our required rate of return. This is also known as the discount rate in this model.
Let’s assume that ACME’s cashflow in the next 12 months is $1 million. With cashflows increasing at 5% per year and a 10% discount rate, the discounted cashflows for the next 5 years are:
Year 1: $909,000
Year 2: $867,700
Year 3: $828,300
Year 4: $792,800
Year 5: $754,900
We’ll also assume that the terminal cashflow beyond year 5 is three times the value in year 5. So, that number is $2.265 million.
Therefore, the total cashflow we expect from ACME is $6.41 million. That’s the value of ACME today. If there are 100,000 shares of ACME outstanding, the value per share would be $64.18.
Now let’s make one change. Let’s assume that a pandemic has hit, and as a result ACME’s discounted cashflow next year is expected to be $450,000 instead of $909,000, a decline of 50%. Let’s also assume that the recovery from the pandemic is “V”-shaped. In other words, the company will quickly recover and its cashflows in all subsequent years will remain the same (as above).
What is the value of ACME? It’s $5.95 million. If there are still 100,000 shares outstanding, the value per share would be $59.51. So, even after next year’s cashflow drops by 50% because of the pandemic, the stock’s value only dropped $4.67, or just over 7%.
This may explain how investors are viewing many publicly-traded companies. Investors may be expecting to see their cashflow (earnings) drop in the short-term, but quickly bounce back.
Only time will tell whether the optimism we see reflected in the stock market is well-founded.
Last Friday, the Dow Jones Industrial Average was up 829 points, or 3.15%. The S&P 500 Index rose 81.58 points, or 2.62%. The Dow is down just 5% for the year and the S&P 500 Index is down 1.1% for the year to date. The tech-heavy Nasdaq index rose 198 points and set a new all-time record.
Optimism has spread to other investments, too. The yield on the 10-year Treasury Note jumped from 0.66% in the prior week to 0.903%. Yields rise when prices fall, and this means that investors were selling Treasuries and moving back into riskier (presumably higher-returning) investments.
Similarly, the price of gold dropped by 2.5% last week. The yellow metal is another perceived safe haven for investors. It is still up by 25% since the beginning of the year.
Globally, across 187 countries, there have been over 7 million confirmed cases and over 400,000 deaths. In the US, over 1.9 million have been infected and over 110,000 have died. We note that Americans are not following the virus nearly as closely as they did at the beginning of the pandemic. As various sections of the country begin to re-open, the mood has shifted. We should keep an eye on the rate of new cases across the country. It recently jumped in Oregon. This could be related to increased testing, or to a spike in new cases after the Memorial Day weekend.
In the weeks and months ahead, we will be following many things that begin with the letter “P.”
Pandemic – What will be the course of COVID-19 in the months ahead? Will we have adequate testing? Will there be a treatment? Will we have proper contract tracing and quarantine measures in place as the country re-opens? When will a vaccine be available?
Will we experience a resurgence of the virus, as states and counties begin to relax physical distancing measures? Will the virus spike this fall, as the northern hemisphere enters flu season? Will the health care system be able to handle another jump in infections?
Policy – What will the Federal Reserve, Congress and the Administration due to support businesses, workers, states and municipalities? Enhanced unemployment benefits end in July. How will laid off workers make ends meet? Will Congress pass a fifth aid package?
Protests – How long will the protests continue? Will we see more riots, looting and property destruction? Will the protests lead to actual change in the nation’s social fabric? Will law enforcement agencies change their policies towards black Americans and others of color?
Panda – This refers to China. Our relationship with this great nation has suffered over the past year. It is the most important two-country relationship in the world. There have been disagreements (and agreements) over bilateral trade. We are in a stand-off in the South China Sea over international navigation rights. There is tension over the source of the novel coronavirus. There are disputes about intellectual property and technological security. There is a race for a vaccine that resembles the race to space.
Politics – In case you’ve forgotten, there is a major election this fall. The nation will elect a president. The outcome will undoubtedly have an effect on the stock market. We just don’t know what it will be.
In closing, we offer the following for which we are grateful:
- The brave people who have peacefully protested for racial equality and fairness.
- The police officers who have joined them in protest and who have protected them from violent agitators.
- Leaders in government, businesses, entertainment, sports, and education who have expressed support for change in our race relations.
May we treat each other with respect and dignity.
Keep the faith, be safe and stay healthy.
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