Reality Check

By Brad Thomason, CPA
 
 
A lifetime ago (a professional lifetime, anyway), I read the Peter Lynch classic, One Up on Wall Street.
 
My central takeaway from the book was that when it comes to the stock market, one cannot lose sight of the fact that ultimately, everything comes down to corporate profits.
 
Profits are what you are ultimately buying a share in.  Profits are the reason that the company exists in the first place, and whether they are being made or not is a gauge to the effectiveness with which the company is reading the wants of the customer market place, and executing its plans to succeed.  Profits provide the perspective required to make inferences about whether stock prices are high or low, relatively speaking.
 
As you know, we are in the midst of a significant market decline, the third such decline in the past two decades.  While each of these three events bear obvious similarities in terms of the effect on prices, and the lost wealth represented by those changed prices, why each of them came about is quite different from the other.
 
I think you could make the case that this one may be the most real decline we’ve seen, at least in terms of how the market’s most basic machinery is supposed to work.
 
In the dot.com bubble we had a case of certain stocks becoming wildly overvalued because a new way of doing business lead some people (a lot of people) to conclude that new laws of commerce and economics had come into being.  They hadn’t.  The novelty of the goods and services offered by the tech industry would eventually come to be understood as a new verse.  But the song itself was the one which had always been playing (and continues to play, today).  The process of realigning price with value was chaotic, to say the least; and destructive to wealth as chaotic moves frequently are.
 
With the Financial Crisis you had a situation of such complexity that even today most people don’t fully understand the details of what happened; and even the ones who do have a tough time reducing it to a quick summation.  But at base, you had another wildly overvalued situation, albeit in some assets which for the most part initially seemed quite tangential to the broader financial market.  Once the realization of that imbalance became understood, the market started trying to make adjustments to realign price and value.  However, the way that the mortgage paper and the credit default swaps interacted with each other was an untested problem, and the resulting uncertainty essentially caused market participants to start freezing up.  Again, that’s not even remotely a full explanation, despite that fact that everything just mentioned was a significant factor.  But it will serve for the point I’m working up to, here.
 
The precipitating events in both of these were related to finance and valuation.  In the aftermath, consumer spending declined, which in turn lead to lower economic output.  For sure, some firms saw their profits drop.  But not all of them, and certainly not in equal measure.  Many of the losses booked by the most heavily-impacted industries (tech in 2001, finance in 2008) were due to one-time write downs, versus losses from the ongoing sale of goods and services to customers.
 
That’s what makes this one different.  You can make the argument (and I have…) that the stock market was too expensive going into this thing.  But not the same version of overvalued that we had in the other two.  This time it was more of a garden variety type of too-expensive, driven mostly by boredom and inattention (people kept progressively bidding prices higher, in relatively modest increments, because they couldn’t, evidently, come up with anything else to invest in).  But it was not an unwinding of that valuation mistake (“mistake”) that lead to the decline.
 
This decline has occurred because people have stopped buying stuff.  Like, a lot of stuff.  And the decline in sales (from the company perspective) occurred far faster than the related drop in expense levels.  The natural, mathematical, and mechanically-inevitable result:  profit levels have fallen.
 
The market has adjusted accordingly.
 
What we are seeing right now is about the most straight-forward expression of the fundamentals that I can remember.  Sales are down.  Profits are down.  Prices have adjusted to reflect that condition. 
 
It is too early to tell if the market “got it right” in terms of revaluing the changed reality.  But there’s no mystery or complexity as to what has driven the revaluation.  Stock prices have changed because profit reality has changed.
 
As I said, even though the price decline is similar to what we have seen before (in excess of 30% already, and no confirmation that we have seen the low point yet on this latest one), the how and why seem very different.  At least they do to me.
 
So I don’t really know if any of that tells you much in the way of what to do.  Consider it more of a perspective piece.  Like all of you, I’m spending a fair bit of time these days wondering what all of this means, and I think the process by which we come to those answers lies in picking things up and looking at them from different angles.  This is the angle that’s been on my mind the past couple of days, so I thought it might be something you would find interesting, too.  Stay safe.