In a nutshell, the answer is fear. The common perception is that collapsing earning expectations during recessions drive share prices. However, they explain only a small part of the price move. In this market sell-off, share prices should have fallen by only 5% if earnings were to fall by a similar magnitude to 2008 and 9% if there was to be a total loss of earnings for the next two years. The rest of the share price fall is from fear, driving up the equity risk premia and the discount rate applied to the earnings. The good news is that fear eventually fades and then the discount rate comes down, driving share prices back up. But this will take time.
Investors wondering how to steer through this crisis should simply ask themselves whether they need to access the capital that they have already invested while the fear level remains high. If the answer is no, then the prudent course would simply be to wait for this turbulent period to end—it always does. This approach may not of course be suitable for investors who do not have such a choice. But, to investors with available liquidity, this market should present attractive long-term opportunities.
Our intention with this newsletter is to explain the underlying drivers of share prices. We hope that this will be of assistance to investors looking for some guidance on how to navigate through these turbulent times.
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