Lessons from the pandemic
The March 2020 experience was a dark time for investors but offers some valuable lessons.
First, in the face of uncertainty and a confusing threat, many investors—and this includes retail investors as well as professional fund managers—have a tendency to catastrophize and go straight to worst case scenario.
The financial media, which thrives on extreme emotion for clicks and ratings, also tends to egg us on.
During the pandemic, investors began to price in the most dire forecasts of death and destruction from the virus. As markets plunged, these forecasts seemed to gain legitimacy, further justifying the extreme pessimism.
The impact and ultimate form of Trump’s tariffs are currently unknown in that the final rates will be a function of negotiation with other countries. This uncertainty is one of the biggest problems with the current dynamic, and many people appear to be assuming the worst.
By selling down stocks, investors are implicitly pricing in a substantial decline in future corporate earnings and/or earnings growth rates.
But investment outperformance occurs when expectations are surpassed. Sell-offs of this magnitude therefore often present good buying opportunities because the market temporarily becomes way too pessimistic about the future.
Interest rate relief
Second, investors in March of 2020 were focused on the negatives and overlooking the positives.
Interest rates plunged at that time, which led to a liquidity environment that gave a tremendous boost to the stock market over the next two years—such that even investors who bought into the stock market at the worst possible moment in February 2020 ended up with good returns.
We are not now witnessing a decline in interest rates of the same magnitude, but rates are drifting lower. The yield on 10-year Treasuries is now just above 4%. It was close to 5% in early January.
Just as seemingly good economic news, like a strong jobs report, is often interpreted as bad news (because it means the Fed might have to raise rates), bad news can also be good news.
The economy has struggled with high interest rates and inflationary pressures over the past several years. A growth slowdown or economic contraction is never desirable but can be helpful when it comes to inflation and interest rates.
Additionally, while tariffs are problematic for the economy because they function as a tax on consumers and can be disruptive to supply chains, tariffs do yield certain economic benefits.
Higher government revenue can provide room for tax cuts and/or deficit reduction (which would further alleviate upward pressure on interest rates).
Tariffs also redirect demand from foreign production to domestic production, potentially leading to higher wages and greater investment. Many U.S. companies will directly benefit from this shift, as we have previously highlighted.
A valuation reset
Tariffs have been the catalyst for the recent market drawdown, but the backdrop is important to consider.
Prior to mid-February, we saw unusually strong performance (especially in growth/tech stocks), historically high levels of market concentration (Mag Seven) and arguably elevated valuations. Much of this has been reversed.
With the recent decline, the S&P 500 is now trading at just over 24x trailing earnings, from a peak of around 28x. This is close to the lowest levels of the past year.
The NASDAQ Composite is at 28x trailing earnings, versus a peak of 34x, and is also at its lowest levels.
