Economic forecasts are looking terrible at the moment.
Yet, stocks are rising, putting investors in a conundrum.
Should you sell your stocks now?
Or are shares still cheap?
There’s no easy answer.
Advanced estimates from the Ministry of Trade and Industry point to Singapore’s Gross Domestic Product (GDP) contracting 2.2% in the first quarter of 2020.
And the situation is about to get worse.
The nation’s GDP is expected to shrink by as much as 4% for the full year.
Worryingly, the Monetary Authority of Singapore (MAS) has warned that there are “significant downside risks”, implying things could get much worse.
And yet, stocks have risen.
As I write, the Straits Times Index (SGX: ^STI) is sitting above the 2,500 level after bottoming out near the 2,200 mark in late March.
That’s an increase of more than 14% in less than two months.
Have your shares become overvalued?
Given the rapid recovery in stock prices, investors have started to question whether shares are setting themselves up for another crash.
After all, second-quarter results for most companies are expected to be terrible.
And if earnings were to deteriorate, surely stock prices will decline as well, investors reason.
In other words, current share prices may be driven by an overly optimistic outlook and could prove to be overvalued.
Any good investor knows that you should buy stocks at a price less than what they are worth.
But assigning a value to a stock is not as straightforward as it looks.
How’s the business doing?
“Just giving the numbers is like describing people using their body temperature”
— Tom Gayner, CEO of Markel
Before you can value a stock, you need to know the business behind it.
Understanding the business is essential in whatever valuation metric you choose.
The better you understand a business, the better you will be at valuing it.
For instance, if a company is in a cyclical industry and exhibits lumpy revenue, you wouldn’t assume that the company’s future growth will be in a straight line up and to the right.
Meanwhile, businesses that have matured may have less growth runway ahead.
Under such a scenario, investors should exercise caution in projecting past growth trajectories into the future.
For example, the mobile penetration in Singapore was over 154% in May 2019, suggesting that there is little room for significant growth for the local telco industry.
As such, we shouldn’t be too generous in our projections.
Innovative companies, on the other hand, may deserve some leeway in valuation, as much of the value could be hidden and only be revealed in the future.
Amazon (NASDAQ: AMZN), for instance, has morphed from being a bookseller to selling almost everything under the sun. Amazon Web Services (AWS) has also opened up new possibilities for the company that were not fully visible until 2015.
Valuing Amazon shares prior to 2015 based on its online retail operations alone would miss out on the future value of its AWS.
Selling Amazon too early based on an incomplete valuation would have been a mistake.
As such, understanding the business is a good starting point. But the hard part is guessing what will happen next.
In whatever valuation approach that we choose, we cannot avoid the fact that we are trying to guess what will happen in the future.
As Josh Brown, CEO of Ritholtz Wealth Management, once said “We’re all just guessing, but some of us have fancier math”.
His observation is particularly relevant for the current situation.
Making assumptions on what is going to happen in the next few months is hard.
The COVID-19 outbreak has been ruthless in forcing governments around the world to define which services and goods are essential for their nation’s daily needs.
The impact has been staggering.
Businesses that rely on tourism and travel have been hit particularly hard as country borders were closed off.
Public transportation, a daily staple, has seen a significant decline in usage as the vast majority of the workforce stayed at home.
Yet, today we stand at the cusp of the end of the circuit breaker measures for Singapore.
But the easing of safe-distancing measures might not mean that businesses will return to normal activity levels immediately or in a sustained way.
If new COVID-19 clusters emerge, the government may be forced to enforce the circuit breaker measures again.
Get Smart: Looking past the clouds
Making guesses for the short term is hard.
But if I had to guess, stock prices today are reflecting the possibility of a recovery in the near term.
Whether or not a recovery in business will truly happen, and in what form, remains to be seen. Some businesses, such as air travel and tourism, may indeed take longer to return to any semblance of their previous highs.
Making guesses on the long-term, while imperfect, is actually easier.
It is unlikely that businesses will sit idly and watch the world pass by.
When forced to a corner, necessity becomes the mother of all invention. I believe that the most innovative companies out there will adapt to whatever shape or form the eventual recovery takes on.
And yes, I think that a recovery will eventually happen. How and when it happens, though, is unknown.
Either way, we want to own the companies that adapt and continue to move the world forward. These are companies that will eventually help us get over one of the most challenging times of our generation.
And we will.
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Disclosure: Chin Hui Leong owns shares of Amazon.
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