Today’s article is by Scott Kubie, CFA, Senior Investment Strategist of Omaha, Nebraska-based Carson Group.
A stock’s long-term value is derived from three factors: growth, cash flow and risk. As the equation below shows, the constant growth model estimates fair value by dividing the cash flow one year from now by the difference between the required rate of return and the constant growth estimate.
Beyond being an elegant way to estimate long-term market value, this equation also offers a guide to how markets can get out of whack.
When investors’ estimates divorce themselves from reality, they overpay for stocks. The last two major market declines came from investors misestimating the growth prospects and cash flow of corporations.
During the dot-com bubble, investors overestimated growth, pushing valuations to extremes. In the financial crisis of 2008, cash flow was overstated, as banks booked profits on loans that wouldn’t be repaid.
Some investors continue to focus on the two most recent large downturns for indications that trouble is on the horizon. But we believe the next trouble spot will more likely come from the third part of the equation: risk. If risk estimates become too low, investors will pay too much and suffer when risk returns to normal levels.
The spoiler is this is already happening. The low-risk expectations suggest investors have become too complacent and are ignoring a number of risks.
Market risk levels, based on the CBOE’s Volatility Index (VIX), have dropped to historic lows. The market continues to hum along, and the danger is that investors will steadily bid up a suddenly less-volatile stock market.
Of course, the very act of bidding up returns pushes volatility down with a steady flow of new investments, further extending the trend—at least until a shock pushes risk up and causes a large reassessment.
Then, complacent investors can quickly become scared investors, increasing the risk of a sharp market downturn.
How should you, as an investor, respond to a market where a sharp downturn is likely?
At the time of writing, the author held no positions in the securities mentioned. For a list of disclosures, please click here.