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Jan. 25, 2021, 2:28 p.m. EST

Stocks priced for vaccination and perfection leave investors exposed

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By Satyajit Das

The facts are straightforward: A complex, silicon chip-based civilization has been brought to a stop by a virus. Economies that assume mobility and are based on consumption are bleeding out because the most technologically advanced society in the history of the planet has had to revert to medieval techniques of infection control. 

While several COVID-19 vaccines have been found, their long-term effectiveness, duration of protection conferred and acceptance amongst populations skeptical of authority are unclear. The daunting logistics of production and vaccination are already apparent. Recall that the global eradication effort for smallpox took 11 years, from 1966 to 1977. In short, no one has a clear idea of the trajectory including the growing number of armchair virologists and epidemiologists. 

Under conditions of profound uncertainty, investors have two choices. One is to husband liquidity in safe assets, awaiting clarity. The alternative is to follow John Maynard Keynes’ “beauty contest” advice: Invest based on what you anticipate others favor. The current prices of risky assets, particularly stocks, suggest that investors have chosen the latter strategy. Markets are priced for vaccination as well as perfection.

Investment pundits have retrofitted elaborate theories to buoy asset markets. But there are several reasons for caution.

First, normal indicators, such as employment and activity, are not currently useful. Government and central banks are significantly distorting measures. Most growth in advanced economies is propped by artificially low rates and pandemic benefits. Some of it is duplicated, resulting in uplifts of income greater than what is lost. Default figures are disguised by repayment and rent suspensions.

Second, where there are large fluctuations, rates of change are useless. A drop of 25% and subsequent rise of the same amount leaves an index down 6.25%. Only absolute levels matter now. 

Recent sharp increases in payrolls mask the fact that the numbers of employed and hours worked both remain well below pre-COVID-19 levels. The prospects for new technologies are being extrapolated from high rates of growth off low bases and assume continuous high rates of technical improvements. Most will follow sigmoid or “S-shaped” curves, subject to asymptotic limits. Trees don’t grow to the sky.

Third, traditional valuation metrics fail in extreme conditions because of the inability to model all necessary variables, confusion of coincidence and causality, and complex feedback loops. Price-earnings measures are meaningless where earnings are artificial, non-existent or speculative. Zero- or negative interest rates imply infinite present values. Historical relationships between money supply, unemployment and inflation have broken down.

Fourth, the long-term effects of the pandemic are yet to be fully understood or felt. Even if COVID-19 is brought under control, the economic emergency has only just begun. 

The measures taken to support economic activity have high costs. Surging government debt levels will create a global overhang that will last generations. Companies have borrowed heavily to replace lost revenues rather than build productive capacity. There are large crisis liabilities such as customer credits for services not rendered which must be honored. Savings have been denuded. Businesses and households may never recover. If they do, it will take a long time. 

A rapid return to the status quo also has risks. Stronger than expected private consumption, investment, government spending and a flood of liquidity could result in inflation overshooting as economies’ capacity to produce is outstripped. Higher interest rates on extraordinary levels of debt may then prove unserviceable. 

Fifth, the ability of governments and policymakers to influence outcomes is constrained. Interest rate cuts, repeated rounds of quantitative easing, currency intervention and jawboning or forward guidance have all been tried since 2008 with limited success.  Rate cuts and printing money are easy but do not bring back lost jobs or restart businesses forced to close.

Sixth, there is a marked difference between risk (known unknowns) and uncertainty (unknown unknowns). Keynes thought there is no scientific basis for calculating the probability of wars, long-term prices or the fate of new technologies with anything like reasonable accuracy. Today people ignore this problem, choosing to rely on technical and mathematical sophistry.

Investors would do well to heed the observation of author William Goldman about the film business: “Nobody knows anything. Not one person in the entire motion picture field knows for a certainty what’s going to work. Every time out it’s a guess and, if you’re lucky, an educated one.” 

Current investment bets may be correct or they may be wrong. Results will depend on factors over which investors have little control. Ultimately, it will ruin those who first bet against the rise in prices, and then on those who bet on it. 

Satyajit Das is a former banker. His latest book is “A Banquet of Consequences,” a new edition of which covering the effects of the pandemic is to be published in Australia in March 2021. He is also the author of Extreme Money and Traders, Guns & Money.

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