Neither the author, Tim Fries, nor this website, The Tokenist, provide financial advice. Please consult our website policy prior to making financial decisions.
With coronavirus affecting the stock market and blood running in the proverbial financial streets, those who haven’t lost it all would be wise to wonder whether things have hit rock bottom. After all, the best time to buy is when things are at their cheapest price, at least if you’re looking at things long-term. Has the market really “bottomed” and is it a good time to buy? Let’s analyze these questions and more to find an answer.
Is Capitulation a Sign of the Bottom?
Anyone paying attention to the stock market right now in light of the coronavirus epidemic is seeing something startling. Big companies, trading firms, and general Wall Street big players are all starting to exit the market entirely. Rather than recouping their losses and coming in for another shot, they seem to be saying, “We quit!” This is capitulation.
In the investment sense of the word, capitulation is close to the strict definition: it describes the point where investors decide to stop working with the market to recover from their losses and instead conserve what they have left. Why does this matter?
Many of the biggest spenders in the stock market suddenly withdrawing means that the stock prices across the board are likely to fall. As a result, financial experts think widespread capitulation is the sign of a potential bottom for stock prices. How do they know this? It all ties back to a general “cycle” of investor emotions that every human can understand.
The Emotional Cycle of Investing
You see, investing is actually an emotional journey even for the most rational stock market players, as depicted in the image below. The majority of stock market investors start at the Reluctance stage, which reflects the innate human aversion to risk and loss. After all, when it comes down to it, most people are more afraid of losing what they have than interested in gaining what they don’t.
However, during economic booms, financial markets can rise and opportunities for investment and profit expand and become more common. Even the most risk-averse begin to invest more frequently, particularly as investors discuss the rising markets with their competitors and peers. Fear of losing what they have can often turn into fear of not making enough money – quite the change, but one almost everyone can empathize with. This describes the Optimism stage.
Investors will often go to Excitement and Exuberance, in which they excitedly invest in the stock market and make some of the biggest plays for profit. Exuberance kicks in when they make money and enjoy the high points of the stock market, especially if successes pile up and it seems like they can’t lose.
However, everything that goes up must come down. Sometimes investors, so interested in their continued winnings, can enter the Denial phase where they don’t believe that the market is starting to drip after having reached its peak. This leads to Fear, then Desperation as they don’t stop buying or start to protect what they currently have well enough and end up losing money.
Thus comes Panic, the penultimate stage to Capitulation. And as the chart above shows, Capitulation leads investors right back to where they began… Reluctance.
In this way, stock market experts often see capitulation as a signal that things have essentially dropped as far as they’ll go until the markets rise once more.
2021 P/E Multiples: What They Are and What They Can Indicate
Investor emotions are interesting, but they don’t necessarily give us actionable information as to whether the stock market has really hit a bottom. There have to be other ways to figure out whether it’s a great time to buy (while staying home to maintain social distance!).
P/E, or Price to Earnings, multiples may provide some insight. In a nutshell, P/E multiples are simplistic calculations and main attributes used to analyze the value of a stock. This formula is:
A company’s stock price/it’s earnings per share
That’s it. Most P/E multiples are between 12 or so to 50ish, though there’s plenty of variation between these limits. As the stock market falls, odds are good that most stocks’ P/E multiples will start to fall along with it, which is why many looking at the big picture impact of coronavirus have started claiming P/E multiple values are a sign of a “bottom”.
This may indeed be true, but there are limits to the P/E multiple method of analysis. For instance, many inexperienced stock market investors will see companies with P/E multiples either skyrocket or plummet in apparent contrast to the market trend overall.
P/E Multiple Limits Explained
A great example of the limitations of P/E multiples are firms that have very narrow profit margins. In these cases, companies can have a “bad” year on paper and get a P/E multiple that goes into the 100s. But this may not fully indicate the actual value of the company at hand, as they might be just on the horizon of market dominance for their niche.
P/E multiples are also victims of high expectations for future growth, particularly with speculative markets. Investors may buy into a company or firm and expect the company to grow annually without pause, only for the firm’s actual value to be revealed some time down the road.
All in all, a company or stock’s P/E multiple being attractive isn’t necessarily a sign that you should start snapping up their stocks everywhere you can, even from reliable firms like Nestle. As with all things in the stock market, there’s usually more than meets the eye aside from the raw mathematics.
Attractive P/E multiples can be offset by things like a business making a key critical error with its customers that might drive the price down in the future, or worldwide events that could change the demand for a product or service on an international scale.
Still, P/E multiples being low across the board is another sign that things have hit or will soon hit an overall bottom. If you do your due diligence and research deep into the companies you want to buy stock in, you’ll be well-positioned to take advantage of the bottom or make some smart purchases now for your long-term portfolio plans.
What History Tells Us About Resilience
Right now, the stock market is being predominantly affected by coronavirus, although other global and local factors are constantly influencing international and smaller firms alike. With all the panic and the stock prices continuing to fall, many who don’t understand the stock market are beginning to proclaim the real end of days. For someone wondering if they should invest and buy when the time is best, this can be troubling to think about.
Looking at history offers a more balanced perspective on today’s troubles. Here are two main examples we can use.
Stock Market Reaction to 9/11
When airplanes hit the World Trade Center in New York City, the New York Stock Exchange didn’t open for trading for fear of the market crashing. The idea was that people would panic and try to pull out what money they could before things got worse.
When the markets eventually did open again on September 17, the market fell by 684 points altogether. The end of the week saw even worse losses across the board. Then what happened?
The Dow recovered from a 17.5% drop by early November. In fact, the Dow was higher than it had been beforehand and continued to grow until March 2002.
1987’s Black Monday Stock Market Recovery
Let’s check out another example: Black Monday of 1987. This infamous collapse occurred on October 19 and saw the Dow lose 509 points in one session. This was, for the record, even more of a drop than the onset of the Great Depression in 1929.
Yet two years later, the Dow was higher than it had been before. Even the aforementioned Great Depression wasn’t enough to stop the market forever, and the unprecedented success of the 50s and 60s is evidence of this fact.
Why is this all relevant? It goes to show that the stock market is more resilient than many give it credit for. While the urge to panic and sell may be present in most of us, it’s important to resist that urge and wait for the market to bounce back. Particularly if you deal in America, you can trust that things will get better. Picture the emotional cycle we mentioned earlier if that helps – it also describes the stock market!
The Time to Buy is Actually… Now?
Seen in this light, with these various pieces of evidence, it may indeed be a good time to start buying if the signs of a bottom continue. Contrary to what naysayers may believe, buying at a time like this is smart business sense if you know how to invest in stocks.
With a number of stock trading apps available, investing has now becoming easier than ever. Coronavirus won’t be around forever; in contrast, the stock market will assuredly last longer than this global crisis and the other crises to follow.
Many of the most innovative people in history have been contrarians, going against the crowd even when others told them otherwise. The time has come again for many to decide: are they with the crowd, or trailblazers seeking an opportunity for gains?
What do you think about the current stock market situation? What are you planning to do in the following weeks as coronavirus progresses? Let us know in the comments below.
Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird's US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firms specializing in sensing, protection and control solutions.