Nevertheless, for the more intrepid investor, a systematic method of varying exposure to factors with different cash flow betas could prove successful. For a more detailed example of how this might work, see Polk, Haghbin and de Longis (2020). Either way, we need to keep a perspective. The decline in equity prices is consistent with an increase in the discount rate and a negative cash flow shock that resulted from the intertwined impact of the pandemic, the oil price collapse and turmoil in credit markets. Uncertainty is high so volatility is likely to remain high. Investment principles help us navigate this environment just as they have in all other crises. A factor approach can help, whether the crisis gets much worse or ultimately proves less severe than expected.
Xavier Gerard PhD, CFA, is Senior Research Analyst at Invesco Quantitative Strategies. Stephen Quance is Global Director of Factor Investing at Invesco.
^1 For a perpetual asset, which a stock exchange index can be regarded as, a simplified model of the dividend discount model is the Gordon Growth Model. This states that the current asset price (P) is equal to the current dividend payment divided by the difference between the required return (r) and the long-term growth rate (g). At the end of 2019, the MSCI World Index had a total market value of USD 44.6 trillion and that year paid total dividends of USD 1.0 trillion (Source: MSCI). If we estimate the long-term growth rate of dividends at 3%, this implies about a 5.4% return required by investors. If we believe the year to date (25 March 2020) 24% drop was a result of changes in both dividends and required returns, it is surprising how little these need to change in order to be consistent with the price drop. For example, if this crisis cuts the current year dividends by 5% but leaves the long-term growth rate of dividends unchanged at 3%, the required rate of return only needs to rise from 5.4% to 6.1% for the MSCI World index to fall 24%. Given all the uncertainty, big swings in prices are not be so surprising.
^2 To understand this, assume a two-period investment which pays a dividend (D) in year 2. In year 1, expectations about D remain the same but the discount rate (r) goes up, bringing price and return down. Yet in year 2 one still earns D, and a high return because of the lower starting price.
^3 As r stays the same there is no improvement in investment opportunities: there is nothing to buy that would give a higher return.
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