The risk in the index

As well as its lessons in the maths of exponential change, fat tails and black swans, the coronavirus (Covid-19) has in stock market terms further borne out Baillie Gifford’s contention that the index contains fundamental risk.

The notion that equity indices are somehow risk-free has always been a dangerous fallacy, one amplified by the rise of passive investing.


Actually, all three of the significant market crises in my own investment career – the technology, media and telecoms (TMT) bust in 2000, the 2008 financial crisis and now the coronavirus – have each done enough damage to a particular part of the index to demolish the thesis that index investing somehow diversifies away risk.


In this crisis, the demand shock exposed risk in supposedly robust areas and in large constituents of the index. Most obvious is the collapse of traditional extractive energy. The industry simply can’t store what’s being produced, leaving only the safety valve of falling prices. But it’s also present in second-order ways. Companies that prided themselves on resisting the move online – such as Primark in UK fast fashion – suddenly looked very risky when customers were forced to desert their retail temples.


Of course, some of this is short term in nature but it would appear to be likely to accelerate existing trends such as changing ways of consuming and will enhance economic shifts helpful to disruptors.


The pandemic has posed a second huge challenge to market orthodoxy: the disappearance of apparently safe dividends. It’s hard to escape the symbolism of Royal Dutch Shell cutting its dividend for the first time in 80 years and the devastation inflicted on those who relied on such dividends providing superior returns to cash.


There is an immediate shock to valuations based on dividend growth models and a challenge to future reliance on dividends, especially as many of those cancelled had already been agreed. This adds a further impediment to the already difficult task for value managers of assessing intrinsic value with one tool in their toolbox being severely impaired.


At the time of writing, estimates are that 2020 dividend income globally will decline by 25-40 per cent. Even that could prove conservative. Many of the fabled dividend payers with consistent and growing dividend streams have lost their halos. It is worth saying that cutting dividends is the right decision for companies whose revenues and cash flows have evaporated but that doesn’t lessen the potential market impact.


Of course, there will be some recovery in pay-out ratios and growth in future dividends, but 2020 will come to be seen as an epochal moment: The relative import to shareholders of long-term revenue and earnings growth loomed unignorably large against the diminished security of dividends.

Mark Urquhart


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