“DEFENCE DEFENCE”

This article has been excerpted and edited from our quarterly newsletter to clients dated September 2, 2020.

This title, meant to be chanted, is apropos with pro sports back underway. Especially so, because even with the fake fan noise being pumped into arenas and stadiums, this particular chant is noticeably absent. As with everything else recently, we find ourselves chanting this from our sofas, while we watch our Toronto Raptors defend their championship title. It’s hard to believe that was just one year ago—time normally flies, but the pandemic has seemed to put everything in slow motion.

While we haven’t been chanting at the office, we have taken a defensive stance toward the markets. While the overall markets and many of our peers now appear to be all about offence, we are concerned that the recent overzealousness has stretched valuations too far. The markets are above our estimate of Fair Market Value (FMV) at a time when the economy may struggle to fully revive.

We can rationalize why the markets are back to all-time highs, even though the economy is still suffering a terrible recession. First and foremost, the virus didn’t prove as dire as some projected. Second, concerted stimulus from central banks around the world has made its way into the markets. After the global economy essentially ground to a halt, the stimulus launched a recovery. Both contributed to the fastest peak to trough in history. When the outlook is bleak investors head for the hills, but when earnings hit bottom as they did in late May, and begin recovering, market participants celebrate. And real interest rates (rates less inflation) are extremely low, enhancing the appeal of riskier assets.

By the way, for our American clients who may be questioning the spelling of our title, please note we have used Canadian spelling—particularly appropriate since we Canucks take claim to the invention of basketball. Thank you, James Naismith.

The Top Five Players

The capitalization weighted indexes have been propelled by a handful of companies, led by Apple, Microsoft, Amazon, Facebook, and Alphabet. These 5 remarkable ubiquitous organizations who dominate smartphones, office software, cloud computing, online shopping, social media, and online search, have been ‘putting on a clinic’. Open for business right through the pandemic, they have grown, added to their cash-flush balance sheets, and seen their valuations benefit from ultralow interest rates. Investors have taken comfort in these behemoths versus other investment alternatives which appeared unsavoury. But as a group they are now rather overvalued, mostly attributable to the excessive valuation of Apple. Alone, these 5 companies represent 24% of the S&P 500, the highest concentration in history. Their dominance of the Nasdaq 100 is even more pronounced at 48%. In March, as the market was bottoming, we owned all but Apple in our
Growth (equity) accounts, but these companies now trade at levels that imply perpetual growth rates that are likely unachievable. Now, only Microsoft barely meets our criteria. And certain bench players, like Tesla and Netflix, are in valuation leagues of their own.

In this context, it’s no wonder the Nasdaq has performed so well year to date. But the technology index is now overvalued and at a TRAC^TM ceiling in our work, leaving it susceptible to a decline, which in turn could soften the entire stock market.

On the rebound

The economy has bottomed. At the same time, health care professionals are now much better equipped to deal with the virus. Testing has improved too. Japan is using a saliva test with instant results (beats a Q-tip shoved halfway into one’s frontal lobe), and more important, better treatment methods have been implemented. Furthermore, drugs and vaccines remain in the works by over 120 companies around the world.

Because the economy was so depressed—Q2 U.S. and Canadian GDPs down a record 33% and 39%, respectively—there’s a massive recovery underway. Industrial commodity prices, an important measure, are trending up. Yes, there is pent-up demand too, post lockdowns. Car and home sales have really picked up. And everyone needs a vacation, so travelling (a good thing aside from basketball) will boom again. Hopefully soon. We all need a vacation from our time away from the office. Most of us don’t get an off season.

It’s not just stocks which have participated in the rebound. Unusually, stocks, bonds and gold prices have all been hitting new highs—a rare occurrence, likely due to negative real rates. This correlation has tended to be positive for short-term performance; however, we prefer a cautious stance because of the long list of potential impediments.

What we’re up against

In addition to the pandemic, we are facing an imposing lineup: enormous debt, anemic growth, high valuations, and outright speculation.

We just endured the fastest, most severe, and widespread economic downturn in history with 93% of all countries around the world in recession, much higher than the 14 global recessions over the last 150 years. The fiscal stimulus response has left most government debt levels around the world at record highs relative to each country’s GDP. And it’s at all levels of government.

Budgetary deficits are shockingly high with promises for additional spending to save the day. So the end is yet in sight. A fifth U.S. stimulus package is expected in the weeks ahead.

In recent years, foreign investors have been financing U.S. debts. However, those net foreign purchases of U.S. Treasuries are now negative. This could make deficit financing much more difficult moving forward. And unfunded liabilities (e.g., social security) are several hundred percent of GDP. Those unfunded amounts will likely need to be restructured at some point.

There has also been a massive injection of money into the system. Money supply grew at its fastest pace since WWII. Though it peaked in late May, it remains elevated. The Fed’s balance sheet, which was $800 billion before the Great Recession, has leaped to $7 trillion from just $4 trillion a year ago and could soon expand to as high as $10 trillion, approaching 50% of GDP.

Despite all the monetary stimulus, the velocity of money is low because of weak economic activity, low lending activity, and high savings rates. And this is not just pandemic related. The Fed has been targeting inflation of 2% for years now and has only managed to have it exceed that level for an instance in early ’18. With such high debt levels, we continue to have a weak growth outlook.

When government debt hits record levels, bond investors typically sell in droves. Fearing nonpayment, bond prices fall and interest rates rise. The Fed can control short-term administered rates but not longer-term market-set rates which could harmfully rise.

A New Game Plan

There are only two effective ways of diminishing the debt problems over time—austerity and higher taxes. A Biden win would bring a minimum tax rate, a higher corporate tax rate (28%, up from 21%), higher taxes on U.S. companies’ foreign income, an increase in personal income taxes but so far only for the top 2% income earners, and higher capital gains rates. Over-taxing could suffocate growth as well. Tax rates in Europe are also likely headed higher from proposed new taxes on financial transactions, greenhouse gas emissions, and digital transactions.

Even with all the stimulus, U.S. unemployment has only fallen to 10.2%, down from 11.1% in June after peaking at 15% in April. Sadly, it took several years for employment to reach its peak in the previous expansion. We have likely inflicted permanent damage on many industries—commercial real estate, retail, entertainment, dining, travel, and various small businesses which represent 40% of GDP. Therefore, after the bounce (pun unintended) off the bottom, an economic leveling off should occur.

All this is to say that it will be extremely difficult to achieve a reasonable rate of growth with the debt smothering the economy. It likely means a continuation of disinflation too. It’s particularly tough to reignite inflation when capacity utilization is at multi-year lows, demographics are poor with aging populations, and advances in technology and particularly the Internet promote such a competitive pricing environment.

It could take until 2022 for the U.S. economy to simply get back to its Q4 ’19 peak. And we expect the massive accumulated debts and record deficits to constrain global economic growth beyond that.

Records are Made to be Broken

It doesn’t help that corporate debt is at record levels too—almost 50% of GDP in the U.S. Rating agency S&P’s corporate downgrades are already at an annual record high and we’ve still got a few months left to go. Defaults are likely to follow as debt refinancing will not be easy in this environment. The wall of maturities in the U.S. is still in place too—more than $4 trillion of corporate debt coming due over the next five years. And issues could be exacerbated by rating downgrades from investment grade which force institutions, precluded from holding lower-rated investments, to sell.

Meanwhile bankruptcy filings continue to stack up. After many high-profile filings last quarter, recent names include Briggs & Stratton, Cirque du Soleil, 24 Hour Fitness, California Pizza Kitchen, GNC, Ascena Retail, and Lord & Taylor

A High Scoring Affair

After not knowing where to look first, because we were finding so many attractive risk-reward buying opportunities near the market lows in March, we now find ourselves turning over many more rocks than ever with little of interest. Valuations are too high. For the first time in history, both the Value Line Index (1700 North American stocks equally weighted) and the S&P 500’s P/E ratios are above 22x forward earnings.

The S&P 500 is above its FMV based on our models. It’s looking like the dot-com bubble, the only other period with such lofty multiples in the last century. Though during that period, the outlook was rosier despite the subsequent recession.

The forward P/E of the Russell 1000 Growth Index is now nearly 35x. It has averaged about 20x since the bubble and maxed out at 45x at the height of the dot-com frenzy. We remember that period well and the household names that did not surpass peak prices for over a decade despite solid growing results. There are now more than 120 companies with at least a $10 billion market cap that trade at more than 10x revenues—an astonishing stat.

Many key stocks, such as Apple, the largest in the land, are now priced beyond perfection, with implied growth rates that are extremely difficult to justify. With their continued dominance and concentration, they are also becoming more susceptible to anti-trust issues, legal cases, and the law of diminishing returns. Not to mention that tech companies are always at risk of a new mousetrap germinated from someone’s garage (now fancier than ever with more time spent there).

Tesla’s market cap currently exceeds the combined value of Toyota, Volkswagen, Hyundai, GM, Ford, Fiat Chrysler, and Honda. Together these global leaders annually produce over 50 million vehicles and generate over $100 billion in EBITDA versus a half million and an estimated $4 billion respectively for Tesla. Tesla may turn out to have world-class products in automotive, autonomous vehicles, battery storage, and solar but its valuation is extreme. The froth has lifted the median S&P 500 stock’s P/E ratio—now sitting at the 100th percentile in comparison to the last 40 years.

Playing with Wild Abandon

Market participants are too optimistic based on many criteria. Sentiment has reached extreme levels on many fronts—indicators are at the worst levels since the ’70s. Investors are piling in to leveraged ETFs. Short interest is now at multi-year lows. Measures that were reading extreme fear at the March low have now risen to extreme greed. Individual investors are speculating. Indiscriminate selling occurs rather often because investors tend to flee at the first sign of turbulence. Indiscriminate buying is highly unusual. Speculation is running rampant. Day trading, a veritable crapshoot based on market history, is back in vogue. Investors seems to be plunking money into hyped stocks, assuming the next participant will bid it yet higher. Millions of accounts have been opened by individual investors. We even witnessed a nonsensical run-up in early June, and subsequent collapse, in bankrupt or near-bankrupt companies’ shares. Apple and Tesla have also both run on their respective 4:1 and 5:1 August 31 share splits, an event that in no way creates value yet seems to lift share prices in the short term nonetheless.

Ned Davis Research has an ‘Historical Bubble Composite’ which combines the 5-year ascent preceding 1929’s Dow peak, Gold’s 1980 top, Japan’s Nikkei 1989 blow-off and the Nasdaq bubble of 2000. The aggregate compounded return was 33% annualized. Combining the top 5 and Netflix has produced an identical result in the 5 years ending in early July. The Nasdaq is up 76% from its March bottom, after a 30% decline to the bottom, with the largest correction on the way back up of only about 6%.

Meanwhile, this is all against a backdrop where predictability remains scarce causing earnings guidance to be pulled by many companies. Over 400 companies in the S&P 500 did not provide forward earnings guidance in the most recent quarter, the highest in at least 20 years.

Management teams are likely concerned too. Corporate buybacks are at the lowest point in 20 years, though this is also related to prizing liquidity over value-enhancing strategies. Insider buying is at lows too with only 4 insiders buying their own company’s shares for every 10 selling.

And performance has really narrowed. The percentage of S&P 500 companies outperforming the index in the most recent 3 months has only been this low at the peak in 2000 and 2007, both long-term market tops.

The S&P 500 Equal Weighted Index and the Value Line indexes (a broad representation of the North American equity market) are still down this year.

The Best Defence is a Good Offence Defence

Many sports pundits believe that offensive prowess makes up for defensive lapses. While true from time to time, both are required to come out ahead. And defence, which is less exciting, is often overlooked. Short-selling, a defensive hedging mechanism, is practiced by few.

While we clearly reinitiated our short position too early, we are comfortable being short the S&P 500—about 20% overvalued—and long individual high-quality positions that we believe to be even more so undervalued. For most clients, who are not declared traders for tax purposes, even if accounts merely hedge off gains, there is a tax advantage because long gains incur capital gains treatment whereas short losses are income losses that are tax deductions at a substantially higher rate.

We continue to be concerned with: a resurgence of coronavirus infections (already happening in many countries); the impact still to be seen from shutdowns on small businesses; social unrest and widening inequality; uncertainty related to the Presidential election which normally brings additional volatility (it’s a really sad state of affairs when two-thirds of polled Biden voters are not voting for him but simply casting votes against the other guy); the unresolved U.S./China trade war (banning TikTok and WeChat—what’s next, declaring soy sauce a national security risk since over 40% comes from China?); and risk of developing country foreign currency meltdowns with the Turkish Lira leading the way.

Remember March when the S&P 500 had several daily 5% declines? How soon we forget.

Let’s hope valuations are buffered by the zero-interest rates environment. But with the realization that implied growth rates are near all-time highs when the prospects for growth appear limited, we’ll plan for volatility and poor index results.

OUR STRATEGY

Just 5 months ago we were conducting analysis to assess a major market bottom. Now we’re busy comparing today’s market with other major tops.

We are comfortable with our defensive stance. The retest of the market low, which normally occurs in a bear market, clearly was not in the markets’ playbook. But the markets have risen too far too fast and a setback, even a material one, could arrive at any time. If volatility picks back up it should allow us to trade more readily too.

We don’t see an immediate catalyst to begin a correction, which could bring growth stocks back down to reality. Though sometimes, especially at ceilings in our work, supply of shares merely begins to overwhelm demand which proves enough to inhibit future excesses and causes a rollover in prices. When sentiment was this skewed in the past it did not take much time for a market correction to follow.

Looking for Lay-Ups

The recent furious rise in the market’s tech leaders can extend even further as momentum takes over, but these types of moves don’t normally end with a sideways trend but with a thud. Valuation multiples went sky high in the dot-com bubble because investors were tripping over themselves to get in on the new era action, at a time when the economy was robust and interest rates contained. These are not the circumstances before us today.

We have a defensive stance with a fair amount of cash and a reasonable sized hedge while we continue to scavenge for high quality companies selling at TRAC^TM floors below our FMV estimates. And much like the NBA, whose teams are full of the best players from around the world, we will continue to look abroad for holdings seeking the best undervalued companies we can find, with the added bonus that foreign markets should offer more near-term opportunities because they’ve lagged U.S. stocks.

Slam dunks don’t come easily. Especially for some of us not-so-tall portfolio managers. Regardless, we aim for lay-ups—investments that meet our criteria where the potential rewards outweigh the risks. And unlike on the basketball court, there’s no shot clock to inhibit the pace of our process. There are no trade or draft choice deadlines to contend with either. Our patience may be tried but we can wait on the sidelines without pressure until we’re ready to emerge from the market induced ‘time-out’.