A Little Too Interesting

The meaning of ‘may you live in interesting times’ is controversial. Some argue it originated as a Chinese curse. We embrace that assertion because we’ve always responded to, “interesting times, huh?” with, “a little too interesting!” Turbulence, tension, and a feverish pace should be relegated to roller coasters, entertainment or, perhaps, between the sheets. But for the status of the world around us, we root for the mundane. We’ve just endured anything but.

In the recent period everything slowed down, except the stock market. With stay-at-home policies invoked around the world, the economic switch—the one nobody’s supposed to touch—was turned off. With fear of not just widespread illness but considerable deaths, markets began to adjust. Stocks plummeted in record fashion.

Of the 21 trading days between February 27 and March 27, a total of 18 days saw moves in the S&P 500 of more than 2%—11 down and 7 up. They included the biggest daily percentage gain since 1933 and the second-biggest percentage loss since 1940 (exceeded only by Black Monday in 1987). It was way more turbulent than prior periods. The S&P 500 experienced several daily 5% declines, which had only occurred a total of 23 times since 1950.

Normally, there’s ample time to react to a bear market (a 20% or more decline from a market peak). It took 188 days for the S&P 500 to drop more than 20% in ’08 and 242 days in ’01. The median had been 288 days over the last 100 years. The recent bear market took just 16 days, faster than the 30 days in 1929 and the 38 days culminating in the Crash of ’87. And small cap stocks had their worst quarterly return in history.

With the rapid decline resulting in so many attractive risk-reward buying opportunities, we didn’t know where to look first. Yes, prices could have gone lower. But it appeared that for many quality businesses, the depressed prices were unsustainable. It’s only in periods like these— during bear markets—that superior companies are available at prices which are so deeply discounted from our estimates of underlying intrinsic values.

As the market was bottoming, everything was being discarded. Even typical safe havens like Utilities and REITs were being crushed by indiscriminate selling.

The markets dove below our TRIM^TM lines, triggering a bear market signal, and promptly fell right to the bottom of their next TRAC^TM floors on March 23. Then, from a significantly oversold position, the markets recovered, bouncing back to a ceiling. For the S&P 500, a 34% decline from the peak and a 32% rise from the bottom—practically all since our last quarterly letter. Once again we find the markets at our estimates of their Fair Market Value (FMV), as if it’s business as usual.

IF YOU WANT TO BE INTERESTING, BE INTERESTED

Central banks are always interested. And boy did they become interesting. Governments around the world have been reacting—the largest emergency rate cut in the Fed’s history, loan guarantees, UI benefits, cash handouts, and the promise of outright purchases of mortgage-backed securities, bonds, and ETFs. All designed to counteract the impact of this deep flash recession.

Because this economic downturn was hastened by a pandemic and governments realized they reacted too slowly in the Great Recession, they were immediately on the case providing stabilization and stimulus. It took months after the crisis erupted in September ’08 for the TARP package to be enacted and in the meantime credit markets froze. Whereas we have now witnessed the largest issuance of investment grade credit in the history of our markets, just after the Fed announced it would be a significant buyer.

There’s been stimulus on the stimulus—the Fed’s balance sheet expanding from $4 trillion to over $6.6 trillion. Something had to be done to save the day. The damage is pervasive. In Q1, U.S. GDP was down -4.8%, Europe -4%, and China -6.8%, its first contraction since 1976. The Bank of International Settlements estimates that U.S. GDP will decline by about 12% in 2020 or around $2.6 trillion. The authorities have clearly looked to replace this with an equal or greater amount of stimulus. Meanwhile, high profile bankruptcy filings in the last couple of months include: J. Crew, Stage Stores, satellite operator Intelsat, Neiman Marcus, J.C. Penney, Whiting Petroleum, Diamond Offshore Drilling, and Hertz. Many more, especially in retail, travel and oil & gas are likely to follow. Pier 1 Imports, a 60-year old business, declared bankruptcy protection in February but just announced its stores will never reopen.

Some other businesses, like American Airlines and United are in rough shape, with daily cash burns of over $70 million and $40 million, respectively. These companies aren’t likely to fail but may suffer undue dilution from capital raises or finding the government as a partner. Lufthansa is now owned 20% by the German government.

Unlike the last recession, which became known as ‘too big to fail’, this period will be characterized more as ‘too small to survive’. The little guy—the corner store, the restauranteur, and other mom and pop service companies—is struggling to survive, with early stats suggesting that as many as one-third of small businesses may fail. We hope that’s overstated. There will be ripple effects too because small businesses represent over 40% of GDP and their closures will have implications for unemployment, overall consumer spending, and bank loan losses.

And with the economic ‘switch’ (now more like a dimmer switch) slowly being turned back on, our minds are turned to the trajectory of the recovery.

ISN’T THAT INTERESTING

After hearing talk about a V-shaped or U-type recovery, the latest is a swoosh—a rapid decline followed by a tepid incline. And we too are concerned about the pace of the recovery.

There’s plenty of pent-up demand for everything from haircuts to new vehicles. And most people can’t wait to socialize. But dinner and a movie won’t be the norm for several months. Travel plans will remain uncertain too, whether for business or pleasure. Not to mention, with high unemployment, simple affordability will be an issue for some time. Capital expenditures, R&D initiatives, and mergers & acquisitions are on hold.

The world will also need to adjust to new patterns such as work from home. Hopefully we won’t have additional waves of the virus but the mere concern is acting as a restraint. Recoveries usually don’t occur overnight. It took several years for employment levels to return to their previous peak after the last downturn. Many of the most severely impacted segments of the economy should take years to fully recover. Therefore, we are tempering our expectations.

There are other aspects that concern us too. A realization that, even if we find a vaccine, like with the flu shot, one for the coronavirus is expected to require to be updated as the virus morphs. The Presidential election will be a focal point, and we find neither candidate’s policies appealing. Once again it appears to be a choice between the lesser of two evils. There are many issues now involving China: the unresolved trade war; the lack of disclosure about the inception of the virus; the proposed rule of law changes for Hong Kong; and the slowing down of the world’s growth engine. Russia and OPEC seemed to be locked in a lose-lose battle that helped take oil prices negative briefly. It’s uncertain whether nations will work together or be increasingly nationalistic. And, worst of all, we are going to be left with even larger debt loads from deficit spending that’s out of sight at all levels of government.

This startling amount of debt will impact the global economy in many ways for years to come: spending restraints (the term ‘austerity’ will return with a vengeance); increased taxes (to fund budgets and because of left-leaning politics); potential inflationary implications (from monetary stimulus which debases currencies); and higher interest rates (a necessary enticement for buyers to purchase public debt). And the excessive debt levels are across the board, as public, private, and corporate debts are at record levels as a percentage of GDP.

Corporate downgrades have hit record levels. Defaults are likely to follow as debt refinancing won’t be easy in this environment. And there remains a wall of maturities ahead for corporate America. Furthermore, as we’ve noted previously, when companies fall below investment grade there’s forced selling from institutional holders who are precluded from holding lower-rated investments.

At least for now interest rates and inflation remain extremely low, buffering any immediate fallout. With economic decline, deflation prevails, especially since the velocity of money is muted, because lending is more or less frozen despite oodles of monetary stimulus. The ultimate way out from under the pile of debt is via the printing press—even more monetary stimulus— which is usually inflationary. But spending will likely be slashed in favour of savings. Debt will be shunned by most, because individuals and corporations will want rainy-day funds for the next major event. This stifles economic activity but should help keep a lid on inflation while demographics and the digital age also continue to inhibit inflationary pressures.

REVIVAL

We appear to be well on the way to finding treatments for the coronavirus, although eventually, general immunity should develop. The mortality rates are already falling as a result of policies, behaviour, and nature running its course. We’ve already seen a plummet in cases in other countries whose infection rates started earlier.

The worst for the economy is behind us—mostly because it can’t get worse than essentially being halted. The expression ‘ripping off the Band-aid’ comes to mind. We had already been worried about a recession. The economy was weakening when the virus hit. Though we may never know whether the efforts to contain the spread alone caused the recession, it certainly intensified it.

At least we now know that recovery is underway. And the market normally bottoms when forward looking earnings bottom. For example, next-12-month earnings bottomed in May ’09 and the stock market had bottomed 2 months prior. We believe we’re close to approaching the bottom of expected earnings for this cycle. The difference being that the market has already recovered to its fair value.

However, value stocks—our kind of stocks—are at a major historical low versus growth. Value has outperformed growth in over 90% of all 10-year periods, but the last number of years have been a relative disaster for value as it underperformed dramatically. Value stocks tend to outperform once economic recovery accelerates as more dependable companies are switched for cheaper names whose stocks have been shunned but whose businesses are becoming more predictable.

Currently, we’re in a period where predictability is scarce. Even grocery stores have pulled their earnings guidance. Additional costs from extra wages, products in limited supply, more cleaning, and store reconfigurations have made even these open-for-business essential services difficult to predict.

Then there’s the fact that most people are antsy even going to the supermarket, let alone eating at a restaurant or flying on an airplane. So, even though recovery is underway, because growth should be slow and the market has risen back to its FMV, leaving it without material upside and implying susceptibility to decline, the odds favour another decline.

MARKET GYRATIONS

Often when we buy a stock, it has rising earnings and a share price that has fallen. In the last few weeks, the market has delivered the exact opposite. Normally there’s a 90% correlation between the direction of corporate earnings and share prices. The correlation has been -90% recently as earnings estimates have collapsed while markets have risen, resulting in a dearth of buying opportunities.

With the S&P 500 right back to its FMV, its current P/E is 22x next-12-month earnings— extremely elevated for a recessionary period. In fact, the only time the market has traded at a higher multiple relative to previous peak earnings over the last 100 years was during the dot-com bubble.

However, interest rates barely register; U.S. 90-day t-bills through to 10-year Treasury bonds can be measured in basis points and a number of key regions of the globe still have negative yields. With the S&P 500’s earnings yield at 4.6% (and a 1.9% dividend yield) while 10-year bonds yield 0.7% (even the 30-year yields a mere 1.4%), stocks still appear preferable to bonds, though in the short term stocks could easily fall out of favour again.

OUR STRATEGY

In March of last year our Economic Composite (TEC^TM) alerted us to a potential peak in the business cycle that historically follows about 10 months later. Therefore, we began taking on a defensive stance this January. We initiated a short position (for clients who have authorized short selling) of an S&P 500 ETF or bought an inverse long ETF which mimics short selling in other Growth and Balanced accounts. We raised cash levels too as some stocks achieved our FMV appraisals. Then, as the market declined, we invested the cash in attractive opportunities and eliminated our hedges 2 days prior to the March 23 bottom.

We did not believe, as many did, that this was similar to the Great Depression. In 1929, before its crash, the market had nearly quadrupled in a very short period of time in a significant blow off. Furthermore, back then, there wasn’t a Fed, a social welfare system, unemployment insurance, a system for margin calls, or market circuit breakers.

So in this spring’s decline—when the S&P 500 fell 39% on an equal-weighted basis (which equates to a rare 2 level decline in our TRAC^TM work) and the markets were at record oversold levels (the Value Line geometric index, 1700 stocks equally weighted, fell 46% to its low), we believed a material bounce was at hand.

We emphasized high quality enterprises that were open for business with durable and resilient business models (i.e., well financed, less cyclical, with competitive advantages) and priced at attractive discounts relative to our valuation estimates. Some have since been sold as they lifted toward our FMVs.

We reinitiated hedges for client accounts in late April when the markets reverted to TRAC^TM ceilings and our FMV estimates, and we just further increased the hedges when the S&P 500 increased directly to its TRAC^TM ceiling break point and the top of its TRIM^TM band, our defining line between a bear and bull market.

We are comfortable with our current hedges, especially since the shape of the recovery is uncertain. While a retest of the market low after an initial bounce does not always happen, it does occur during most bear markets. At the same time, we are clinging to our individual holdings because we believe they are still undervalued and these positions could rise while the overall market falls away from fair value. Alternatively, the holdings should benefit if the market keeps rising.

We will try to be as nimble as possible, especially since we expect fits and starts. Given our expectation for continued volatility in the markets, we will attempt to be as attuned as possible to rises back to FMV and declines to floors, in order to optimize the trading in our positions.

For our Canadian dollar reporting margin accounts, when the CAD fell below $0.70 we initiated a significant debit position in USD, offset by a CAD credit, to hedge against a rise in the CAD visa-vis the USD. The CAD typically falls to a floor in a recession and is now back on buy in our work, headed towards its purchasing power parity value above $0.80. We prefer not to offset our potential gains in our USD holdings with currency losses. And for our USD reporting accounts, we have removed the hedges we had in place on Canadian positions for the opposite reason.

I WANT TO GO OUT FOR LUNCH

We expect the turbulence in the markets to continue and will attempt to do our best to cope with these interesting times. In the meantime, we find ourselves repeating two of our favourite lines from movies. There’s Bruce Willis as officer John McLane in Die Hard, while crawling through an air duct, “Come out to the coast; we’ll get together, have a few laughs;” and Goldie Hawn, as Private Benjamin in the pouring rain, “I want go out for lunch; I want to be normal again.” None of which we can do right now. Here’s to less interesting times.

This article has been excerpted and edited from our quarterly newsletter to clients dated May 29, 2020.