Double Shock

Double Shock

3/21/20

Investors looking to jump back in may be too early. The market went on sale this month, but only off of peak valuations. It is commensurate with the "value" most shoppers find at discount retailers and factory outlet malls. Inherent value is not equivalent to discounted prices.

And that is exactly what we are witnessing in the markets today. After a decade long post-2008 bull market driven by discounted rates, cheap money, a Fed put, and corporate buybacks, we are now seeing the deleveraging effect on the other side of the hill. It always falls off faster, quicker, and steeper than the climb up. And it will continue... in the short run. 

It will continue because the market is a function of 3 factors: (1) The supply of stock, (2) The demand for those shares, and (3) The economy. Global supply chains are frozen due to the Coronavirus, and the demand for non-essential products grinded to a halt. Companies across the globe are instituting their disaster plans. They are focused on preserving liquidity, not growing their companies. 

The supply of stock is not increasing as private companies are not even considering going public; but the supply of stock available for sale on the market is growing faster than the scary charts CNN is showing on the proliferation of the virus. This is partially driven by the near term outlook, a rush to liquidity over the uncertainty, fear from the prior banking crises, and forced selling from 401-Ks. Most Americans live paycheck to paycheck, so when their job prospects look grim, they must sell their equity portfolios regardless of valuations. 

True this is the environment Warren Buffet and other value investors love. True that valuations are certainly more reasonable today than at any time over the past few years. True that buyers today will perform well over the next decade if they buy and hold high quality shares. But the double supply and demand shock that is still in its infancy will prevail in the short term. 

A downside $150-$160/share EPS for the S&P 500 is reasonable given 1-2 quarters of material economic contraction. A downside multiple of 14x is possible. In 2008 it briefly dropped much lower, but interest rates are now at record lows, so spreads imply a more reasonable bear case S&P multiple. At 14x $150-$160, the downside for the S&P 500 in the double shock we are experiencing is 2,100-2,240. The S&P closed on Friday just over 2,300. We are getting close to attractive buying levels, but build your shopping list and wait a little longer. Do not be fooled by the intermittent pops from short term volatility.

     

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Now that you have a year's supply of toilet paper, get your equity shopping list prepared!

For over a year it felt like the market was focused on a single story, namely that low interest rates and pro-business fiscal policy would let the bull run for another decade undeterred. I had nothing to post!

Warren Buffet's hoarding of record amounts of liquid cash was questioned by market pundits, similar to that of every other economic peak. Predicting a recession triggered by a global pandemic was only predicted by a few (see Bill Gates TED speech). Nobody could accurately see the timing until the stories from Wuhan emerged, and many like Bridgewater's Dalio still refused to accept the inevitable spreading from forecasting models. Based on what we see in Italy and China, things could get worse but should still recover in 2020 if our political responses are effective. Trading based off healthcare related modeling could be difficult to those without industry experience, like most Wall Street investors. 

My prediction is that the wild volatility of -9% followed by +9% trading days will continue as the institutional capital and algos react to news and margin calls, but the trend will continue down. When looking at the massive uncertainty over how long this could impact the economy, even the most realistic bullish case implies a still frothy market. I understand that valuations warrant a strong PE multiple when interest rates dropped to record lows. But the EPS on the S&P 500 can drop a lot more when the global economy (Main Street) just ground to a halt. Goldman predicted a menial 5% EPS hit to 2020 S&P earnings. I was not buying it. Then they lowered it 5% again to $157/share. They estimate the S&P could drop to 2,450 before rising to 3,200 by year end. I am not going to discuss the upside target for now. It is realistic should everything work out. However, let's focus on actionable trading for the next 3-6 months. Where should you start allocating? Ignoring individual positions, a realistic downside multiple on a recessionary outlook with super low rates could be 15x trough earnings. 

Assuming a fairly drastic cut of 25% to total 2020 EPS versus original guidance of $174/share * 15x, the downside S&P target would be ~$2,000. At today's S&P we have 20% more downside to this very conservative case. We also have ~32% upside to Goldman's realistic year end target should we recover. Current positioning indicates investors should remain bullishly positioned, or even add to their original equity weightings, but recognize that we are not yet in an aggressively bullish trading environment.

We are starting to see some individual bargains too which can be picked up while recognizing the impact of extremely high correlations, indexing, and deleveraging when considering allocations. 

Get your equity shopping lists ready!



Dan Shainberg#DanShainberg#RecessionResister@DanShainberg