Month: March 2020

The Global Economy in Freefall: What Investors Need to Know

The Global Economy in Freefall: What Investors Need to Know

Dear friends,
We hope you and your family are healthy and safe.
The past quarter in the markets has been one of those periods where days can seem like years, and weeks like decades. We entered 2020 with risk assets, including stocks and high yield bonds, trading at all time highs. Stocks reached lofty valuations on cyclically high earnings. An exceedingly overvalued market then ran into an exogenous shock that has prompted comparisons with the dust bowl of the 1930’s.
The S&P 500 started the year at 3230, and rose as high as 3393 in mid-February. Six weeks later, it ended the quarter in a bear market, down over 20% at 2584. This has been the quickest descent into a bear market for stocks in many decades. The moves in the bond market have been equally extreme. Early March was a period of immense dislocation in many major markets, precipitated by a collapse in oil as travel was curtailed across the globe. This created a spate of margin calls and the collapse of many levered trading strategies that rely on stable correlations between different asset classes. The margin calls and panic this induced drove numerous participants to raise cash, at any cost. The rush towards the safety of US treasuries pulled the 30 year yield below 1% in early March, a level never before breached. That was the earliest sign that something had begun to go very wrong. By late March, most market participants came to realize that without extended stay at home orders, the US healthcare system would be overwhelmed by the same issues confronting Northern Italy. Facing the possibility that death counts would rise exponentially as hospitals drowned under the load of COVID-19 patients, most US governors made the responsible decision to curtail movements. We are now at the point where market participants are estimating the duration of these disruptions to normal economic activity.
Our view remains the same as it was in early March. This is not a short-term pause, but rather the end of a business cycle. The size of the exogenous shock suggests to us that the damage will be extensive and could rival the 2008-2009 crisis. The speed with which job losses have occurred, essentially shuttering entire industries, has been shocking. US unemployment claims have never exceeded 900,000 in a single week. The week ending March 20 saw over 3.3 million workers file for unemployment. As if that number wasn’t staggering enough, it doubled the next week. 6.6 million additional workers filed for unemployment benefits during the week that ended March 27. Several large companies announced mass lay-offs or furloughs in the week ended April 3, so the news will likely continue to be grim. Every one of those lay-offs represents a family that now faces enormous uncertainty around basic material needs including shelter, food and healthcare. The human cost of our current situation is not limited to those who have fallen ill.
The US unemployment rate is almost certainly well above 10% right now (in 2009, it peaked at 10%). Fed governors have speculated that in a worst case scenario
unemployment could climb as high as 30% or even 40%. These are numbers that the US has not seen since the Great Depression. While the US economy is very resilient, it’s hard to imagine a scenario, even with outsized levels of stimulus, where the economy bounces right back from this magnitude of systemic shock.
The largest unknown in all our estimations is the actual trajectory of COVID-19. We have begun to see case numbers in parts of Europe and harder hit areas in the US level off, but it’s unclear how long the restrictive measures currently in place will be required. We do know that our government’s haphazard, tardy and contradictory response to the crisis in the early weeks closed off some of the less costly paths we could have followed. The US is
now the clear epicenter of the pandemic and the developed economy most likely to shoulder the highest burden from it. The current conversation centers around “flattening the curve” of new infections, which have been rising steadily in the US (even in the absence of readily available, accurate tests). As the World Health Organization has pointed out, once the curve is flattened, it has to be brought down as well. The example of the Asian countries is that relaxing stay at home orders can easily lead to a resurgence in infections. Eradicating the pandemic is a task that will be measured in months, not weeks.
The machinery of the markets has been operating throughout the crisis, despite extreme volatility in both stock and bond markets. We have, however, seen the city we love come to a virtual standstill as every effort is made to contain the impact of the pandemic. It has been strange to see silence descend on New York during the daytime, a silence broken only by the tragic and constant wail of ambulances. Like many of you, our lives have been directly impacted by the pandemic. We have been unable to work from our office for weeks and have initiated our disaster recovery plans to work from home (we were prepared for this type of situation despite how remote a possibility it may have seemed a few months ago). Unfortunately, the best information we have suggests that many other areas of the country might face similar circumstances.
In our view, the market’s recovery from this sudden stop will be slow and halting. In 2000- 2002, it took the stock market over 18 months to bottom. In 2008-2009, it took a year and a half of declines before the nadir was reached. Though this crisis has arrived with remarkable speed, there is no reason to believe the recovery will be as sudden. The rolling, global nature of the shutdowns required to control the spread of the virus will ensure that some level of demand weakness remains through much of the year. Most economists now forecast a global recession that lasts three quarters with US GDP declines being estimated at 10-30% at their height.
We believe these numbers are in the right range, though there is an outside chance that the extreme measures to mitigate the spread of coronavirus last longer. The impact on many industries and enterprises will be severe. A survey of small businesses in the US indicated that 25% of them anticipate closing permanently within weeks if conditions do not improve. Large businesses will face enormous financial stresses if revenue streams continue to be disrupted for months. We have already seen the impact in the high-yield bond space, where many enterprises were operating at very high leverage with no margin for error.
Lastly, the scale of the fiscal and monetary stimulus required to stabilize the markets and the broader economy is immense. The US government has already passed a stimulus that will cost about 10% of GDP. We believe more will be required. The profligacy of the current administration meant we were operating trillion dollar deficits in the midst of an economic boom. With economic activity rapidly collapsing and the need for more stimulus measures apparent, the deficit will surely balloon to multiple trillions in 2020. It is clear that tax rates will have to rise in the future, and US government finances will be weaker. Among the long range factors to consider is the reality that the US economy has now seen three extreme market crashes within the space of 20 years. This history will surely have an impact on the manner in which younger investors view the markets.
We continue to advise caution and recommend investors prepare for more big swings in volatility as markets respond to news flow and search for stability over the coming months. For several quarters now, we have been increasingly defensive in our positioning (reducing stock exposure), concerned about outsized valuations. Though we believe the broad stock indices have not yet reached a bottom, we have begun to see decent valuations on some individual companies and some good opportunities in the bond space. The next few weeks will see a flood of Q1 corporate earnings reports and we’ll get more insight into how companies have managed this crisis and which are best positioned going forward.
The silver lining to major market downturns is that it provides a buying opportunity for investors who are patient and focused on the long term. By being defensively positioned, we’ll have the opportunity to shift money from low-risk bonds into stocks at more favorable valuations. While we think stocks likely have further to fall, calling a market bottom is difficult, so our strategy will be to buy incrementally when we see good value and think the risk/reward looks favorable.
Within every crisis are the seeds of adaptation that make us better able to avoid such crises in the future. Though the short and medium term prognosis is weak, in the long-term we expect to return to normal levels of growth. As with so many other challenges our society has faced, we are convinced we will make our way through this one as well.
Best,
Louis and Subir

The foregoing contents reflect the opinions of Washington Square Capital Management and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or constructed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. 

Post performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

How low can the S&P 500 go?

How low can the S&P 500 go?

The demand shock created by the Coronavirus outbreak has already created historic levels of market volatility. Today, the market plunged after the Fed announced in a call on Sunday that it would cut rates to zero and implement buying programs for US Treasuries and Mortgage Backed Securities. During such periods of market volatility, we keep an eye on both “technical” analysis, and fundamental “value”. One question we’ve been asked repeatedly by clients is when they should consider entering the market.

Our short answer is not yet, unless you see a compelling opportunity in an individual stock. The companies trading at the steepest discounts are the ones most affected by the current virus driven downturn, oil, travel, airlines, hospitals, restaurants etc. Since the real economic impact and the length of the widely expected global downturn is still unknown, we advise investors to be very cautious when evaluating such stocks.

The follow-up question is always, well when should we begin to buy. That is a question we cannot answer definitively, but we can identify levels that are of interest to an investor looking for a signal of a market bottom.

We are going to outline a case that S&P 500 levels can go far lower, as a means of stress testing our theses. We do not know what the magnitude of the economic shock the US and global economies will suffer. It does appear though, that large and extensive are the operative words. The Empire State Manufacturing survey (an indicator of economic activity in New York state), fell by the largest amount ever. Estimates of GDP in China (which appears to have controlled the outbreak) are extraordinary. Industrial output declined more than 13.5%, retail and investment were down more than 20%, auto sales have dropped 80%. These are traumatic adjustments and we are nort persuaded by the view that consumers and businesses will snap back to normal when the quarantines pass.

Jim Reid, a strategist at Deutsche Bank, added that “the impact of the various Western World shutdowns will mean that at its peak the Covid-19 impact on the global economy will likely be worse than the peak of the financial crisis.” — Stocks gain after biggest Wall Street sell-off since 1987
https://www.ft.com/content/a9d76acc-67ee-11ea-a3c9-1fe6fedcca75?shareType=nongift

Tuesday will deliver a number of US economic indicators including Advance Retail Sales, Industrial Production and Business leaders survey, so we will get a better look at how the US economy fared in these very early stages. While we await better data, we can work with simple assumptions about earnings.

S&P 500 index earnings for 2019 were slightly over $140. Let’s assume earnings drop 25% for 2020. That’s not unimaginable given the extreme stress on oil, airlines, retail, yield curve, durable goods, trade etc. That gets us to $105 earnings. This sounds extreme, but might in fact be optimistic since it doesn’t account for losses, which are widely expected in some sectors. A 5% drop in revenues can drive a 25% drop in earnings in many industries.

$112 is equivalent to 2016-2017 earnings, when index levels were roughly 2000-2400. It is worth noting that this is a global event, and different economies are being impacted at different times. Most of Asia has led, with enormous impacts in Q1. Europe, the US, Africa, South America are following, with impacts in late Q1 and Q2. In our globalized world, as economies try to recover, they could be dragged down by the fact that others have not fully recovered or are entering recession.

Now let’s discuss multiples. Today’s close around 2400 puts prices at 17x trailing earnings (i.e. a p/e of 17). We generally assume there will be support at 10-12.5x from long cycle timers (we include ourselves in that cohort). So we end up with 4 critical levels for the S&P 500:

  • 2400 (Dec 2018 low)
  • 2000 (2016/2017 levels)
  • 1300 (12.5x estimated $105 in 2020 earnings)
  • 850 (very long term trend line support)

The 2000-2400 levels are corroborated by other value investors. GMO, one of the large investment managers we follow, publishes a 7 year return expectation for each asset class. In January, they forecast the annual expected return on US large cap equities (S&P 500) was -4.7%. That implies GMO believes the S&P 500 would deliver a 0% return at 70% of its January levels. In January, the index was at 3270. 70% of that is roughly 2300.

A measure we follow closely is Robert Shiller’s Cyclically Adjusted P/E (CAPE), which averages 10 year earnings to smooth out cyclical effects. In January, with the S&P 500 at 3270, CAPE was over 31. In 2009, CAPE bottomed out at about 13. CAPE at 13 would place the index at 1300.

We understand that the last two levels may be shocking. However, we were last at 1300 in 2012, that’s 8 years ago. In 2009, the S&P re-trenched to a level last seen in 1996, 13 years prior. We were last at 850 in 2009, which was 11 years ago. So by that reversion metric, even 850 is not outlandish.

Many investors believe stocks bottom out in a recession at 10x earnings, a 40% reduction in 2019 earnings would get us to $84 earnings. 10x $84 places us at 840. Notably, this is a significant long-term trend-line extending from many major lows, including 1929 and 2009.

Of course, it is possible that none of these scenarios materialize and we recover from current levels. However, we have to consider that possibility as well. We are beginning to see some buying opportunities, but we do not see the market action that would suggest a bottom has been reached. We have seen dramatic declines based entirely on expectations of poor economic data. If the measured economic readings reach levels seen in China, or the economy stalls due to distress among a spate of small/medium sized businesses, we could see the lower cases materialize.

For long-term investors, it is very important to note that timing such swings in very difficult. Our approach is to take gradual steps to return to long-term allocations. We believe the next 6-9 months are critical. Ours is a resilient species, society and economic system. We will, in good time, recover from this challenge as we have from so many that came before. We are prepared to act on behalf of clients to invest in attractive equity issues when the timing warrants.

We wish you and your families good health as we work through this serious contagious disease.

Regards,

Subir Grewal, CFA, CFP Louis Berger

Market update: Risk assets in a bear market

Market update: Risk assets in a bear market

Friends,

The last few weeks have been history-making for global stock markets, but today was especially notable. We’ll let a graphic for the US markets illustrate (see above).

Today was the worst day for US stocks since 1987, when markets fell over 20%. But the point drops today are even more extreme. The Dow, a narrow index of 30 large cap US companies, but one closely watched by many, fell 2,352 points. Looking at the one month chart makes the recent moves seem even more extreme (see right). Global markets fell overnight as a result of an ever-mounting list of bad news. At the opening bell, US markets were down significantly, triggering a trading curb and halting trading for 15 minutes. Broad indices closed decidedly down for the day, with all US equity averages down over 9%. The small-cap Russell 2000 was down over 11%. European markets closed down in similar ranges. 

By midday, the Fed stepped in and announced a $1.5 Trillion package to inject liquidity into the short-term money market. Stocks briefly rose on this news before retreating back to their lows within minutes. This indicates a crisis of confidence, more on this later.

The one month charts show the medium term declines have put us firmly into bear market territory, with all major US indexes now down over 25%. The indexes have also moved below their 50 month moving average (a key technical measure).

Under normal market conditions, we anchor ourselves using fundamental equity valuations. In times of extreme volatility, we begin to lean more heavily on what are called “technical” or “chart” analyses. We do this because volatile markets indicate a sudden shift in expectations for future returns and risk. In such an environment, valuation measures are uncertain because the underlying assumptions (earnings, creditworthiness) are questioned. Most risks remain to the downside, not only because of pandemic concerns, but also because we are at the tail end of a long boom which has driven valuations up to extreme highs.

Looking ahead, there are several key levels of interest. In December 2018, the S&P 500 reached a low of 2416. This is a major psychological level and we are approaching it. From a technical perspective, we would expect further downside if this level is convincingly breached.

We also want to emphasize that today’s downward moves extended to all markets, including bond markets. There are a flood of margin calls across the street at the moment, as well as a desire to hoard cash on behalf of many companies uncertain about the near-term sales outlook. This has led some investors to sell indiscriminately, accepting a haircut on many assets. This need for cash has caused bond bids to dry up and we’ve seen short-term investment grade corporate bonds trade below par (very unusual in a low interest rate environment where investors are seeking safety). We believe this is due to transitory liquidity concerns that the Fed is well placed to address and expect these bonds will come back in price as the Fed’s policies help stabilize the credit market.

The underlying cause of the stock market decline is, however, not something the Fed can do anything about. The WHO has declared the Coronavirus a global pandemic. As we discussed two weeks ago, we believe the measures required to slow the spread of Coronavirus are extreme, and will impact the real economy. A global recession looks all but inevitable at the moment. This fact is a big part of what’s driving markets down.

Worse, rather than hitting all at once, the bad news is coming in at a steady dribble: sporting events cancelled, flights halted, all retail closed in certain countries, domestic travel restrictions, schools closed, politicians quarantined, celebrities infected etc. etc. etc. There is no respite in sight. It seems certain that the “social distancing” measures recommended by public health authorities will have an impact on corporate earnings for this quarter and the next. Small and large firms will see a sudden shock to cash flow, and this will impact their ability to service debt and continue business operations.

Perhaps worst of all is the lack of information in the US. There are credible reports in the media that the executive branch has sought to limit testing for Coronavirus because it believes a rise in the number of confirmed cases is politically damaging. This is a dangerous development which puts the health of millions at risk. The president has also tried to downplay the seriousness of the disease, again placing lives at risk. 

South Korea, in the past 24 hours, has probably done more tests for coronavirus than the United States has done in the past two months. South Korea can administer 10,000 tests per day. At last count, the US has done somewhere between 5,000 and 8,000 tests in total. — https://www.npr.org/2020/03/12/814881355/white-house-knew-coronavirus-would-be-a-major-threat-but-response-fell-short

The population of South Korea is 50 million. The US population is over 300 million. It has rapidly become clear to market participants that no one in the US has any idea how bad the spread of this virus already is. South Korea and China appear to have been successful at containing the pandemic. The chances of the US doing the same now seem very remote. In the absence of accurate information as to the extent of the disease’s spread, market participants are free to speculate. Questions have been raised about the veracity of information coming from this administration, and its response has been haphazard. The travel restrictions with Europe were not coordinated with European entities and took them by surprise. We do not believe a sudden outbreak of competence is imminent. All of which leaves us here: we do not know yet how widespread the epidemic is, or what impact it will have on our healthcare system. There is no clear indication as to how long US regions will need to practice social distancing and other measures to limit the spread of the virus.

All the news, rumors and lack of verifiable information is weighing heavily on risk assets. Our advice to clients and readers continues to be to maintain caution under the current market conditions. 

Now, with this said, let’s all take a deep breath.  While markets are volatile, it can be very easy to lose perspective.  Yes, we are the midst of a very challenging crisis, but this too shall pass.  As investors, our job is to carefully consider the current market conditions, but also think about where markets will be months or years from now. For investors with a long time horizon, it’s important to remember that markets move in cycles, corrections are part of a functioning economy and risk assets outperform over the long term.  Falling asset prices can present great buying opportunities for investors who are patient and prepared.  By positioning portfolios defensively in the months leading up to this crisis, we now have the opportunity to become more aggressive when valuations are low and stocks look cheap again.  Our plan is to reallocate into underpriced risk assets when the time is right.


Please contact us if you would like to discuss your portfolio or investment allocation.

Regards,

Subir Grewal, CFA, CFP                                                      Louis Berger

Market update: Extreme Volatility in financial markets

Market update: Extreme Volatility in financial markets

Dear Friends,

The financial markets saw a substantial sell-off in risk assets today as all major US stock market indices closed down over 7%. Current market levels are roughly 1-2% away from levels that would signal a bear market (20% down from recent highs). The decline was so steep, market circuit breakers kicked in this morning, halting trading for 15 minutes. Market wide trading halts have not been triggered since 1997. Currency and commodities markets have also seen extreme moves.

The moves in the bond market can only be described as unprecedented. The yield on the entire US Treasury bond curve is now below 1%. Investors are demanding less than 1% annual interest to lend to the US government for 30 years. These levels have never been seen before, and are indicative of a flight to low-risk assets by investors. Gold, another safe haven asset popular during volatile times, also reached a 7 year high today.

In our view, there are two precipitating factors for these moves:

  1. We are at the end of an 11 year bull market where US equities have returned over 400%. Valuations were, and continue to be at high levels.
  2. As we discussed in our note last week, the measures being taken to contain the Corona virus outbreak have an impact on economic activity and could lead much of the world into recession.

Our view on the first is not a surprise. to our readers. We have expressed our valuation concerns for several quarters and are not taken aback that the broader market has begun to share them.

On the second, we believe the measures required to contain this dangerous virus may easily have a significant impact on the economy. Several regions across the world, including all of Italy, have mandated quarantines and closed schools. Such steps can curtail economic activity for weeks. Major employers in the north-western US have mandated employees work from home. Many large US employers have curtailed non-essential travel. The impact on the airlines, hospitality and oil industries is already significant, with airline executives comparing the environment to the period after 9/11.

We believe there are significant risks that remain to be expressed. We have repeatedly asked ourselves where the good news is, and cannot come up with a good answer. The market is already pricing in zero interest rates for the next 30 years. Interest rate policy has effectively been neutered. The Federal Reserve has lost substantial credibility under this administration. The market seems skeptical of both fiscal and monetary stimulus, unconvinced either or both can prevent further drops.

We continue to advocate a defensive position and do not see a quick recovery to previous levels for risky assets like stocks. That said, with steep sell-offs come opportunities and we are looking closely at where to deploy capital when valuations become more favorable. We don’t think valuations are there yet, but at some point there will be an opportunity to buy high quality companies at discounted prices.

Please contact us if you would like to discuss your portfolio or investment allocation.

Regards,

Subir Grewal, CFA, CFP                                                      Louis Berger