2020 Second Quarter Review

“I don’t think that the same God who has given us our senses, reason, and intelligence wished us to abandon their use.”

Galileo Galilei

Market Review

Our whiplash collar needed to be adjusted after this year’s violent market crash and rebound. The -34% move in the S&P 500 took all of 23 market days. The move back north has been nearly relentless. Shifting market narratives have moved under the feet of many an investing giant, turning that ground into quicksand. The monetary response issued by the Federal Reserve coupled with the fiscal response of the US government has turned on a spigot of liquidity. At this point we do not want to hear “unprecedented” anymore, and we have never said that before. The reality is that money has flowed, and much of that has flowed back into the equity market. Will the unprecedented fiscal and monetary response end? One of the biggest worries is what will happen if the government pulls out the policy bazooka again and the market does not care.

We started the quarter quite defensive in all our models. We built up our equity positions slowly to end the quarter at a neutral position across our Asset Allocation models. While we always say that we do not make predictions about the market direction we mean it here. Markets have been volatile this year, and we continue to see fits and spurts of volatility during the “calm” march north in the indexes. Traditional equity market guideposts have ceased to be telling. This is causing confusion to many. Forward looks stats look bad, but that doesn’t seem to matter right now.

Currently the market has been “looking through” these difficult times. What are we looking through? Why are we looking through? Who else is looking through? Can we see through? The “Buy the Dip” sentiment has been loud. We have seen companies that should not get second chances get them. We are still in the early innings of the exploration of how COVID will affect our economy in the long term. The increase in corporate debt during the pandemic has been staggering. With the Fed backstopping low interest rates on corporate debt (a new thing) we have seen companies that were, in our opinion, already overly indebted take on more debt to make it through the crisis. How those companies will unwind the extra debt remains to be seen. We try to stay away from overly indebted secularly slowing companies, so we have for the most part avoided this issue in our portfolio companies.

Secular economic trends accelerated during the lockdowns. The shift away from brick and mortar and to online retail proceeded at a furious pace. This trend may stall some once reopening finally completes, but how much permanent damage has been done is still a question. Of course, this period has been extremely difficult for the restaurant industry. That segment has seen the biggest hit from this crisis, and we do not know when that industry will recover. Full-service restaurants are something that we will miss if the recovery does not complete its full circle.

Looking forward to Q3 2020

Governmental and other assistance programs coming off the books
1. Credit card forbearance ending.
2. Auto loan forbearance ending.
3. Possible state & local government budget cuts.
4. Delayed federal income tax deadline.
5. Enhanced unemployment insurance ending.
6. Student loan forbearance ending.
7. Mortgage forbearance ending.
8. PPP grace period ending.

The presence of all these programs or policies has allowed the US consumer to make a good comeback as the country comes out of lockdown. What happens if these end and nothing replaces them or tapers them out remains to be seen.
All the new programs could be renewed, or not. Policy response will continue to be key to the continued recovery. Simply having an end to a program does not mean that other support will not appear. Of course, election year dysfunction could hold up crucial aid.

The election
- We are not big believers that equity markets are affected long term by the occupier of the White House.

Of course, there will be short term deviations, but our collective long-term path is charted far more by non-political events than the pols would like us to think.

Q2 earnings season
- Q1 earnings season was one of forgiveness. There was no penalty for missing the consensus earnings forecast as nobody knew what to expect.
- Will Q2 be a season of forgiveness? We really cannot know the answer to this question at this point. It is still difficult to judge the full short-term impact of lockdowns on earnings, but analysts have discounted Q2 earnings quite a bit already.

According to FactSet 54% fewer companies issued guidance for 2020 in Q1 than average. This guidance is very important to giving analysts an insight into trends in the marketplace.

Corporate Zombies and the use of leverage
- In FY 2019, 22% of the Russell 1000 had earnings that were less than their interest payments to service their debt. This is a rough definition of a zombie company, one who does not earn more than its debt payments
- During COVID companies have been on a borrowing spree. This means that more companies will be zombies in the future even with low borrowing rates.
- Wise use of debt is advantageous, though we may see a serious falling out over time of these “zombie” companies. When they must roll their newly acquired debt in the future the street may not give them a pass.
- Traditional Metrics
  - Traditional metrics of the equity markets are not predictive in this market regime.
  - 12-month forward price-to-earnings ratio (P/E) for the S&P 500 is 21.7 right now, vs 16.9 for the 5-year average.
  - But the market is looking through the next 12 months. On some level it always does this, but it has become extreme right now.
  - There are of course reasons for this, and the question that needs to be answered is whether the long-term growth rate of our GDP has been altered. That will take some time to sort out.
- The stock market recovery has not been even across market segments.
  - As with the virus and lockdowns, the response of equities has varied widely.
  - We have highlighted this issue several times over the past quarter, but it bears repeating. US Large Cap equities have been the market segment that has recovered best.
  - Small Caps, International, Dividend, and Value equities have all lagged US Large Cap by a significant margin.
  - In general returns are mean reverting, but it could take years before the performance difference reverts.

We continue to pray for a speedy economic recovery, and a healing spirit to come to our torn country. Please stay healthy and safe out there.

EWM 2020 Q2 Review in PDF form