A Market Review and COVID-19's Impact
The market goes up. We look out at a sea of difficult numbers and equities go up. We get bad news and equities go up. Forward valuations are spiking, and equities continue to go up. We are reminded of Bill Murray, in what we consider his finest monologue, from Meatballs telling us “It just doesn’t matter.”
At some point it does matter. Debt crushes future growth. US companies came into this crisis with massive levels of debt. Since the Global Financial Crisis of 2008-09, the companies of the S&P 500 have increased their debt levels 138%. Instead of deleveraging their way out of a crisis like in the past they are re-leveraging their companies to get through. We will see a better picture of debt levels when companies report in August but expect a large increase in debt. Most will tell you that to not take advantage of ultra-low interest rates of recent years provided by the persistently dovish Federal Reserve would have been a mistake. This can be true, but many companies that took on debt did so not to reinvest in their business, but to engage in financial engineering. Those same companies are now coming back and asking for additional leverage to be put on their balance sheets to get out of this. Maybe they should have lowered their payout ratios and not levered up in the first place.
There have been some companies that have gone out and raised equity capital, and that should be applauded. However, most have just increased debt levels. We have moved from Gordon Gecko’s “Greed is Good” to the modern equivalent “Debt is Good”??? Debt is a hamper on future growth as the cash flows that must go to servicing that debt cannot be used elsewhere.
Underemployment: We have all seen and heard the eye-popping headline unemployment numbers. But let us look a little under the hood at the U-6 numbers. U-6 is the most comprehensive official unemployment including those employed part time for economic reasons. This has spiked to 22.8%. Companies are taking this crisis to cut future costs without the negative repercussions normally associated with cutting employment. It took the US economy 11 1/3 years to get back to the U-6 levels it had before the Global Financial Crisis. This has nothing and everything to do with the equity markets. If this level does not come down fast, there could be serious political repercussions and volatility.
Valuation: Goldman Sachs came out and told us to ignore 1-year forward price-to-earnings (P/E) multiples. They told us that Forward 2-year P/E multiples were what we should look at now. This sounds logical in the abstract; we know that 2020 earnings per share (EPS) is going to be shot to hell due to the lockdowns. But 2021 EPS is nothing more than a wild guess, and if history tells us anything it is that 2-year EPS projections are overly optimistic guesses to begin with. Generally in the US, consensus estimates begin to be given 2 years out. Most of the time those estimates trend down until the very end of the quarter. Then the actual numbers come in above where the consensus had marked them down to.
So, forward valuations almost always come down. Why do we think that consensus estimates two years out are ok to base a valuation on? When analysts build their company models, they do so one quarter at a time. The first quarter out may be somewhat accurate, but each quarter after that has an error term built into the models. The “error term” is the uncertainty in the analyst’s estimate. As you add more forward estimates onto the model, the error terms get larger and larger as unknowns pile on top of each other. This means, that by the time you are modeling out 2 years into the future, there are 8 error terms that must be factored in, generating a much larger error than a 1-year number. We are currently getting these warnings when we go to look at company results versus consensus from FactSet:
Nobody knows how to model out the near term, so their long-term projections are most likely not great either.
Now we can look at forward valuations with a very healthy dose of skepticism; forward earnings estimates will most likely continue to fall, and the consensus is not really the consensus. A gentle breeze could topple the analysts estimates right now. Since 2/19 (the market high) the forward P/E multiple has increased +8% while the price has fallen -15.91%. This is not the normal way that multiples act during a crisis. Multiples tend to contract into the crisis, not expand. Maybe we are moving into a new type of market regime where we will have to pay more for earnings going forward. That can happen as the average multiple changes over time. Accounting standards and taxes also change, so it is entirely possible that we are seeing this.
Narrow: This is one of the narrowest rallies in the market that we have seen. If you are not a mega-cap tech company, the recovery has not been tangible. The spread between the mega-cap US equities and the rest of the world in terms of risk assets has been stark. The spread has been double digits this year. This is on top of 2018 when the exact same thing happened. Mean reversion should have set in at this point, but it has not. There is a concentration of money pouring into the top companies.
Emerging Markets: Emerging market economies and companies generally must raise debt in US dollars or Euros. This limits their ability to issue massive bailouts like we have seen in the US. They simply know that they cannot finance the debt in a foreign currency while collecting taxes or revenue in their local currency.
The Election: At this point both parties are committed to keeping the tap open, so there is no good economic reason to choose one party over another. They argue like there is a difference, but they are both behaving like socialists now. They are privatizing the gains and socializing the losses. Debt is a hamper on future growth as cash flows that must go to servicing that debt cannot be used elsewhere (lower taxes, infrastructure spending, social programs). The US could quickly become Japan with its massive debt load, zero immigration policy, and below replacement birthrate.
Trade Wars: These could ramp up again. The current administration may come out of the COVID crisis incentivized to push as much of the supply chain out of China as it can. Not a bad thing.
CapEx Pullback: Before COVID-19 there was already a slowing of corporate capital expenditures (CapEx) growth. Listening to the earnings calls we are seeing CapEx being demolished at this point. Maybe next year…
Bail Out: The fallout on the balance sheets of companies for basically skipping one or two months of revenue has been staggering. Bankruptcies are starting and we are seeing some bailouts. Be careful buying distressed companies. We have seen clients ask for airlines to buy or oil to invest in. Those situations move so quickly and trying to catch a falling knife can chop off a few fingers.
QE4-Ever: “We really are going to use our tools to do what we need to do here”, said Federal Reserve Chair Jay Powell. Where will it end? It is already going to some quasi illegal areas of bond buying. What happens if the equity market falls again? There already seems to be no end to the lengths the Fed will go. Will Treasury begin to buy stocks? We have seen the Fed’s balance sheet explode again, more than doubling over 1 month. Good or bad is not the question here. The question is where does the equity market rally go if the Fed either stops easing or the investing public loses faith in the money that is being created?
Return to Normalcy: Normalcy? What does that even mean? We have been reading voraciously and cannot even come up with a consensus as to what the world will look like in 6 weeks let alone updated spending patterns.
With all these highly negative market signals it is difficult to see the reason the equity markets have been “recovering”. They are, and we are, watching and taking the actions that we see as appropriate. Reopening does not mean doing well. We pray for a speedy recovery but are prepared to be in this for the long haul. Please stay healthy and know that we are here for you, our clients.
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