Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

Month: July 2020

DON’T FIGHT THE FED: Facts and Fiction

July 8, 2020

Steven Rattner, who served as counselor to the Treasury secretary in the Obama administration, recently wrote an op-ed in the NYT, The Mystery of High Stock Prices: Why is the market doing so well when the economy is doing so poorly?

  • Some hold the view that the economy’s troubles will be short-lived; a V-shaped recovery will soon unfold and the stock market is merely looking ahead.
  • Others cite the upsurge in buying by small individual investors.
  • My vote for the most significant driver of stock prices is the huge amount of liquidity that the Federal Reserve has injected into the financial system, in an effort to counteract the depressive economic impact of the virus. That has pushed interest rates to record lows, turning money market funds, bonds and other fixed-income instruments into low-returning investments. The Standard & Poor’s index of 500 stocks, for example, currently has a dividend yield of 1.9 percent, compared with 0.7 percent for 10-year Treasury notes. Unusually, an investor can now make more in current income from stocks than from high-quality fixed-income securities while participating in any future appreciation in share prices. (…)

Rattner concluded with the famous mantra: “Don’t fight the Fed” but, just before closing, added:

In fairness, the Fed is not the only factor influencing the market. Individual investors, known for their often poor timing of entry and exit points, have been trading actively, aided by commissions that major online brokers have dropped to zero.

First, let’s establish some facts:

  • Dividend yields typically substantially exceeded fixed income yields prior to 1960. That likely had to do with the fact that the October 1929 peak in equities was not revisited until the summer of 1954, a quarter century later. Investors demanded a higher dividend yield to compensate for the lack of capital appreciation and higher risk in share prices over a very long period.

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  • S&P 500 EPS peaked in December 1929, collapsed 74% through 1932 and took another 15 years to exceed that peak again. It was only after WWII that the economy and corporate profits really recovered. But years of poor returns kept investors away from equities and valuations remained depressed until the 1960s.

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  • There is really no clear pattern between fixed income and dividend yields other than, since the seventies, in the general trends in yields, although dividend yields did not declined sustainably below 2.0% in this century contrary to interest rates. The relative yield argument should thus not carry a hefty weight, even more so given that dividends are currently declining. Dividends dropped 24% between 2008 and 2010.

In his book, “Winning on Wall Street,” the legendary technician Marty Zweig explained his “Don’t fight the Fed” mantra:

Monetary conditions exert an enormous influence on stock prices. Falling interest rates reduce the competition on stocks from Treasury bills, certificates of deposit and money market funds. Zero percent interest rates will not provide investors with a return that can keep pace with inflation. Also, low interest rates provide corporations low borrowing costs, allowing profits to rise. As interest rates drop, investors tend to bid prices higher, expecting corporate earnings to rise.

TINA (there is no alternative) is much older than many think.

Ed Yardeni’s chart adds color to Zweig’s argument. Periods in blue are when the Fed is easing. My red rectangles indicate when equities kept falling amid Fed easing.

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In 1969-70, in 1974, in 1982, in 2001-02 and in 2008, not fighting the Fed proved very costly with redemption (capital recovery) years away in most cases. What about the corollary, checking for consistency and predictability? After all, if we should buy stocks when the Fed is easing, we should sell when it is tightening. Well, just look at Yardeni’s chart. For example, the Fed raised rates seventeen times between 2004 and 2006 and the bull kept raging.

The debate on the shape of the expected economic recovery continues. So far, the “V” remains credible, if only because reopening the economy would in itself create a V-shaped chart for most data series. We will see how that right leg goes from here but there is significant doubt that we will get a symmetrical “V” shape when summer and fall data are in.

Then there is the shape of corporate profits where analysts are seeing a nice enticing “V” with quarterly S&P 500 EPS back to their 2019 level in the third quarter of 2021, 15 months after the trough and only about a year from now.

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  • We needed 30 months and 500 basis points drops in short-term interest rates to revisit the 2007 high point in EPS after the trough in the fourth quarter of 2008.
  • We needed 30 months and 300 basis points drops in short-term interest rates to revisit the 2000 high point in EPS after the trough in the second quarter of 2001.
  • We needed 27 months and 500 basis points drops in short-term interest rates to revisit the 1990 high point in EPS after the trough in the fourth quarter of 1991.

In 2009, equities sprinted back from their March 2009 low and logged spectacular gains thereafter. But that started when equity valuations were at generational lows and profits at their cyclical trough. Many investors, still shocked by “the lost decade” stayed away from equities through most of the bull market.

In late 2002, equities started on a 5-year powerful trek up. That started with equities at the “20” fair value level on the Rule of 20 scale and fed by a strong uptrend in the R20 Fair Value (yellow line in chart below) thanks to rising profits and declining inflation.

In late 1990, equities troughed at a conventional P/E of 13 and an undervalued R20 P/E of 18.4.

Today, valuations are at cyclical highs and profits are still falling abruptly. The investing crowd, determined not to miss this bull, is very active in markets and on social media.

Today, we are fighting an invisible virus, hoping for a cure and/or vaccine before economies can fully and confidently restart. Nothing the Fed can do for that.

Today, the Fed is not in easing mode, rather in damage control mode with interest rates already near zero. The Fed is not stimulating, only preventing a financial and economic collapse pushing liquidity into a highly indebted corporate sector, making it even more indebted.

Today, the U.S. Congress is firmly Democrat while both a GOP Senate and President are fragile going into the election stretch. There is a clear and rising risk of a Democrat sweep. I have yet to see higher tax rates embedded in forecasts used in the below estimates.

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Entering the Q2 earnings season, S&P 500 profits are expected to crater 44% YoY, followed by -26% in Q3 and -14% in Q4, assuming analysts prove right in this unusually dark environment. By the end  of 2020, trailing EPS will be around $125, meaning the S&P 500 is at 25 times full year EPS. One year out, still assuming analysts prove right, trailing EPS will be $134, current of P/E of 23. Using the full 2021 year estimates of $163, the P/E is 19. The crowd is in…

In June 2009, the P/E on trailing EPS was 14.5, on full year 2009: 13.1; on EPS 12 months out: 12.8 and on full year 2010: 10.7. Nobody cared then…

In the chart below, all these P/E levels are shown, in red for the current “buy high” P/Es and in green for the 2009 “buy low” vintage.

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In Bear Essentials, I analyse the seven bear markets since 1960:

  • Equity market troughs happened irrespective of profit trends around the lows. In 4 of the 7 episodes reviewed, but in 4 of the last 5, equities troughed and rose while profits were still declining, sometimes brutally like in 1974-75 and 1990-91.
  • Bear markets end irrespectively of the trend in Fair Value. At previous bear market troughs, Fair Value was rising 3 times, flat twice and declining, strongly, in 2 episodes.

Briefly said, in 4 of the last 7 bear markets, equity markets troughed before fundamental conditions improved.

However,

  • Excluding the 2000-02 episode, market lows were reached at a Rule of 20 P/E between 14.5 and 18.4 (average of 16.7, median of 17.2) and a conventional P/E between 7.2 and 16.1 (average of 11.8, median of 12.8). The range of valuation lows was much narrower using the R20 P/E. (All P/Es on trailing EPS).
  • To sum it all up, bear markets end when fear is sufficiently embedded in valuations and the Fed has become friendly. The Rule of 20 provides a dependable reading of equity valuations. During the last 7 bear markets, accumulating equities when the R20 P/E was below 17.5 AND the Fed was clearly in easing mode has proven rewarding.

This March 29, 2020 analysis led to worst case levels ranging from 1850 to 2300 on the S&P 500 Index. The March 23 low was 2183.

As I then tried to look past the potential low points, I thought that it was “reasonable to assume that valuations will not quickly return to recent excesses.” After all,

From the low in September 1982 to the next peak in 1987, the R20 P/E (black line) needed 40 months to return to its 20 Fair Value level, spending the first 36 months deep into undervalued territory. A similar cautious state prevailed after the October 1987 crash as the R20 P/E returned to 20 only 31 months after the sudden and quick bear punch.

After the 2000-02 wallop, valuations spent the better part of the next upcycle in the undervalued 18-20 R20 P/E range. Actually, it was not until well after the 2008-09 brutal and enduring Mama bear that valuations successfully crossed into the overvalued area in mid-2016.

Given this nasty Pole bear and its viral origins, it seems reasonable to expect another extended display of investor cautiousness. If so, it would be more appropriate to think of the equity valuation range for the next 2-3 years as between 16 and 20 R20 P/E. There is really nothing wrong with that. It means that Mama bear will eventually morph into a gentle, slowly aging bull wary of jumping wildly across the Fair Value fence where it always transforms itself into the dangerous ursid kind.

Well, I was obviously expecting to much “reasonable” behavior and cautiousness from investors.

When pizza tasters-turned-stock-picking-gurus get famous buying stocks with tickers drawn from a bag of Scrabble letters and mock Warren Buffett in the process, it means that a crowd of inexperienced/uncouncious people has invaded equity markets. Trendy stocks get trendier, untrendy stocks find trends and valuations reach for the sky…until gravity eventually returns. We know that will not end kindly for everybody, whenever the ending happens.

Buying or holding a large equity exposure here is a lot more than “not fighting the Fed”. It is “not fighting the crowd”, “Buy high” and pray hard that “stocks only go up” as the now famed Dave Portnoy claims to his 2.6 million followers on Instagram.

The facts are that stocks actually don’t “only go up” unless one is willing to hold or is capable of suffering during 6 (1973-80, 2007-13), 13 (2000-13) or 25 years (1929-54), buying and holding equities at excessive valuations thinking stocks only go up and the Fed has your back. I wish it were that simple!

Buying bankrupt companies that the savvy/smart/experienced Carl Icahn is unloading because one thinks highly of the Hertz name and marvels at the number of rental cars without even considering the $37 billion debt against the assets is magical thinking only magnified by blind followers on social media piggy-backing on the self-created momentum.

We have seen this movie before and, while we don’t know when, we know how it will end.

In the meantime, it is prudent to calibrate one’s equity exposure with one’s personal risk tolerance and watch some key technical indicators.

Martin  Zweig also coined “Don’t fight the tape”. For people with hair darker than mine, that means “Don’t fight the trend”. The main technical indicators I watch are

  • the 13/34–Week EMA Trend Chart,
  • the 200-day moving averages and
  • Lowry’s Research analysis of supply and demand.

All three are currently positive. The trend is your friend…until it no longer is, ‘cause this is not a strong, loyal and lasting friendship, whatever your personal guru says.

In closing, look at the consistency in the Rule of 20 P/E range since the 1950s (black line). The Rule of 20 is a good, dependable friend:

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The charts below present the historical returns on the S&P 500 since 1927 at various R20 P/E levels:

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This chart shows the probability of losses 6 and 12 months out:

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THE DAILY EDGE: 8 JULY 2020

Coronavirus cases in the U.S. rose 1.8% from a day earlier to 2.96 million, according to data collected by Johns Hopkins University and Bloomberg News. That matched the average daily increase over the past week and marked a fourth day in which new cases topped 50,000. Deaths rose 0.6% to 130,813.

  • Florida had 213,794 cases, up 3.6% from a day earlier, compared with an average increase of 5% in the previous seven days, according to state health officials. Deaths reached 3,841, an increase of 1.7%

  • California reported a 3.4% daily jump in virus hospitalizations, to a record 5,989 patients. San Francisco will delay plans to open indoor dining and outdoor bars as planned July 13

  • Arizona health officials reported 3,653 new cases, bringing that total to 105,094, a 3.6% increase. Deaths rose by a record 117 to 1,927

  • New Jersey’s virus transmission rate rose to 1.05, the highest in about 10 weeks, according to Governor Phil Murphy’s office. Weeks ago, the rate was 0.64

  • Montana cases rose 6.2% to a total 1,327, according to data compiled by Johns Hopkins and Bloomberg News

Coronavirus deaths are ticking up in the new hotspots of Florida, Texas and Arizona, even as they continue to trend down nationally, Axios’ Caitlin Owens writes.

  • Arizona reported a record 117 deaths yesterday, and hospitalizations are skyrocketing there and in other hotspots.

  • Texas reported a record 60 new deaths and 10,000 new cases.

  • Florida reported 63 new deaths.

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PANDENOMICS

Yesterday, I summed up Markit’s Services PMIs with

My take is that in spite of the normal snap back in demand from re-openings, with the  exception of China, we are still not seeing indications of a sustained solid turn in new orders (business demand) that would then solidly lift employment (consumer demand) that would fuel more new orders and create the typical post-recession self-feeding recovery.

Later in the day, Markit posted this chart on global employment, orders and backlogs which are, in my view, the critical series to watch currently.

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The current situation is also very different from prior global downturns. Although global PMI indicators of new business showed record gains in both manufacturing and services in June, a rebound from enforced closures of non-essential business and household lockdowns was only to be expected as operations restart. Companies have also reported that lockdowns have led to pent-up demand for certain goods and services which is now supporting business activity.

Quite how long this pent-up demand effect will last remain uncertain. Even with the rebound, the latest global new business indicators remain below 50, reflecting a situation where more companies reported a drop in new work than saw an improvement, hinting strongly at subdued underlying demand. Broader indicators of global trade from the manufacturing PMI surveys also showed exports continuing to act as a particular drag on the global economy, leaving many economies reliant on domestic demand to drive growth.

Furthermore, the current demand environment also reflects emergency stimulus measures, both from central banks and government, the latter notably via fiscal support and employment retention schemes, which have helped provide temporary platforms to support demand and consumption.

The big question is therefore whether the demand indicators will continue to improve beyond the initial rebound from the lockdowns, and in particular how employment will hold up when support measures are removed. Encouragingly, the rate of global job losses eased for a second successive month in June. Business expectations for the year ahead have almost recovered to levels seen earlier in the year. Whether these positive trends continue will ultimately depend on central bank and government policy support, and also of course on the absence of a renewed upward trend in COVID-19 infections. Any renewed faltering of the PMIs in coming months will flash warning signs of a W- rather than V-shaped recovery.

Weekly Economic Index The WEI is an index of ten daily and weekly indicators of real economic activity, scaled to align with the four-quarter GDP growth rate.

WEI Chart
Recession Forces Spending Cuts on States, Cities Hit by Coronavirus State and local governments from Georgia to California are cutting money for schools, universities and other services as the coronavirus-induced recession wreaks havoc on their finances.

(…) Widespread job losses and closed businesses have reduced revenue from sales and income taxes, forcing officials to make agonizing choices in budgets for the new fiscal year, which started July 1 in much of the country.

Governments have cut 1.5 million jobs since March, mostly in education, and more reductions are likely barring a quick economic recovery. In Washington state, some state workers will take unpaid furloughs. In Idaho, Boise State University cut its baseball and swim teams in an effort to save $3 million.

Dayton, Ohio, Mayor Nan Whaley says the city may have to cut up to 8% of its general fund budget, which pays for fire, police, roads, water and trash collection. (…)

The National Governors Association says states need another $500 billion in federal aid to make up for lost revenue. The U.S. Conference of Mayors says cities need $250 billion. (…)

Almost all states and local governments require balanced budgets. For now, they have largely avoided raising taxes to plug budget holes, opting instead to cut spending or dip into reserves. (…)

The median state went into the crisis with reserves totaling a record 7.8% of its general fund budget, according to the National Association of State Budget Officers.

California lawmakers used $9 billion of their $16 billion rainy-day fund to help balance the $202 billion budget that Gov. Gavin Newsom, a Democrat, signed June 29. Even so, state employees will have to take up to two unpaid furlough days a month, and public colleges and universities face about $602 million in reductions. (…)

With an uncertain outlook, officials are trying to maintain reserves in anticipation of more lean years.

“You may need to use it in 2022 and beyond,” said Brian Sigritz, director of state fiscal studies at the budget officers’ association. “They’re not expecting this decline to be a one-year or two-year thing.” (…)

States and cities’ aggregate expenditures are 60% larger than the federal government’s. They employ 18.4 million people (13% of the U.S. total employment) compared to 2.9 million for the federal government. So far, employment in states and cities has declined 7.5% from February while total employment dropped 10.2% and federal employment is up 0.6%.

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  • United Airlines Holdings Inc. warned employees that a jump in coronavirus infections in parts of the South and West is jeopardizing a nascent recovery for U.S. travel. The shares plunged. The airline has seen a sharp drop in bookings, particularly at its Newark, New Jersey hub, as states in the New York City metro area add new quarantine rules for travelers, United executives told employees Monday in a town hall meeting. Bookings at United’s Newark hub were 16% of 2019 levels as of July 1, or about half of what they were several weeks earlier when travel began reviving, according to the presentation. United is watching for signs of a similar drop at its Chicago hub given restrictions the city imposed last week on travelers arriving from more than a dozen states, said a person familiar with the matter, who asked not to be named because the employee discussions were private.
  • Covid Still Poses Challenges for Financial System, Fed’s Quarles Says Global policy makers responded decisively to the coronavirus outbreak earlier this year but the financial system isn’t out of the woods yet, a top Federal Reserve official said Tuesday.
  • American consumers may not be prepared to return to pre-pandemic spending levels. More than 40% of people who spent money on movies, event tickets or at bars before the pandemic now plan to spend less on those activities, according to a new survey for CreditCards.com. Meanwhile, more than 60% of small businesses say they need spending to return to normal by the end of the year to stay open, according to American Express data.
  • Ascena Retail Group Inc., the owner of mall brands that occupy almost 3,000 stores in the U.S., is preparing to file for bankruptcy and shutter at least 1,200 of those locations, according to people with knowledge of the plan. The company, which owns brands such as Ann Taylor and Lane Bryant, could enter Chapter 11 as soon as this week with a creditor agreement in place that eliminates around $700 million of its $1.1 billion debt load.
    • The Johnson Redbook index of same-store sales is yet to see a meaningful rebound. (The Daily Shot)

    • Chinese retail sales have been recovering but remain well below previous trend growth.

Source: Gavekal

  • A growing number of Japanese businesses are failing amid the coronavirus pandemic. Some 780 Japanese firms filed for bankruptcy in June, 148% more than the prior month and the most this year, according to Tokyo Shoko Research Ltd. There were 94 pandemic-driven cases last month, bringing the total to 240 in the first half of the year, with sectors such as hotels and restaurants badly hit. Growing distress among businesses is in line with the record jump in bank loans and deposits in June, as companies continued to tap emergency credit facilities and hoard cash.
  • European Union leaders will probably fail to agree at a summit next week on a massive spending plan aimed at reviving their economies, according to Hungarian Prime Minister Viktor Orban. Negotiations will be “very tough” and will likely need to continue throughout the summer, Orban said on Wednesday in an online panel discussion with Slovenian Prime Minister Janez Jansa and Serbian President Aleksandar Vucic.

Pointing up Also posted today: DON’T FIGHT THE FED: Facts and Fiction

Below is the forward P/E ratio for the S&P 500 Consumer Discretionary sector.

Source: @LizAnnSonders, @business

With four months to go, how US equities are trading the 2020 elections. Three different markets suggest three different 2020 election perspectives: (1) Prediction markets suggest a Democratic sweep. Market pricing currently implies the Democrats will control the White House, Senate, and House of Representatives. The current probabilities equal 62%, 61%, and 85%, respectively, compared with 43%, 30% and 61% in late February. (Goldman Sachs)

FYI: