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

The Rule of 20 Strategy Goes All Cash Again

July 16, 2020

The Rule of 20 Strategy moved to a 100% cash position as trailing S&P 500 EPS dropped abruptly as Q2 results started coming in pushing the Rule of 20 P/E to 24.2 at yesterday’s opening.

We have reached “extreme risk” levels on equity valuation (black line) while the R20 Fair Value [(20 – inflation) X trailing EPS] (yellow line) is in a clear downtrend as EPS are falling faster than inflation.

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The current environment is one of extreme valuation risk accompanied by deteriorating fundamentals. Either investors are totally oblivious to very negative basic equity parameters or they believe the current environment is unusual and/or temporary and valuations do not reflect intrinsic values and better upcoming earnings.

My sense is that both beliefs are in play: expectations of a “V” shape recovery and the desire not to miss this other “don’t fight the Fed opportunity” by inexperienced and momentum-driven people. When the economic expectations will prove wrong, the ensuing decline in valuations will be exacerbated by the crowd’s quick return to earth. Equity markets have this habit of declining much faster than they climb.

This chart shows periods when the Rule of 20 Strategy was all cash since 1957 (black line = R20 P/E). This truly is a “buy low/sell high” strategy.

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Since 1957, after the R20 Strategy dictated a 100% cash position, the S&P 500 Index offered negative returns to the next valuation cycle low 7 out of 9 times, shielding investors from severe losses averaging 23%.

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The Strategy was all cash during the dot.com bubble keeping investors out of this highly speculative, “irrational exuberance” period.

The only period when the Strategy really failed was between March 1991 and December 1994. However, the S&P 500 was unchanged until November 1991 while earnings declined 12%. EPS then surged 63% during the following 3 years while inflation declined 150 basis points, providing a sharp boost to the Rule of 20 Fair Value which skyrocketed 83% during the period. Overvalued equities were supported by the strong backwind provided by a sharply rising R20 Fair Value. Not quite the case now.

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NORMALIZING THE ABNORMAL

This is not a normal, Fed-induced, recession and the economy and financial markets are being strongly supported by governments and central banks around the world. There is thus a case for normalizing earnings. However, there are no rules for that nor are there any precedents to help us assess what “normal” profits will be post pandemic.

  • First, we do not know how it will evolve and when it will end (timing issue).
  • Second, we do not know what the economy will be like and how corporate America will look like when it eventually ends (revenue/margins issue).
  • Third, we do not know how the gigantic economic and financial support will be paid for (growth/taxation issue).

One way out is to calculate what earnings need to be for equities to trade at Fair Value which, in the Rule of 20, is arrived at by multiplying trailing EPS by (20 minus inflation).

If we assume inflation is 1.0% (1.2% in June), fair P/E would be 19.0. At 3220, we would need $169.50 in EPS to be at Fair Value. Current forward 12-month estimates are $143 but full year 2021 earnings are forecast to reach $163, essentially back to their 2018-2019 level.

On that basis, one could argue that equities are close to being fairly valued based on normalized earnings and that a large cash exposure is not warranted. Counter arguments are:

  • Any estimate currently is only based on hope that the world will return to normal early in 2021.
  • Most companies are unable to provide guidance given the uncertainty.
  • In a normal world, with normal growth, normal corporate guidance, forward estimates almost always prove too high, by some 10-15% in general.
  • The post pandemic world will be nothing close to normal (see THE DAY AFTER…).
  • The coming U.S. elections could materially change the financial outlook, particularly with respect to taxation.

In addition to the earnings risk, the assumption that equities will settle at Fair Value is not supported by history. The Rule of 20 P/E always over-correct one way or the other so it is safer to assume that the valuation downside risk is for the R20 P/E to cycle back to between 17 and 19 which, at 1% inflation, means a P/E of 16.0-18.0. Applied to the $169 low-probability estimate, we get a range of 2700-3050 for a 6-16% downside risk on not-very-solid earnings estimates.

WHAT ABOUT TINA?

Another argument in favor of high equity valuations is the abnormally low level of interest rates. The argument is that low interest (discount) rates boost the value of future cash flows while simultaneously keeping people invested in equities since There Is No Alternative. Counter arguments are:

  • The discount rate is also a function of the probabilities of achieving estimated cash flows. Any mid-to-long term forecasts at this time is subject to abnormally wide error factors which should tend to keep discount rates higher than normal.
  • If interest rates are abnormally low, it must have a little to do with the fact that growth is also abnormally low. If interest rates stay lower for longer, as the argument goes, they will probably reflect a slower for longer economic growth environment. Expectations for slower economic growth should normally translate into lower earnings growth and lower earnings multiples.
  • There have been periods of abnormally low interest rates before. These have not translated into higher equity valuation, at least per the Rule of 20 which very rarely exceeds 24.0.
WHAT ABOUT TECHNOLOGY STOCKS?

The increasing importance (weight) of technology and other acronym stocks in equity indices such as the S&P 500 Index suggests to some investors/strategists that equity markets are justified trading at higher multiples. Yes, but

  • These companies are growing fast because their superior technology enables them to grow faster than incumbents. The corollary is that these incumbents are growing at a rate slower than their historical growth rate which normally results in a lower multiple for these stocks that are still populating equity indices. If Amazon grows so fast gaining market share, its losing competitors are effectively slowing down and their stocks should attract lower valuations as a result.
  • One could argue that as incumbents disappear (and many will during the pandemic), growth will accelerate for the survivors. If the world returns to normal, that may be so for a short period but once all the weak companies are gone, overall growth has not changed and competition has effectively intensified among the remaining stronger players.
  • Maybe tech and acronym stocks are also overvalued as suggested by this chart from Ed Yardeni. Note that Ed uses forward earnings here:

  • Lastly, there have also been periods in the past when some sectors gained importance in equity indices as a result of their growth and rising domination. Yet, the range in the Rule of 20 P/E has been remarkably constant between 16 and 24 over time.

The Rule of 20 Strategy is not investment advice. It only serves to help us objectively assess valuation risk vs reward. It makes no forecast, only using trailing earnings and current inflation rates, applied on the historical norm that the Rule of 20 P/E normally fluctuates between 16 and 24 with 20 being the norm for Fair Value.

In this hopefully abnormal world, even normalizing earnings and multiples carries abnormal risks.

Mug Once on “Cheers!”:

Sam: “Beer, Norm?”
Norm: “Have I gotten that predictable? Good.

THE DAILY EDGE: 16 JULY 2020

U.S. Industrial Production Picked Up Again in June. U.S. manufacturing increased in June for the second straight month, a sign of economic recovery in the weeks before the recent surge in coronavirus cases.

Industrial production—a measure of output at factories, mines and utilities—rose a seasonally adjusted 5.4% in June from May, the Federal Reserve said Wednesday. That was a bigger increase than the 4% rise anticipated by economists surveyed by The Wall Street Journal. (…)

Still, despite the recent gains, the index for the second quarter as a whole fell at an annual rate of 42.6%, the largest quarterly decrease since World War II. (…)

The Fed’s beige book, which compiles business anecdotes from around the country, said employers increased hiring across the country as many businesses reopened. Still, many companies reported new layoffs and said it was difficult to rehire workers given health and safety concerns, child-care needs and expanded unemployment benefits that exceed normal pay for some workers.

Some businesses were concerned the pace of recovery wouldn’t continue if the coronavirus wasn’t contained. In the Cleveland Fed district, more firms cut worker pay, particularly for higher-salaried employees, than in the last beige book’s reporting window.

The pace of economic recovery in St. Louis had slowed since mid-June. “One staffing contact reported small firms were ‘decimated,’ estimating that 5% of their small clients had filed for bankruptcy and expecting up to 25% to do so by the end of the year,” the report said. (…) (WSJ)

China Becomes First Major Economy to Return to Growth Since Pandemic China’s economy expanded 3.2% in the second quarter from the same period a year earlier, rebounding from a historic coronavirus-induced contraction in the first three months of the year.

On Thursday, China said its economy grew 3.2% from a year earlier in the second quarter, as authorities benefited from an aggressive campaign to eradicate the virus within its borders.

In sequential terms, China’s second-quarter growth in gross domestic product represented a 11.5% rebound from the first three months of the year, according to data released by Beijing’s National Bureau of Statistics. For the entire first six months of the year, China’s economy contracted just 1.6% when compared with the first half of 2019.

The growth figure for the second quarter beat a median estimate from economists for 2.6% growth and was at the top end of an unusually wide range of forecasts, from a contraction of 3.1% to growth of 3.5%. It followed a historic 6.8% contraction in the first three months of the year, when Beijing shut down the country in late January as the coronavirus spread across China from the central city of Wuhan. (…)

With the second-quarter growth, China is looking more like a bright spot in a world ravaged by the pandemic. The International Monetary Fund expects China’s economy will grow 1.2% for the full year, which would make it the only large economy to report positive data in 2020. (…)

On Thursday, China reported that its urban surveyed jobless rate dropped to 5.7% in June, compared with 5.9% in May. China’s headline unemployment rate doesn’t factor in many migrant workers, tens of millions of people who lost their jobs during the first three months of the year.

Industrial production, meantime, rose 4.8% in June from a year earlier, in line with expectations and up from a 4.4% increase in May.

Fixed-asset investment dropped 3.1% in the first half of the year, improving from a 6.3% drop in the January-to-May period, which was better than the 3.2% decline expected by economists.

China’s retail sales fell 1.8% in June from a year earlier, compared with a 2.8% drop in May, falling short of economists’ projection for 0.3% growth.

Investment in commercial and residential real estate rose 1.9% in the first six months of the year from a year earlier, reversing a fall of 0.3% for the January-to-May period.

American Airlines Plans to Furlough Up to 25,000 Workers The airline told tens of thousands of employees that their jobs are at risk after federal aid expires Oct. 1, as air-travel demand falls again amid climbing coronavirus infections.
Professor Whose Formula Predicts Bankruptcies Has a Big Warning

(…) More than 30 American companies with liabilities exceeding $1 billion have already filed for Chapter 11 since the start of January, and that number is likely to top 60 by year-end after businesses piled on debt during the pandemic, according to Edward Altman, creator of the Z-score and professor emeritus at NYU’s Stern School of Business. Companies globally have sold a record $2.1 trillion of bonds this year, with nearly half coming from U.S. issuers, data compiled by Bloomberg show. (…)

For Altman, some of the debt sold “kicks the can down the road” for firms that don’t deserve support.

Companies are doing the opposite of what they should be doing, which is to de-leverage as the banks did after the global financial crisis of 2008, he said. “When there is an increase in insolvency risk, what you do not need is more debt. You need less debt.”

Bank of Canada Signals No Rate Hikes Until at Least 2023
OPEC and Russia-led Oil Alliance Agree to Increase Production An alliance of crude producers led by Saudi Arabia agreed to increase oil production starting in August, officials in the group said, amid signs that demand is recovering following coronavirus-related lockdowns.

Key members of the Organization of the Petroleum Exporting Countries and its Russia-led allies agreed to loosen existing production caps by about 1.6 million barrels a day, partly reversing draconian output cuts enacted to stem a sharp price decline in the early days of the coronavirus pandemic.

In April, Saudi Arabia, the world’s largest oil exporter, led a push among the 23-producer group to cut collective output by 9.7 million barrels a day, as the pandemic led to a collapse of oil demand. (…)

The group officially agreed to an overall relaxation of cuts of two million barrels a day of production, but required some countries that lagged in enforcing earlier cuts to reduce their output by a net 400,000 barrels a day. Those cuts will be required until the end of October. (…)

In its widely read monthly report Tuesday, OPEC itself said it expected that the world’s demand for oil would increase by 7 million barrels a day next year, after a forecast 8.9 million-barrel-a-day decline in 2020. (…)

WSJ/NBC NEWS POLL Biden Expands Lead as Trump’s Approval Drops

A Democratic Senate Is Looking More Likely

Trump replaces presidential campaign manager US president sidelines Brad Parscale as he trails Democrat Joe Biden in the polls