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.

• 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.

• 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.

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.

• 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.

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.

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:

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

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