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

THE DAILY EDGE: 11 MARCH 2020

Virus Update

Gleaned here and there:

Confirmed cases globally rose to 118,475 after a surge in Italy, where the government will spend $28.3 billion to help combat the outbreak.

The U.S. has 1,001 confirmed cases of coronavirus, according to a Johns Hopkins University tally, which also shows 28 deaths in the country. The list includes cruise ship cases, with 46 from the Diamond Princess and 21 from the Grand Princess. Massachusetts reported 51 new cases Tuesday tied to a drugmaker’s business conference. New York added 31. And in Washington state, where the infection has ripped through one nursing home and spread to several more, 105 more people were diagnosed. NYC Mayor says outbreak “evolving very rapidly”. De Blasio urged New Yorkers to do whatever they could to avoid crowds – take the subway during off-hours, telecommute, if you can. If you’re sick, stay home. “Take it seriously,” de Blasio said. First case reported in Philly

The U.S. has shifted into a new phase of its coronavirus response after efforts to stamp out sparks of an outbreak have failed. Authorities now are focusing on limiting damage. The reality is that a troubled rollout of diagnostic kits consumed weeks and meant that local health labs had little ability to conduct wide surveillance of patients. That made the number of infections look far smaller than it likely was.

Washington Governor Jay Inslee gave a dire warning. He cited statistical models that estimated there could be anywhere from 500 to 2,000 unidentified cases in the state. “If there are 1,000 people infected today,” Inslee said, “in seven or eight weeks there could be 64,000 people infected in the state of Washington if we don’t somehow slow down this epidemic.”

Less than three weeks ago, on Feb. 21, Italy had only 17 known cases. Now there are more than 10,000, at least 631 people have died. Health workers in Milan have said that the number of severely ill patients is beginning to overcome the ability of hospitals and doctors to treat them. Mortality rate in Lombardy hits 8% – higher than Wuhan

Seoul cluster dashes hopes South Korea outbreak is under control Surge in new cases from call centre reverses 4 consecutive days of declines

Germany has recorded 1,565 coronavirus cases and two deaths so far. Austria total cases hits 182

Three Canadians test positive in Calgary

Turkey earlier confirmed the first case of coronavirus had been identified in the country. The person contracted the virus from Europe and his family has been placed under monitoring.

Poland’s government shut schools for the next two weeks as part of its campaign to contain the spread of the coronavirus, Prime Minister Mateusz Morawiecki said. About 6 million school and preschool children, along with 1.2 million university students will be affected. The government will also close museums, cinemas and cultural centers. Poland has confirmed 25 cases.

Prime Minister Shinzo Abe extended cancellations of large events for another 10 days as Japan battles the spread of coronavirus.

Beijing will quarantine all inbound visitors from overseas for 14 days, Zhang Qiang, an official of the city’s party committee, said. Beijing earlier quarantined inbound travelers from South Korea, Italy, Iran and Japan.

London Heathrow airport has introduced regular deep cleaning across all terminals, it said after two British Airways baggage handlers last week tested positive for coronavirus.

Three Transportation Security Administration agents at Mineta San Jose International Airport in California have tested positive for coronavirus, the agency said. All TSA employees they came in contact with in the past 14 days have been quarantined at home. Santa Clara County, which has reported 45 cases, has banned large gatherings of more than 1,000 people effective midnight Wednesday.

Hubei, the Chinese province at the center of the coronavirus outbreak, will allow some work resumption after the region was locked down in January. Companies in sectors including utilities, daily necessities and agriculture necessities in Wuhan city and Hubei province can restart production, the provincial government said in a statement.

This chart is a few days behind but the curves are similar:

Coronavirus Confirmed Cases

Coronavirus Confronts Global Economy With Tough Recovery Businesses are bracing for a longer and steeper coronavirus-triggered downturn than the single-quarter event initially anticipated, as companies face both a shock to supply chains and weaker demand from rattled consumers.

Business operations across Asia, Europe and the U.S. are being disrupted by factory closures, quarantined workers and shortages of components, crimping the availability of goods and services—a so-called supply shock. Meanwhile, postponed public events and mounting fear are causing consumers and businesses to hold back, avoiding travel, restaurants and lavish purchases, even where restrictions haven’t been imposed—a demand shock.

The combined effects risk pushing the global economy into a self-reinforcing, downward spiral—a possibility fueling market turmoil and prompting many executives around the world to prepare for darker scenarios than before. (…)

Lawmakers Rebuff Trump on Payroll-Tax Suspension for Outbreak President Trump’s push to suspend the payroll tax to boost the economy during the coronavirus outbreak fell flat on Capitol Hill, as lawmakers of both parties said they preferred targeted measures to assist hourly workers and the battered travel industry

(…) The House is aiming to vote on something before it leaves Washington on Thursday, likely a measure aimed at helping workers, a congressional aide said. (…)

Morgan Stanley assesses consumers’ reaction (via The Daily Shot):

  

But I would not annualize the oil windfall. Somebody will come to their senses. Given the impact on world economies and financial markets, and the terrible timing, the pressure on SA will be immense.

Saudi Arabia to Boost Oil Output Even Further Saudi Arabia fired another salvo in its oil-market war with Russia on Wednesday, unveiling plans to boost its oil-production capacity to a record 13 million barrels a day.

State-run Saudi Arabian Oil Co. said it would boost production to 12.3 million barrels a day in April, some 300,000 barrels a day over the company’s previous maximum sustained capacity.

Russian Energy Minister Alexander Novak, meanwhile, said his country could rapidly open its own taps.

Even as the price war escalated with fresh salvos from both sides, former Saudi energy minister Khalid al-Falih was in talks with Mr. Novak in an attempt to reverse the production hikes and revive the collective OPEC-Russia output curbs, according to Saudi government advisers and officials.

Mr. Falih, who negotiated the initial production cuts in 2016, is now Saudi Arabia’s minister of investments. His outreach to Mr. Novak is done with the approval of Saudi authorities, the advisers said. If Mr. Falih’s mediation succeeds, the advisers and officials said, OPEC and its allies including Russia will convene an emergency meeting in April.

Mr. Novak said Moscow isn’t ruling out further cooperation with OPEC, adding that the next scheduled meeting is planned for May or June.

“The doors are not closed,” he said. (…)

Russia’s failure to find common ground with Saudi Arabia and OPEC on oil cuts was preceded by talks in early February between Riyadh and Moscow that focused on the possibility of forging a broader, long-term alliance. Under one scenario, Saudi Arabia would have sped up its investments inside sanctions-hit Russia and backed the Kremlin’s military efforts in Syria, according to people familiar with the matter.

Ultimately, the crown prince didn’t commit to a deal, say the people familiar with the matter, because he didn’t want to alienate the U.S. Weeks later, roughly at the same time that Russia was refusing to endorse the Saudi-backed plan to cut oil output, Mr. Putin was initiating a rapprochement with Turkey, a Saudi foe, the people said.

“It’s all about egos now, not about the oil market,” said a Saudi-government adviser.

Meanwhile, Prince Mohammed saw the OPEC debate as a way to assert his broad influence over the kingdom’s oil policies and to prove to his older brother, Saudi energy minister Prince Abdulaziz bin Salman, that he could force Russia’s hand, according to people familiar with his thinking.

In a terse phone call to Prince Abdulaziz late Thursday, the crown prince overruled his brother, who had agreed to a three-month production cut with OPEC, and extended the proposed cuts through the end of the year, these people said.

The crown prince ordered the minister to force OPEC to adopt the decision—even if that meant risking any hope that Russia would join in, they said. (…)

“It was the Saudi declaration of war against Putin,” said a senior Saudi official. (…)

Russia is better prepared to weather low oil prices than in the past. Oil is now accounts for less than a third of budget revenue. The country has also accumulated massive reserves. The Russian finance ministry said Monday that it could withstand 10 years of prices at $25 to $30 a barrel. (…)

ECB’s Lagarde Warns of 2008-Style Crisis Unless Europe Acts
EARNINGS WATCH

The Rule of 20 Strategy also changed Monday, taking cash down from 20% to 10% as the R20 P/E declined below 19.0 at 2750. Remember, this is an automatic move exclusively based on the Rule of 20 P/E and earnings trends.

Yesterday I posted BOTTOM FISHING? to share my thinking and reasoning.

This morning, Goldman’s David Kostin capitulates:

After 11 years, 13% annualized earnings growth and 16% annualized trough-to-peak appreciation, we believe the S&P 500 bull market will soon end. On February 27th we lowered our 2020 S&P 500 EPS estimate to $165. We are now reducing our profit forecast again. Our revised 2020 EPS estimate equals $157, representing a decline of 5% vs. 2019. On a quarterly basis, EPS will likely collapse by roughly 15% in 2Q (consensus expects +3%) and 12% in 3Q (consensus expects +8%) before rising by 12% in 4Q and 11% in 2021. Drivers of our reduced EPS estimate include lower crude oil prices and interest rates that diminish Energy and Financial company profits. Domestic business activity outside of those sectors is also likely to be weaker than we originally forecast, as underscored by reduced or withdrawn guidance from a number of firms in recent weeks.

Despite low bond yields, a widening yield gap explains our new mid-year S&P 500 target of 2450 (15% below the current level and 28% below the market peak).

Kostin sees 3200 at year-end.

By year-end, economic and earnings growth will be accelerating, the fed funds rate will be at the zero lower bound, and the impact of any fiscal stimulus will be flowing through to consumers. Under this scenario, equities will appear attractive relative to bonds and cash. Investor sentiment will improve as policy uncertainty abates following the US election.

Using his quarterly estimates, I infer that trailing EPS would trough at about $150 after Q3, so by mid-November. At 2450, this would be a 16.3 conventional P/E and, assuming 1.5% inflation, 17.8 on the Rule of 20 scale, pretty much along my numbers in BOTTOM FISHING?.

His year-end number of 3200 looks heroic, however, unless investors “normalize” 2020 earnings, assuming much of the damage is temporary and will disappear come 2021. Kostin sees $175 EPS in 2021, meaning 18.2x forward earnings. Seems stretched to me. Read on.

A BEAR? WHAT KIND?

Another GS strategist, Peter Oppenheimer, wrote a good piece Monday, arguing there are 3 kinds of bears

  • Structural bear market – triggered by structural imbalances and financial bubbles. Very often there is a ‘price’ shock such as deflation that follows. This bear market on average see falls of 57%, last 42 months and take 111 months to get back to starting point in nominal terms (134 months in real terms). My old friend Don Coxe called this a “Mama Bear”.
  • Cyclical bear markets – typically a function of rising interest rates, impending recessions and falls in profits. They are a function of the economic cycle. Cyclical bear markets on average see falls of 31%, last 27 months and take 50 months to get back to starting point in nominal terms (73 months in real terms). “Papa Bear”
  • Event-driven bear markets – triggered by a one-off ‘shock’ that does not lead to a domestic recession (such as a war, oil price shock, EM crisis or technical market dislocation). This “Baby Bear” on average see falls of 29%, last 9 months and recover within 15 months in nominal terms (71 months in real terms).

“Event-driven bear markets have typically emerged with fairly modest inflation. When there has been deflation, it has been very modest. To some extent it was this more stable monetary environment that prevented the event from causing the stresses that would have turned it into a more sustained bear market. There have been no deflationary periods during event-driven bear markets.”

Just kidding Yes but, what if Baby Bear brings along Papa Bear in its footsteps? The 6-month demand/supply shock could bite companies, large and small, so much that they would see a need to restore their even more stretched balance sheets, reorganize their supply chains, and cope with bruised export markets (think Europe, Italy, Japan). And oil prices? And interest rates? Can we expect Financials earnings to simply rebound in a V-shape manner?

Ailing Chinese Bank Secures $1.7 Billion of New Capital Bank of Jinzhou, one of a handful of Chinese regional lenders that have run into trouble as the economy cools and Beijing tries to crack down on financial risk-taking, will sell $1.7 billion in new shares to two state-backed buyers.
U.S. Small Business Optimism Improves Slightly

Only if you care. I wait for March data.

Biden Opens an All-But-Insurmountable Lead Over Sanders

BOTTOM FISHING?

March 10, 2020

Chest waders on, I am tentatively testing the bottom, one foot at the time, seeking solid and stable ground, amid rapid, murky waters. I am anxious to cast my line but I first need to make sure I can keep myself dry in this torrent.

Anglers have suddenly disappeared. There were so many, piled on each others, throwing lines just about everywhere, frenzy to catch anything moving. Some even used automatic casting machines they could trigger at a distance. Like if fishing can always be rewarding, whatever the conditions, whoever is handling the rod. There’s always fish, but it’s not always good, not always healthy, not always edible. Some can even be dangerous.

Experienced, I am normally able to read the environment, understand the flow, assess the risk. I know there’s good fish there now. I can see them. These can be very rewarding conditions.

But this swirling viral wind in my face makes casting very unpredictable. The gusts are so violent, any cast can swiftly hit back at me. On unstable ground, I could slip, get wet, hurt myself, perhaps seriously, even permanently. The sky is getting so dark, scaring everybody. Often the best time for bottom fishing.

But this nasty viral wind is tough to read…

***

Before doing any casting here, let’s try to assess the bottom, if we can.

I did a number of scenarios using conventional measures of P/E and P/BV at various valuation levels:

S&P 500 trailing operating EPS tend to cyclically decline 10-15% peak-to-trough since 1970, absent special events such as the dot.com bust and the Great Financial Crisis. From the current $164 level, trailing EPS could drop to the $140-150 range. (Charts other than mine via Morningstar/CPMS)

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Apply a 15 P/E on that and you get 2100-2250, a potential 25% slide from here (2800)!

Why 15? Because apart from the 1974-90 high-inflation era, 15 proved a fairly reliable bottom in tough environments:

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Using the relatively more stable book value, the S&P 500 ROE would find a bottom at about 15% if it remains within its long-term upward channel (remember tax reform?). Adding 6 months of earnings to the current BV of $920, we get earnings of $140-150, validating the above exercise on earnings.

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On a P/BV basis, a trough in the 2.7 range would seem reasonable given ROE levels and the likely absence of a financial shock Fingers crossed. That would be 2500 at current BV, a further 11% cut.

Let’s now look at the Rule of 20 P/E measure which takes inflation into account. The Rule of 20 says that fair value is 20 minus inflation times trailing EPS. Currently this is 2918 using trailing EPS of $164.60 and inflation of 2.3%. On that basis, equities are now 4% undervalued (@ 2800). A deeply undervalued level would be for the R20 P/E to slip to 16.0-17.0, deep into the “lower risk” area (it troughed at 16.8 in December 2018). At 2.3% inflation, this would mean a regular P/E of 13.7-14.7 and 2250-2400 on the S&P 500 Index on current trailing EPS.

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However, trailing earnings seem set to decline for a while. But so is inflation given weaker demand, particularly on heavy-weight services, and lower oil and commodity prices.

Assume trailing EPS decline to $140-150 per above and CPI inflation retreats to the 1.5% range in the next 9 months. Per the Rule of 20, we get a regular P/E of 18.5 and the S&P 500 Index in the 2590-2775 at fair values (R20 P/E of 20) with possible slippage to 2030-2325 deep into undervalued territory.

To recap the readings from the Rule of 20:

  • Current fair value is 2918 but deep undervaluation would be at 2250-2400 in a static state.
  • The apparent worst case earnings with lower inflation would put fair value at 2590-2775 and deep undervaluation in the 2030-2325 range.
  • Using BV and ROE scenarios, we get 2500.
  • Given likely lower earnings ahead, the low end of fair value is 7.5% lower (2590) but the worst case is –27% (2030).

Now, let’s take into account the extraordinarily low interest rates which could incite investors to buy equities at valuation levels above deep historical lows because of abnormally attractive dividend yields.

The dividend yield on the S&P 500 Index is 2.1%. It was also 2.1% at the end of December 2018, when 10Y bonds were yielding 2.7%, now 0.6%. S&P 500 dividends rarely decline. S&P 500 companies are now paying 36% of their trailing earnings in dividends, the same as in December 2008 before dividends were cut 25% during the financial crisis which decimated earnings by 48%. But in 2008, dividends were 32% of cashflows vs 24% now.

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Corporate America has shown its strong resilience during the past 10 years, constantly surprising on revenue growth and profit margins. Debt levels are high overall but the Fed has been quick to offer relief to debtors in this emerging crisis and will likely cut further. If cash preservation becomes paramount, most companies will reduce stock buybacks before cutting dividends.

We can thus assume that many investors will be attracted by dividend yields that meaningfully exceed interest rates, short, medium and long. The spread is already historically large at 1.5%. The above worst case scenario of 2030-2250 could prove too pessimistic with its assumed dividend yields of 2.6-2.9% in the context of bond yields near zero and “comfortably” sub-2.0% inflation.

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Perhaps, then, the low will be at 18.0 on the Rule of 20 P/E as was often the case between 2005 and 2007 and between 2013 and 2016. That would be 2300-2475 using the above mentioned EPS range of $140-150. Downside would thus be 11-18% from here.

But there is another scenario: deflation. Assume a global pandemic, totally scared consumers, cocooning, isolated for weeks or months. Global recession, global deflation. Scary with the amount of debt out there!

***

I don’t trust that gusty wind, this strange, darker than ever sky. The head guide, standing comfortably onshore, tells me things will be fine, I should be casting, get deeper to reach the “very beautiful fish”. I know he has little experience in this, not a real fisherman. Worked his way there without ever being a gillie. And he wears this big baseball cap, totally inappropriate for these conditions, and bright red! Good grief, nobody wears red when fishing. Not a serious guide. I can’t trust this guy.

But my gut tells me to swing. I have done dangerous fishing before, and caught very nice fish. Great memories on the St. John…on the tip of my toes…water just under my shoulders, dripping inside my waders. Six more inches for a last cast…some more water in…Cast! …Yes sir!

Or when the Moisie river was all brown after heavy rain. Four anglers sitting in the camp, waiting, praying. Restless, I recall my late buddy saying “if you ain’t fishin’, you ain’t catching any fish”. I get up, tie my never used Swiss fly, bright gold, thinking a salmon may notice it in this murky water. One cast, a salmon sees and follows it, not taking. Wait 2 minutes. Let the little devil lay down. Second cast. He rises again. Boom! Shore lunch is here!That fly, in one cast, rose one salmon, 3 sad fishermen and 4 bored guides, all at once. World record!

But now, my head overrules my instinct and says no. Experience? Age? Probably both. Still dangerous, too dangerous. Not sure enough of the bottom.

I am staying dry, solid on my feet. There will be time. It’s still early in the season. Better be safe than sorry.