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)

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:

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.

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 . 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.

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.

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.

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.