PANDEMONIUM

March 16, 2020

In a splash, the salmon pounds on your drifting fly. You seldom see that coming. Your reel screams. Zzzzzzzz. He’s an angry wild missile, darting through the water, pulling your line, hard. You forgot how strong he can be. Or did you ever know it?

As he furiously pulls the line, it hits you: did you thoroughly check the leader before casting? The strength of this thin nylon string between the line and the fly suddenly becomes crucial. A quick, superficial assessment is not enough. You must feel its whole length, check its fiber, to really appreciate its capabilities to fight any salmon. You never know what will hit you.

The level of confidence in the leader dictates the angler’s behavior. A strong leader allows for an aggressive, quick landing. An uncertain or weak leader calls for caution, patience, especially with a big, nasty salmon.

He knows he’s in trouble. He’s truly scared, crazy scared. He goes back and forth, pulls, hard, stops, pulls again, jumps, head shakes. He tries to reach the faster current. He’s testing the leader, he’s testing me, my fortitude, my staying power.

***

The Rule of 20 once again proved its usefulness. Valuation matters.

As the chart clearly shows, the Rule of 20 P/E (black line) invariably cycles between overvaluation and undervaluation within a fairly steady range across times and economic/financial episodes.

Reversal triggers can vary but the cycles always happen. The drops generally occur suddenly and swiftly while bottoms tend to take more time to reverse.

At extreme high valuations, there is always a careless and poorly informed crowd thinking they figured this “easy game” out. There is also always much margin debt.

When the first cracks occur, when the “buying the dips” strategy (!) stops working and the first big selling wave truly scares people, passive investments start being actively liquidated. Bids get hit, equities decline broadly, margin calls arrive, bids get hit again, and it all unravels indiscriminately, making the news headlines, fueling the panic…

…Until calm gradually returns, either because we see that we can trust our leaders, or because we approach absolute valuation lows.

But what lows?

Using the conventional P/E on trailing EPS, now at 14.8x (at 2440), lows have occurred around 15x, but also at 12x (20% lower), sometimes at 7x (53% lower).

If you still believe that equity investors are smart forward lookers, lows have been seen at 11-13x (now 14.1) forward EPS, but also at 10x, even 6x. Understand that these numbers are based on known, post facto, forward earnings. The current estimated forward earnings of $172.71 (per Refinitiv/IBES) is obviously useless given the environment.

By contrast, the Rule of 20 P/E (actual trailing P/E plus inflation), now 17.2x, tends to bottom between 16 and 18  with worst cases around 14.5x (15% lower).

In a “normal environment”, the current 17.2 R20 P/E would favor overweighting equities given an apparent worst case valuation downside of 15% (R20 P/E of 14.5) against a valuation upside of 16% to Fair Value (R20 of 20) and 28% to a R20 P/E of 22. The valuation risk/reward ratio is favorable.

However, this is no “normal environment”. We know that earnings will decline, perhaps significantly, during the next 6 months, at least, and that inflation, currently 2.4% on core CPI, will also decline, perhaps significantly, during the next 6 months, at least.

So, the current R20 Fair Value of 2900 (20.0 – 2.37 x $164.59) will certainly decline, perhaps significantly, during the next six months.

Since 1957, the R20 FV has declined more than 5% nine times, ranging from –6.7% in 2015-16 to –76.3% in 2007-08, with an average of 28.9% and a median of –23.5%.

The S&P 500 Index declined in 6 of these 9 periods, between –10.1% and –41.4%. It rose 17.1% in 1960-61 (before crashing 23% in early 1962), 4.5% in 1979-80 (before crashing 24% in 1981-82) and 3.1% in 2015-16 (dropping 8.9% in late 2015 before recovering).

Declining R20 Fair Values are like headwinds; they are rarely benign, generally tough and sometimes nasty. Undervaluation is no protection when the floor is dropping.

The LUV debate is on. Will this be a L, U or, as most people say (wish), a V shaped recovery?

Let’s try to objectively describe the environment:

• A global pandemic has just started. No cure, no vaccine. The virus is still not completely understood.
• China has been hit very hard. Its economy almost totally stalled. Restarting?
• Europe has become the epicenter.
• America is starting to feel the pain.
• World economies are deeply suffering from a simultaneous crash in demand and supply.
• China seems to have contained the spread. Will it come back during the restart, or next fall/winter before a vaccine is available?
• Europe struggles with its usual leadership/unity problems. Poor Italy, Spain are closed. Will need bailout money. Here we go again, North vs South…
• America: How bad will it get? Nobody really knows, but we know it will get worse in coming weeks (months?). Americans are truly scared. Will that (closures, social distancing, extreme hygiene, etc.) be enough to stop the exponentiality risk of the disease? Will it come back next season before a vaccine is available?
• When will the world completely restart? This won’t magically go away until there is a widely available vaccine. What shape will we be in then?

Earnings will come down, brutally in Q2 and Q3. The LUV debate: I don’t want to vote now. The risk is that the left leg will prove deeper than expected.

The other risk is the crash in oil prices following MBS’s stupid tantrum. A large swath of the credit market is in shambles, at the most ridiculously worst moment.

The tide has receded, big time, and we’re about to find out who was swimming naked as Warren Buffett once said. But, in reality, we already know that most of the world is swimming naked, and central bankers know it. Hence their swift and radical reaction. More to come, no doubt about that. A global whatever it takes.

On the plus side of this gloomy ledger, lower oil prices substantially benefit consumers and corporate users, including the harshly impacted transportation and services sectors. And most governments are already taking strong fiscal measures.

Inflation will decline, helping everybody, helping support equity valuations, eventually, as long as it’s not deflation…

We know we will eventually recover. What we don’t know is when and from what level.

Alarmist? Yes. Voluntarily. This is no ordinary crisis like we are used to, when, at certain points, we see that we can trust our leaders and start visualizing the landing. Today, there are so many significant known and unknown unknowns. Too many,  with potentially very tough outcomes.

Will our leaders be strong enough, act in bipartisan manners, quickly and smartly?

I am not brave, and smart enough to figure it all out, just yet.

Be safe!