April 3, 2020
By Steve Blumenthal
“There are no new eras—excesses are never permanent.”
– Bob Farrell
Bob Farrell’s 10 Rules for Investing
I went to sleep last night with more hope in my heart then I’ve felt over the last several weeks. These days, I’ve been feeling more like Eeyore than Tigger… It’s been a fight to keep the energy level high. You may feel the same.
The news has had an obsessive hold on me. This disease is awful. We don’t fully know what its toll will be, economic or otherwise. But some good news: Before bed last night I watched an interview with Dr. Stephen Smith, a 1989 Yale Medical School graduate and head of the Smith Center for Infectious Diseases and Urban Health, and Dr. Ramin Oskoui, cardiologist and CEO of Foxhall Cardiology. Dr. Smith told us that his patient findings are similar to those in a recent French study. A combination of hydroxychloroquine, a malaria drug, and azithromycin, an antibiotic, taken together have kept his patients—all of whom are pre-diabetic or diabetic, and thus in a high-risk category—from needing to be intubated. Dr. Smith concluded the interview by saying, “I think this is the beginning of the end of the pandemic.” You can watch the clip here.
As for the markets, volatility remains. The silver lining in the current equation is that valuations are improving and thus subsequent 10-year coming returns will be better. Today, we’ll take a look at the most recent valuation measures and, more specifically, what they tell us about probable future returns. I believe doing so can help us better set our risk and return parameters.
You’ll see that median fair value, based on the 56.1-year median P/E, is at 2,370 on the S&P 500 Index. The measure is good, and I believe it is the target level that gets us back to the long-term 10.1% annualized return line—the historical return for the S&P 500 cap-weighted index achieved since 1929 (you’ll find the market cycle chart below). Reaching the 2,370 area in the S&P 500 Index means we are better shape. But it may get even better.
It’s important to note that in bear markets, it is rare to return to the long-term growth trend line. Rather, prices tend to drop below it. Margin selling, leverage unwind, and investor panic all contribute to the dip. The idea is to be prepared to take advantage of it should history repeat itself. We’ll take a look at what that means today in the “Valuations, Coming Returns, and Bottoming Behavior” section below. And we’ll set some probable market levels to keep in mind.
I’ll tell you when it is safe to start getting bullish again and in size. When the NBA and NHL hold their playoff games in front of crowds, when the baseball season begins, and when Broadway reopens. These happen, and yours truly will be doing a wholesale asset mix shift!
– David Rosenberg, Rosenberg Research
Several times a day, Rosey’s research hits my inbox. It’s a service for institutional investors and family offices. I find it valuable. You can start a free trial here. (I don’t get paid to promote it; I’m just a big fan). I asked Rosey if I could share his quote with you. His quick response: “Absolutely.” I believe his thinking is right on, and that opening day may be nearing.
But that day can’t come soon enough. Many small businesses are in complete despair and some in disrepair. Canceled are the Masters, the Summer Olympics, the Wimbledon Championships, MLB, NBA, NHL, MLS, British Premier League, LaLiga, and more.
Harry Truman, Doris Day, Red China, Johnnie Ray
South Pacific, Walter Winchell, Joe DiMaggio
Joe McCarthy, Richard Nixon, Studebaker, television
North Korea, South Korea, Marilyn Monroe
We didn’t start the fire
It was always burning
Since the world’s been turning
– Billy Joel, We Didn’t Start The Fire
Wuhan, Xi Jinping,
Global crisis, C-19
Toilet Paper, Quarantine
Masters off, Olympics too, NBA and soccer—whew!
We didn’t start the fire
It was always burning
Since the world’s been turning
– Steve Blumenthal, With No Clue as to What He’s Doing
The hit to business is unprecedented. “When Broadway reopens….” Amen to that. I told my wife, Susan, this morning that the funk I’ve been in has cleared. We’ll win and we’ll win soon! Sunshine is coming. Hang in there.
In Wednesday’s Trade Signals post, I wrote: “Expect Retest; New Lows Follow Waterfall Declines.” I suspect that will be true today. We are dealing with a global debt crisis and a substantial shock to the global system. The most pain comes from the areas most leveraged and it’s hard to find many countries, industries, and sectors that aren’t leveraged.
We are in recession. We are fighting to avoid depression. Business relationships are being reconsidered, supply chains are being rerouted, some companies will be rescued and I suspect many will default. The biggest problems exist were leverage is greatest. I don’t think we are out of the woods just yet, but spring is in the air and the sky is starting to clear.
As you read on today, keep Bob Farrell’s advice top of mind, “There are no new eras—excesses are never permanent. We are in the process of working the last one off.
Grab that coffee and find your favorite chair. Let’s take a look a few select valuation charts I follow and see what they tell us about probable future returns. I’m also sharing a great piece that highlights the leverage in emerging markets and what that means for investors everywhere. And, in Trade Signals, I contemplate a few buying targets. More Tigger, less Eeyore… More cash, more opportunity. Thanks for reading!
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Valuations, Coming Returns, and Bottoming Behavior
- “Debt Crisis Awaits in Emerging Markets”
- Trade Signals – Expect Retest; New Lows Follow Waterfall Declines
- Personal Note – The Doer of Deeds
Valuations, Coming Returns, and Bottoming Behavior
“Fear and greed are stronger than long-term resolve.”
– Bob Farrell’s Rule #6
Let’s look at just a few indicators today. Warren Buffett’s favorite, Price-to-Sales and Median P/E. I can pull out many others. In the end, it’s largely the same message.
Corporate Equities-to-GDP
With the Q4 GDP (Third Estimate), we now have an updated look at the popular “Buffett Indicator” — the ratio of corporate equities to GDP. The current reading is 156.0%, up from 144.9% the previous quarter. Note – this is a 12-31-2019 estimate.
Source: dshort.com
Here is a more transparent alternate snapshot over a shorter timeframe using the Wilshire 5000 Full Cap Price Index divided by GDP. We’ve used the St. Louis Federal Reserve’s FRED repository as the source for the stock index numerator (WILL5000PRFC). The Wilshire Index is a more intuitive broad metric of the market than the Fed’s rather esoteric “Nonfinancial corporate business; corporate equities; liability, Level”. We’ve noticed some folks use lagging GDP figures to estimate the current Buffett indicator figures – in other words, people have used the current numerator and the lagging GDP figure in the calculation, which is not accurate. We have chosen to use data from the same time period (currently Q4 2019) for all series.
Source: dshort.com
It is certain that GDP is going to come down, but we don’t know by how much and for how long. A reasonable guess might be 25% lower and more like a L- or long U-shaped recover versus a V-shaped recovery. What we do know is the market (measured by the S&P 500 Index) is down nearly 900 points or approximately 30%.
Ned Davis Research (“NDR”) has an update (estimates) through March 31, 2020. Think of the dotted rising line from lower left to upper right as the long-term trend line similar to the horizontal you’ll find in the “cycle chart” below. Not the same, but conceptually stay with my logic. Also, don’t focus at all on the orange line.
Note how the blue Stock Market Cap (NDR’s estimate of 3800 US Common stocks at March 2020 month-end) moves above and below the long-term dotted trend line. Good values at the dotted line, expensive when above and best values when below. Since Buffett loves hamburgers, as he is famous for saying, you get much more hamburger meat for your money when prices are down. He encourages investors to think the same.
Bottom line with the chart, by this measure, the current ratio is 121.3%. It was 125.7% at the top of the market in 2007, it was a crazy high 167.5% at the top of the market in March 2000, it was 69.6% at the top of the bull market in 1969. Valuations are better, but still above the long-term dotted line.
Price-to-Sales Ratio
Bottom line: At March 31, 2020 quarter-end, the market remains overvalued:
- Let’s keep an eye on the Price-to-Sales ratio relative to the green dotted long-term line.
- Best buying opportunity will come below that line.
- Also note the data box in the upper left hand section of the chart: The gain per annum for the S&P 500 Index is just 1.77% annualized since 1954 wen the price-to-sales ratio is above 1.26. It is currently at 1.82.
Median P/E Ratio
With the latest month-end data, the 56.1-year Median P/E Ratio is 17.3. That puts Median Fair Value at 2,370. This is up from 2,333 at February month-end. We are looking for Median P/E to drop from its current level of 18.8 to 17.3.
At the time of this writing (2:30 pm on Friday, April 3, 2020), the S&P 500 Index is at 2,468.25.
Bottom line: getting close to the 56.1-year Median P/E line (the green dotted line in the center of the next chart. Undervalued is at 1,641.21. A move to that level would present an excellent buying opportunity.
Bottoming Behavior
Markets sell off and reach oversold levels. Margin calls kick in. Market makers step out of the way. Selling dominates and trap doors open. Witness the very large down days. This is what technicians call a “waterfall decline.”
Rallies follow large declines. Rallies end and the lows are retested. In studying past waterfall market crashes, we find similarities in how markets bottom. For example, retests tend to come with lower volume (fewer sellers). And there tends to be fewer stocks making new lows and fewer stocks below their moving averages.
I have several downside targets set in my mind. The first is the Median Fair Value level of 2,333. The recent waterfall (virus crash) sent the S&P 500 to a 2,180 intraday low. The weekly closing low was 2,304.
I’ll keep showing this next chart. I’ve borrowed it from Howard Marks and his excellent book: Mastering the Market Cycle: Getting the Odds on Your Side. The idea is that, over time, the market will produce a pretty good return. Since 1929, that return is about 10% per year. To me, that’s the steady uptrending line from left to right in the next chart. The reality is that prices move above and below the long-term trend line. Stock prices are bid higher by excited investors. Prices are pushed lower by the unwinding of leveraged and fear-based investors (i.e., panic selling). For us, I believe it is useful to help visualize where we are in the cycle and that’s where the valuation work comes in. Note the “We are HERE” orange arrow. That’s my current best guess based in Median P/E is this:
Cycle Chart:
This is not a game of perfect. It’s about knowing when you’ve got the odds on your side (at or below the long-term upward sloping trend line) and when not. So I think we are nearing the point of good long-term opportunity, but I do think we will likely drop to the “We’d be better off here” green arrow.
Rosey notes, “Bear markets have three stages —sharp down, reflexive rebound and a drawn-out fundamental downtrend.” So it will be interesting to see how the market behaves on a retest. If a lower low is made, I believe that brings 1,600 to 1,800 into play. Think returns in the 14% annualized range for the subsequent 10-years.
And of course, we could crash lower but with the Fed and federal government providing massive liquidity, I suspect a floor no worse than a 50% correction (similar to what occurred in the last two recessions 2000-02 and 2008-09). But I may be wrong and it may be worse. Still, the investment opportunities are better and I suspect they will be even better before the global economy finds its footing.
I’m switching from my defense mindset and preparing to put the offensive starters back on the field. Though, I will forever and always trade with risk management processes in place. But my thinking can best be described as “adaptive” and that means I will increase from a maximum 30% equity-focused exposure to 50% on the retest to up to as much as 70% should we move to the “We’d be better off here” green arrow. Then, equity return potential will be best and risk will largely be behind us.
Again quoting Farrell, ”Fear and greed are stronger than long-term resolve.” That’s what moves us above and below the long-term growth line. And it is what creates risk and great opportunity.
“Debt Crisis Awaits in Emerging Markets”
by Axios Markets
| Many of the world’s poor and developing countries could begin defaulting on their bonds in the coming weeks as the coronavirus outbreak has led to massive outflows from emerging market assets and real-world dollars being yanked from their coffers.
Why it matters: The wave of defaults is unlikely to be contained to EM assets and could exacerbate the global credit crisis forming in the world’s debt markets. Driving the news: Investors pulled a record-breaking $83.3 billion from EM securities in March, dwarfing outflows seen during previous “stress events” like the global financial crisis, the 2014 taper tantrum, and China’s devaluation scare of 2015, the Institute of International Finance says.
What they’re saying: “The huge fiscal costs and humanitarian consequences of coronavirus could incentivize a slew of distressed governments to default on their debts,” Edward Glossop, emerging markets economist at Capital Economics, wrote last week.
State of play: The emerging world is being battered on all sides by a slowdown in manufacturing, cratering oil prices and the depression of aggregate demand as a result of the COVID-19 outbreak.
Yes, but: Bullish investors are banking on the IMF and World Bank to deploy up to $1 trillion in relief to help stave off mass defaults and worst possible outcomes. Yes, but, but: That may not be nearly enough.
A number of emerging market central banks will likely begin quantitative easing measures, Capital Economics analysts say, further flooding the world with an abundance of cash never before imagined.
Why it matters: Quantitative easing is an extreme measure that has an unproven track record at stimulating economic growth and has never been attempted in emerging countries, which have higher interest rates than their industrialized peers.
|
The challenge ahead for government policy makers and central bankers will be akin to patching holes in a sinking ship. Can they patch them up quickly enough? Can they get to all of them? The debt problem is so large that I believe we will see fix after fix come our way. It is with this thinking that I believe a correction below the long-term growth trend is most likely. We don’t know, we can’t know because we don’t know the timing or size of various governments bail out measures. How do we reconcile the global debt crisis with the new bazooka the Fed just unveiled?
Last week I shared a note from Jim Bianco:
In just these past few weeks, the Fed has cut rates by 150 basis points to near zero and run through its entire 2008 crisis handbook. That wasn’t enough to calm markets, though — so the central bank also announced $1 trillion a day in repurchase agreements and unlimited quantitative easing, which includes a hard-to-understand $625 billion of bond buying a week going forward. At this rate, the Fed will own two-thirds of the Treasury market in a year.”
But it’s the alphabet soup of new programs that deserve special consideration, as they could have profound long-term consequences for the functioning of the Fed and the allocation of capital in financial markets. Specifically, these are:
- CPFF (Commercial Paper Funding Facility) – buying commercial paper from the issuer.
- PMCCF (Primary Market Corporate Credit Facility) – buying corporate bonds from the issuer.
- TALF (Term Asset-Backed Securities Loan Facility) – funding backstop for asset-backed securities.
- SMCCF (Secondary Market Corporate Credit Facility) – buying corporate bonds and bond ETFs in the secondary market.
- MSBLP (Main Street Business Lending Program) – Details are to come, but it will lend to eligible small and medium-size businesses, complementing efforts by the Small Business Association.
To put it bluntly, the Fed isn’t allowed to do any of this. The central bank is only allowed to purchase or lend against securities that have government guarantee. This includes Treasury securities, agency mortgage-backed securities and the debt issued by Fannie Mae and Freddie Mac. An argument can be made that can also include municipal securities, but nothing in the laundry list above.
So how can they do this? The Fed will finance a special purpose vehicle (SPV) for each acronym to conduct these operations. The Treasury, using the Exchange Stabilization Fund, will make an equity investment in each SPV and be in a “first loss” position. What does this mean? In essence, the Treasury, not the Fed, is buying all these securities and backstopping of loans; the Fed is acting as banker and providing financing. The Fed hired BlackRock to purchase these securities and handle the administration of the SPVs on behalf of the owner, the Treasury.
In other words, the federal government is nationalizing large swaths of the financial markets. The Fed is providing the money to do it. BlackRock will be doing the trades.
This scheme essentially merges the Fed and Treasury into one organization. So, meet your new Fed chairman, Donald J. Trump.
SB here – My forward best guess as to how this may play out: We are backdooring into a global debt jubilee. I’ve been writing that I believe it is the only way out a debt mess that is impossible to repay. Coming will be the “Make America’s Pensions Great Again” bail out and other countries will enact similar measures.
We are navigating the “End of Long-term Debt Cycle” problems. On the other side of this will be a different regime. All of that newly created money to buy government bonds and corporate bonds and maybe even stocks gets into the system. You sell your muni bond to the Fed and they give you cash. What are we going to do with all that cash? Bad stuff goes on the books of the Fed and they may just keep them their books until they mature. Some bond issuers will never be able to repay. Call it a one-time good-good. Ahead of us is an inflationary regime. We’ll all be just fine. We’ll have to invest differently… but that remains a problem for another day.
Trade Signals – Expect Retest; New Lows Follow Waterfall Declines
April 1, 2020
S&P 500 Index — 2,471
Notable this week:
Since 1929, there have been 13 large waterfall declines. In nine cases, the Dow Jones Industrial Average broke the lows. In the three of the four cases the low was not broken, but the lows were retested. The lone exception is December 2018. There was no immediate retest. Suffice it to say, that low was finally broken last month. So call it 13 for 13. There were also twenty -15% or more waterfall declines since 1929. Twenty of the twenty have had their lows retested.
I like to focus on the S&P 500 Index. I’ve previously shared (and will update in this coming Friday’s On My Radar) that the fair value of the S&P 500 Index is 2,333 (based on the 52-year median P/E of 17).
While I have no way of knowing for sure, my guess is that we retest last month’s intra-day low of 2,192.
- A 50% retracement of the 2009-2020 bull market is 2,023. That’s a reasonably probable target.
- A 61.8% retracement takes the S&P 500 back to 1,701. That would present an excellent buying opportunity with subsequent 10-year annualized returns in the 14% area (approximate).
- Median P/E puts fair value at 2,333. That may be a good spot to begin adding to equity positions with expected 10-year annualized returns in the 10% range. But, given the global shock, I suspect we go lower.
I shared the following chart with you last week. The only difference is that the current level on the S&P 500 Index is 82 points lower than it was a week ago today. The two blue horizontal arrows mark what I believe represents a good area for downside support. A retest of the 2,200 March low is probable, in my opinion.
Source: StockCharts.com
The next chart is a weekly chart of the S&P 500 Index going back to April 2008. It captures the entirety of the bull market since the March 6, 2009 market low. A 50% retracement of the bull market sets a price target of 2,023.07. A 61.8% retracement takes the market to 1,701.43. On the plus side of the equation is the Fed and government liquidity responses. On the negative side is the current recession (just beginning) and the default wave that is immediately ahead. We can measure value and coming returns, no one knows how this will play out – the timing and extent of government rescue and who gets the cookies and who doesn’t. I expect it will be bumpy with odds favoring a 50% correction from the bull market high. That to me puts the 1,700 level as a prime opportunity target. Next is a look at said levels:
Howard Marks of Oaktree Capital was in the news mid-March suggesting it’s time to start nibbling on stocks. He said, “Spending some money is not irrational here.” That was Monday, March 16, 2020, when the S&P 500 stood at 2,386. Median Fair Value is approximately 2,333. I could be wrong. I believe we are in a trading range environment and expect a retest of the lows. 1,700 is probable. I’ll be increasing our managed portfolios exposures to equities into the retest of recent low. I intend to get aggressively invested into equities if we get in the 1,700 level. If you have risk management processes in place, then the amount of cash you are accumulating will put you in a position to take advantage of great opportunity. I don’t think we are there yet… I think it is nearing. It won’t feel good, but that’s when the return opportunities are best.
Stick to your risk management processes. I favor diversifying to several. None are prefect, but combined together they are good.
Here is the link to: Howard Marks says the market is ‘pricing in a bad scenario’ and there is value for investors.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
Personal Note – The Doer of Deeds
“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”
– Theodore Roosevelt
“No effort without error and shortcoming….” “And who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”
We have heroes among us, both small and large. Family and friends who provide kindness and comfort through FaceTime, Zoom, and closed windows. Nurses, doctors, and first responders who stand on the front lines—the world’s most giving souls. And the teams that support them. As Roosevelt beautifully said, “These are not timid souls. The credit belongs to the men and women who are in the arena, whose faces are marred by dust and sweat and blood: who strive valiantly; who err but strive to do the deeds.”
A heartfelt toast with love and gratitude to all you doers of deeds!
Remember, hang in there. Sunshine is coming. Thinking about you and your family. Ever forward!
Warm regards,
Steve
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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