Even before the end of hostilities, survivors begin to determine how bad is bad when someone is attacked.
Is this the bottom? For those in and around the stock market there is lots of history to provide clues. At 9:26 AM on the 13th, Larry Goldstein, a very successful micro-cap fund manager and a junior analyst in the same shop with me years ago, wrote the following:
The factors that make a bottom in the US stock market include a combination of climatic selling with an intraday reversal, combined with a breakthrough announcement on testing and treatment for the Coronavirus…This will turn, it always does.
On Monday he was generally right. There was a sizable price gap opening in the DJIA compared to the previous day’s close. The low for the day (21,159 vs 21,200 Thursday close). The close on Friday, which may be close enough to fill the gap, was 9% higher than Thursday’s close.
A largely predictable US stock market fall
What was not predictable is the size of the decline in one month’s time. A student of history could have predicted two out of the three causes for the decline. I know of no way to predict the rapid spread of Covid-19, although it’s clearly possible that some in the medical sphere had knowledge of Chinese conditions.
The rapid spread of the Coronavirus was a convenient time for Russia to attempt to grab a much larger share of the oil market from US shale frackers and “swing” producer, Saudi Arabia. A student of 19th century world trade history would not have been surprised.
In the 19th century a great German military strategist proclaimed that war was just another way to execute national policy. In the 21st century one could easily substitute trade wars for military wars. Some may even suggest that Germany provided the muscle for WWI due to that country’s late economic development.
Germany needed more global markets but found themselves blocked by the trading strengths of the US, Great Britain and others. One could also point to the Japanese attempt to build a “Co-Prosperity Sphere” as being a contributor to the Pearl Harbor attack.
In the current era, China’s contribution of at least one quarter of the growth in world trade was dramatically changing. Under their command economy they needed to create both employment and a rising standard of living.
They were evolving from being an export driven economy to having greater reliance on internal market development. Thus, the growth rate of their exports declined, so too would the rate of import growth. The trade issues with the US added to these contractions, Europe lost some exports to China and they received lower price imports diverted from the US.
Europe’s general economy had slowed and in some cases was approaching stall speed, while Russia and Saudi Arabia attempted to catch up with the more developed world through massive capital projects.
Both are critically dependent on oil exports to generate the capital needed to hold off the global drive of popularism. Thus, the Russian move to capture greater market share makes sense, it came with much lower prices, contrary to the Saudi’s own needs.
Remember, most large expansions by industry and government are debt financed. The equity market is often slower to react to economic trends than the fixed income market. That is exactly why the following quote from BlackRock’s CIO of Global Fixed Income was so unnerving.
“If you don’t know where the safest asset in the world is, it becomes impossible to figure out (where) everything else is.”
This uncertainty for the week ended Wednesday led to net redemptions in corporate investment grade bond funds of $7.3 billion and $5.1 billion from high yield bond funds. (More on the threat of the bond bomb later.)
Going forward
The odds are favorite that we have seen the bottom of the major US stock market indices for some time. (I am guessing there is a 60%-75% chance that this is a correct assumption.) I assume any top or bottom will be tested before investors accept a major turn in the cycle.
The test can be above or below the bottom, but it will have less sustained force behind it. I have reasonable confidence in the turnaround as a result of measuring the price differences of our closely followed roster of financial services stocks, between Wednesday and Friday closing prices were within 0.3% of being equal.
The reliance on reported earnings per share is a worry for equities. It is a much-manipulated figure due to changes in accounting standards, federal/state tax rates and rules, plus buy backs.
Utilizing I/B/E/S data from REFINITIV, analysts estimated that fourth quarter reported S&P 500 earnings would be +10.2%, but net income only +8.2%. That spread widened from 2% in their first quarter 2020 estimate to 2.4 % (+14.3% earnings and +11.9% net income). Since mid-February, or even earlier, no one is holding to 2020 earnings estimates.
The reason for showing the spread is that analyst and perhaps corporate management believe others will accept the reported per share numbers. I always look at any equity in terms of what a knowledgeable person in that or an affiliated business would pay for the entire company.
I believe most acquirers would start with net income in building their price bid, or 20% lower before adding premiums and discounts. Thus, many stocks were priced too high, historically they normally are priced at a discount to what an occasional acquirer would pay.
The problem of valuing fixed income paper is more fundamental. There is far too much reliance on debt in our society. Starting with most governments running a deficit, businesses issuing debt to meet current needs, and individuals use debt through credit cards and other devices to cover living needs.
Too many in the population are not using debt to leverage their equity in the purchase of investment producing assets. Those that properly use debt, their underlying equity assures the lender is not taking the first or possibly the largest long-term risk. These days, most debt issues are largely for refinancing existing debts, not increasing earnings generation.
Most of the time, long-term gold owners use their gold positions to hedge against the valuation of other assets. However, after an extended price rise, such as now, they use some of their gold to meet current cash needs or payoff their debt.
Opportunities
In many respects we have involuntarily entered a new era. Because coronavirus it is now critically important that most families be connected electronically. Instead of traditional European style food shopping where one goes to the food market daily, we will attempt to regularly store essential food needs for two weeks or more.
We may change our entertainment mix so that more is delivered electronically and less in theaters and stadiums. Universities and other schools may have to learn how to educate differently, rather than putting on classes and giving exams on paper. Perhaps we will need to reconfigure the structure and size of campuses and student housing.
To me, as both an analyst and entrepreneur, I believe we have this year a unique opportunity to build soundly without paying too much attention to the impact on the record. We have involuntarily entered a “gap year” and the track handicapper can throw out one or more races as long as the horse, jockey and trainer are building skills.
As an investor and portfolio manager for others, I am going to be searching for what will be different after these crises are over. Covid-19 and similar problems will be addressed with increasing success throughout the year. Near-term energy prices will settle as market forces find equilibrium points. The “debt bomb” will take much longer, perhaps a generation of both write offs and long-lasting penalties.
A former president of the New York Society for Security Analysts, he was president of Lipper Analytical Services Inc. the home of the global array of Lipper indexes, averages and performance analyses for mutual funds. His blog can be found here.
