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Seeds of Financial Crisis May Have Been Sown, Volatility Soars
publication date: Mar 11, 2020
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author/source: Brian Nelson, CFA
Seeds of Financial Crisis May Have Been Sown, Volatility Soars
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 Image Shown: The broader market indices continue to reveal tremendous levels of volatility. The Dow Jones Industrial Average dropped 5.86%, or 1,465 points, to 23,553 during the trading session March 11.
--- From Value Trap: It seems like the markets experience a new financial crisis every decade or so. During the past few decades alone, there have been three significant banking crises: the savings and loan crisis of the late 1980s/early 1990s; the fall of Long-Term Capital Management and the Russian/Asian financial crisis of the late 1990s; and the Great Recession of the last decade that not only toppled Lehman Brothers, Bear Stearns, Washington Mutual, and Wachovia but also caused the seizure of Indy Mac, Fannie Mae and Freddie Mac...It's likely we will have another financial crisis at some point in the future, the magnitude and duration of which are the only questions. My primary reason for this view is not to be a doomsayer, but rests on the human emotions of greed and fear... -- Value Trap, published 2018 ---
By Brian Nelson, CFA
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We wrote a note this morning that hit on the implications of rising loss reserves on "soon-to-be-bad" energy loans and weakened expected banking net income from lower rates, a combination that may pummel the US banks, which coincidentally may feel compelled to pull back from dealings with their European counterparts that are facing sovereign troubles as COVID-19 continues to spread. European bank prices recently broke below post-Lehman lows.
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The news flow from Italy (EWI) has been frightening, as the country remains effectively shut down, the number of new cases of COVID-19 spike there, and the mortality rate in the country hovers around an eye-catching 5%. Our latest note can be accessed here, "Worst in Energy Not Over, Stay Away from Leveraged Enterprises, Seeds of Financial Crisis Sown?" Our team also explained in depth how COVID-19 can transform into an all-out financial crisis in this note here, "2,350-2,750 on the S&P? Could the Coronavirus Catalyze a Financial Crisis?"
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Whether the Great Financial Crisis was called a mortgage crisis or a lending crisis or a subprime crisis or a credit crunch, what one calls something shouldn't really matter as much as its substance because the dynamics that ensue from the original catalyst tend to result in a similar outcome, and generally that's a massive stock market decline. For example, subprime lending could be considered a "mortgage crisis" as much as COVID-19 may be considered a "biological crisis," but as it translates into what's happening in the stock markets today, it meets the definition of a financial crisis to this author.
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While there are a lot of negatives to point to as this crisis continues to unfold, we think one of the biggest red flags occurred today as Boeing (BA) fully drew down its $13.8 billion term loan (a smart move but also one that may be telling of what one might expect from the credit markets in coming weeks). Boeing's stock had one of its worst days in history March 11, falling over 18%. In the event lenders start growing more cautious (most will be feeling the pinch from pressures in the oil patch), we could start to see more prohibitive conditions in the credit markets, which could then have a cascading effect as companies scale back spending, which then ultimately creates the global recession that we might already be in.
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At this point, the only question that remains as it relates to this financial crisis is the magnitude and duration, and from the looks of it, we're just getting started. Even Boeing's massive stock price decline, for example, only gets investors back to levels last seen in mid-2017, hardly catastrophic for long-term holders. The S&P 500, which again closed in our 2,350-2,750 target range, is merely back to early 2019 levels that were originally reached in early 2018. COVID-19 simply caught the market flat-footed, and in a matter of a few weeks, it has taken some of the fluff out of valuations, but not all of it.
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According to FactSet, as of March 6, the forward 12-month P/E ratio for the S&P 500 came in at 17, and that is likely on elevated earnings for 2020 (and 2021 numbers are sure to come down, in our view). This level is above the 10-year average forward P/E (14.9), 15-year (14.6), and 20-year (15.5), and while lower rates may suggest a higher P/E relative to history, the massive net debt positions of S&P 500 companies, which have surged in recent years may completely offset that dynamic (within enterprise valuation, a higher net debt position results in a lower P/E, all else equal). The midpoint of our 2,350-2,750 target is based on 16x 12-month forward earnings, haircut by 10% for COVID-19. We think this is a reasonable range, which the markets have just started to breach at the high end.
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Importantly, our S&P 500 target range is not one that reflects what could result in a financial crisis, but rather one that is based on reasonable valuation expectations. As we have noted before, much of the declines that the markets have witnessed thus far have been more reasonable than overdone, and we maintain our view that investors looking to part with stocks at current levels aren't necessarily panicking, given that valuations aren't unreasonable. In some ways, they're getting a fair price. We'd view panic selling as investors selling at 2,000 on the S&P 500, and only if conditions don't warrant such a valuation at that time (if we ever reach those levels). Remember -- falling stock prices don't mean stocks are cheaper; their value could have fallen even more.
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We wanted to let you know that we continue to release short-idea considerations in the Exclusive publication (learn more here), five of which we "closed" as winning ideas today. We also released a new product including more options-related commentary for members here. We maintain that the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio are well-positioned, and we continue to closely monitor ideas in the High Yield Dividend Newsletter portfolio. We think the risk for the markets remains to the downside, and investors should expect continued outsize volatility, as price-agnostic trading ensues unabated and many reassess the lasting implications of COVID-19 on consumer behavior.
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We're available for any questions.
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Tickerized for the DIA.
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