ICYMI -- Stay Optimistic. Stay Bullish. I Am.
publication date: Jun 8, 2020
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author/source: Brian Nelson, CFA
Image: My great-grandfather (second from left) and his buddies in the 88th Division of the United States Army during World War I, at the time of the Spanish Flu pandemic of 1918-1919. He would serve under Major General William Weigel, become proficient in the 37mm gun, and take part in the largest offensive in U.S. military history, the Meuse-Argonne Campaign. As a corporal, he would survive the Great War and the Spanish flu pandemic, returning to the U.S. in May 1919 from the port of Saint-Nazaire, France on his way to Omaha, Nebraska.
This article was published May 15, 2020.
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New (updated June 4): We continue to encourage members to study the 'Duration of (Stock) Value Composition' in Value Trap: Theory of Universal Valuation to learn about the key drivers behind this bull market (share prices have soared since the March 23 bottom). Read pages 74-83. A stock is a long-duration financial instrument, meaning that most of the value (and its price) today is derived by long-term expectations, with little of the value (and its price) today ascribed to near-term fundamentals and/or the near-term economic environment. Assuming, for example, the Fed and Treasury actions have prevented severe equity dilution (i.e. share price issuance at depressed prices that would impair intrinsic value) as a result of the COVID-19 pandemic, which they have successfully done, a substantially increased money supply caused by unlimited quantitative easing and runaway government spending means terminal/perpetuity values within enterprise valuation (generally the third or final phase of discounted cash-flow modeling) will expand materially thanks to higher pricing and growth levers (see the image that follows in the note below). Importantly, the terminal/perpetuity value, or the value ascribed to the long haul or long-run continuing operations of a company, is not the stock price or value 20 or 30 years from now, but rather it is a component of equity value today that impacts the price and value of the stock today. We could be well on our way to new highs in the stock market. The NASDAQ 100, for example, just broke out to new highs yesterday, and it may be the first of many major indices to do so. We moved to "fully invested" in the newsletter portfolios April 29, "ALERT: Going to "Fully Invested" -- The Fed and Treasury Have Your Back"
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This article was published May 15, 2020.
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Hi everyone,
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Brian here. Today is Best Ideas Newsletter day!
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First of all, I wanted to reiterate how bullish I am on equities for the long haul. There are no risk-less investments when it comes to the stock market, of course, but this "win-win" scenario we seem to find ourselves in today appears to be one-of-a-kind in history. Here's what it boils down to. If the U.S. economy re-opens and everything turns out to be "fine," or at least better-than-expected, it's hard not to be bullish on stocks. We can then possibly look to pre-COVID-19 earnings numbers for 2021 and 2022 with some adjustments here and there, and that means the bull market is on (and new heights may be in sight).
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On the other hand, if the U.S. economy re-opens and economic numbers don't live up to expectations, which could happen, there will likely be even more stimulus--but investors might be bullish in this scenario, too. For starters, there's been more money created during the past few weeks or so than during the entire year following Lehman Brothers' failure (there's even talk of more money creation with another round of stimulus). We cannot forget that, while stock values are calculated on the basis of future free cash flow expectations, they are priced nominally (not inflation-adjusted), and stock investing is one way to combat the risk of inflation as strong companies price goods ever higher to outpace rising costs to reap in ever-higher earnings. Even if this excess money in the economy is not translated into inflation in physical goods and services, however, it may translate into inflating equity prices specifically, as has arguably (or perhaps undeniably) been the case during the period of 2010-2019.
---But there's more to this line of thinking. The Fed owns the "printing presses," and as it has done with other securities such as investment-grade corporate bonds and high-yield debt, has the authority to set up facilities to even buy stocks, if needed. It's not so much if or when the Fed might do this. Just this implicit "threat" means that those betting on market declines need to be cautious, and that alone may keep the short-sellers on the sidelines for a long time. It's an asymmetry that clearly puts the advantage with the bulls. The Fed simply holds all the cards: It can print money, and it can set up facilities to buy equities. How can one possibly bet against the Fed? Personally, I believe the Fed will buy stocks, if need be, and if that doesn't work, it will take even more aggressive measures and do everything it can to keep the market moving higher in the long run.
---That's not the whole story behind this bullish take, however. While those that studied market history were aware of the 1918-1919 Spanish flu pandemic, it's not something (a risk factor outside of travel or leisure stocks) that has been top of mind with respect to equity investing for decades, so COVID-19 has come as a big shock to many. Many aren't sure how we can bounce back from something like this, but we do have historical precedent. I learned the details of the Spanish flu pandemic of early last century while studying the history of my great-grandfather (image above) and his service in the 88th Infantry Division of the United States Army during World War I some time ago. What I can say is that the U.S. not only emerged from the 1918-1919 Spanish flu pandemic that killed millions around the world, but the U.S. ushered in one of the most prosperous decades of the 20th century shortly thereafter, the Roaring 20s--and this happened without the Fed or Treasury guiding the way!
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There's also some political and regulatory reasons why I am bullish for the long haul, too. Without getting into too many specifics as it relates to index investing and modern portfolio theory (MPT), the takeaway from these strategies is that they embrace what I describe as moral hazard--these strategies take on outsize risk because others bear the burden when things go wrong. For example, indexers count on others to set the "correct" prices (i.e. free riding problem), while modern portfolio theory might say holding a diversified portfolio of Enron stock, tulip bulbs, J.C. Penney, airline equities, and the Daily Inverse VIX Short Term ETN may make sense. We all know that uncorrelated risk is nonsense if the underlying holdings are poised to go to $0, but the quants are okay with this. These strategies, which absorb as much as 60%, or maybe more, of trading volumes these days create moral hazard that only continuous bailouts can appease.
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How true this has been yet again, with the bailouts of the airlines and the Fed/Treasury actions during this COVID-19 fallout in the markets. Without a doubt, the strategy of indexing would have gone the way of the dodo bird if it weren't for unprecedented Fed and Treasury stimulus. Without the Fed/Treasury, we would have had a clear separation of winning and losing stocks, and in such a case, not only would index investors have felt the terrible pain of recklessly "buying anything at any price," but active management would have outperformed even more so, as most professionals would have steered clear of airlines, many banks, and many zombie oil companies. There's now no stopping this moral hazard. Congress is not calling Vanguard to testify. Instead, the Fed has somehow adopted the "buy anything at any price" mentality, too, going so far as to buy junk debt via ETFs. The point is that I can't see the Fed/Treasury/SEC allowing fiduciaries that are employing indexing and MPT to fail. In some ways, that means stocks must go higher. After all, how could the government let fiduciaries and indexing fail when they set the rules of the game?
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It may not be fair to active management, but what can we do? Complaining gets us (and has gotten us) nowhere. Nonetheless, the sails may very well be at our backs given all of these dynamics coming to the fore, even as price-agnostic trading (indexing and quant investing) continues to proliferate. We simply may have no choice but to accept the increased risks of outsize volatility, as we outlined in Value Trap. Looking ahead, however, conditions at present (unlimited Fed stimulus and runaway government spending, etc.) suggest that price-agnostic trading and moral hazard advice (MPT) are most likely to result in a massive melt-up in these markets, not another crash. As has been on display the past month or so, the stock market can remain divorced from the economy for a long time (forever).
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A lot of the weak equity holders have already been shaken out, too, as a result of the "Great Crash of 2020," and this might very well pave the way for a blow-off top, in my view. Whether this happens in 2021 or 2022 or some time after that, it's hard to say, but I'm expecting something huge and unprecedented to the upside in the not-so-distant future. As long as the Fed/Treasury guide companies through COVID-19 with little equity dilution (stocks raising equity at reduced prices), there's really not much long-term damage to equity values, as most of a stock's value is based on normalized long-term expectations/conditions (as shown in the image below). But while equity values may not be permanently harmed in such a scenario, there's still the unlimited quantitative easing, zero interest rates, and runaway government spending to the upside!
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Image: Value Trap: Theory of Universal Valuation, page 76.
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While all this money supply must go somewhere (likely translating into inflating equity prices instead of traditional inflation), we continue to witness progress on the vaccine and treatment front for COVID-19, too. We'll have a note that walks through 'who's who' in the potential treatments and vaccines for COVID-19 very soon, but as Big Pharma continues to push forward with therapies and vaccines, so is biotech. Moderna (MRNA) has a vaccine (mRNA-1273) that has been fast-tracked by the FDA, while Sorrento Therapeutics (SRNE) claims it has found a cure, pointing to an anti-body (STI-1499) that "could shield the human body from coronavirus and flush it out of a person's system within four days." Whether it's Moderna or Sorrento or Johnson & Johnson (JNJ) or another player that makes history by solving the COVID-19 crisis, I think it's going to happen, and probably sooner than many expect (if not, there will just be more stimulus, and that's bullish). The number of shots on goal for therapies and vaccines for coronavirus seems to be countless these days, giving me confidence we're going to beat this thing.
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In fact, I don't think I've ever been this bullish, "Never Been More Bullish..." Professor Jeremy Siegel talks about the duration of value composition in equities (image above), the prospect of therapies/vaccines for COVID-19 and optimism surrounding an excellent 2021 in this clip here, and he goes on to say in this clip here that he expects no retest of the lows, to witness new market highs in the next couple years given the liquidity in the marketplace, and he even calls for a 3-4% rate of inflation in coming years. I haven't agreed with Professor Siegel much in my day, but I do in this case. The Fed and Treasury have almost "rigged" the game. Of course I don't want you to think this is a risk-less market because there are myriad risks (tariffs, political, etc), but the Fed and Treasury have not only brought out the bazooka, but they've launched the greatest artillery barrage on this continent since the third day at Gettysburg. The massive stimulus and money printing may only come back to bite the markets, if other countries are doing better. But they are not doing better, and this may only embolden the Fed/Treasury for more action. The repercussions of unlimited quantitative easing and runaway government spending are limited, if at all. Nobody in government is even talking about higher corporate tax rates to pay the bill.
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I know it's easy to be scared--scared for your health, scared for your children, scared about your livelihood and job, and our future. Last October, I welcomed my new daughter to this world, and I worry about what the future might hold for her, but I think the future is as bright as ever. As Warren Buffett said in his now-famous 2008 op-ed, "Buy American, I Am." Stick with moaty enterprises with huge net cash positions, strong expected future free cash flows, asset-light recurring business models, established operations, and otherwise attractive economic castles. This is why the NASDAQ has been soaring--many of these companies are found in there, and these are the types of COVID-19 ideas that we highlighted near the depths in March that outperformed significantly--see here, and we think they will continue to be in favor. Many of our top-weighted newsletter portfolio ideas are performing well, too, and we point to Facebook (FB), PayPal (PYPL), and Alphabet (GOOG) as clear winners in this environment. Net cash and future expected free cash flows are huge sources of intrinsic value.
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With all this said, I wanted to say thank you. Thank you for your support during these challenging times. Thank you for your interest, and thank you for the opportunity for Valuentum to show the importance of stock selection and how enterprise valuation remains the key to outperformance--the traditional quant value factor based on book-to-market registered its worst quarterly return in history during the first quarter of 2020 (Value Trap has been an invaluable guide for readers in almost every respect). But most importantly: "Stay optimistic. Stay Bullish. I am." The May 2020 edition of the Best Ideas Newsletter can be downloaded here (pdf). We sincerely hope that you enjoy it, and please let us know if you have any questions. Always my very best, and please don't forget to order the Exclusive here.
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God bless!
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Kind regards,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com
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Brian Nelson owns shares in SPY and SCHG. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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