ICYMI -- Video: Will Hasty Policy Facilitate the Next Leg Down, or Do We Have It Coming Anyway?
publication date: Apr 19, 2020
author/source: Valuentum Analysts
President of Investment Research and award-winning author of Value Trap: Theory of Universal Valuation Brian Nelson explains how US policymakers are stuck between a rock and a hard place, and how the market may be factoring in too high of a probability of a return to normalcy before 2021. This and more in the latest video report.
Make sure you review Value Trap on Amazon. Do so here.
We think those that bought equities near the bottom of this swoon may be looking to take profits at present levels.
The market is currently reflecting an 80%-85% probability of a return to normalcy before 2021, which we believe is too high at this time.
Our main concern is that government officials will open the US economy too early and have to shut it down again. In such an event, we believe the markets will crash…again. The US remains stuck between a rock and a hard place in this regard. Millions of businesses depend on a re-opening soon but doing so may only bring another shutdown. The next leg down may happen no matter what policymakers do.
While we have stated that we could see panic selling to 2,000 on the S&P 500 during the swoon, we’re now updating our target range on the S&P 500 to officially reflect the range of 2,000-2,750, a reduction of the low end of the range from 2,350.
In a most optimistic case, we’d rely on the view that price-agnostic (indexing/quant) trading may take hold of this market on the back of unlimited quantitative easing and runaway government spending causing a blow-off top to new highs in the stock markets in the longer run.
What is clear, however, is that a revisit to the old highs of 3,400 on the S&P 500, will not be fundamentally driven, in our view, and only manifest itself from a disconnect between price-agnostic index-driven buying and an ill economy suffering from rampant inflation.
Regardless of the eventual pricing and valuation outcome, investors should expect Great Depression-like numbers in the coming months, with huge GDP declines and large increases in unemployment rate.
Let us not fight the last war with empirical data and great folly. Let us continue to fight COVID-19 with forward-looking expected data to save lives.
Video begins (transcript):
Brian Nelson, CFA
I’m sure many of you are anxiously awaiting our next video update, and I thank you for that. Let me first start by saying how much we appreciate your interest. I hope you and yours had a wonderful holiday weekend and that you are staying safe during this global crisis. Let me first say a few words about Value Trap, and then we can proceed with our latest thinking on the markets, divided into considerations regarding equity prices, market valuation assessments, and behavioral dynamics.
Valuentum’s first book in finance, Value Trap: Theory of Universal Valuation, offers much more than a framework that ties together quantitative multi-factor models to the expected return function of enterprise valuation, showing that risk factors must be forward-looking in nature (a huge shift in quantitative thinking).
The book is much more than a documented thesis in the value-timing dynamics of overlaying technical/momentum indicators with tried-and-true enterprise valuation. In showing how all valuation multiples are but shortcuts and ambiguous, as in the failures of the traditional quant B/M value factor, the text is more than a warning about the demise of traditional quant value analysis, which is off to one of its worst starts in 2020 in decades, after underperforming for years.
The book Value Trap is more than a telling of the story of a team of analysts that identified a mispricing across a major energy sector, went against the crowd with their unpopular views, and despite all odds, was proven correct in time. On a price basis, from June 2015 through April 15, the S&P 500 has advanced 31%, while the Alerian MLP ETF has declined over 76%, a huge source of alpha. According to data from CBRE Clarion through September 2019, there have now been 111 distribution/dividend cuts. Many more have occurred since then, too, with several during this latest market swoon.
Value Trap offers much more than this. It also warns about the current stock market structure, and how the markets have become in some ways, a risky place for even the most risk-tolerant retirees to park their hard-earned savings. Volatility has always been part of the stock market, but swings of the magnitude during the past several weeks are simply not “normal.” If pundits are pointing to the Great Depression and Black Monday of 1987 as analogs for what is becoming “normal” market volatility these days, investors are stretching to rationalize current market structure, like a frog in boiling water. Things will only get worse until regulators step in to mitigate the zombie strategies of indexing and empirical quant that continue to get bailed out with every new crisis.
Value Trap has been the ultimate playbook for the Great Crash of 2020. In warning about the spuriousness of small cap value as a fallacious source of expected return, counter to the foundation of quantitative finance, the book’s core served as a source of considerable alpha during this market swoon, as small cap value dropped more than 37% year-to-date through March 27 (the worst performing bucket) versus large cap growth’s average loss of about 17% (the best performing bucket), according to data from Morningstar. As presented in Value Trap, enterprise valuation may very well have saved many investors from the worst of the worst of this financial crisis.
But why am I comparing small cap value to large cap growth in the context of Valuentum investing? Well, certainly the case against small cap value was explained thoroughly in the book Value Trap, but importantly, we also believe that most quantitatively defined large cap growth stocks are the ones that are truly undervalued—a thesis we explained during our AAII circuit this year. Said another way, most equities in the Schwab U.S. Large Cap Growth ETF, ticker SCHG, for example, boast strong net cash positions, solid free cash flows, resilient and “moaty” business models, and otherwise present investors with a grouping of stocks that fit the mold of the Valuentum investor (undervalued stocks showcasing relative strength or solid momentum characteristics). Quant’s definition of large cap growth is as much nonsense as its definition of small cap value.
Though the value factor has now experienced its largest drawdown in history, we maintain our view that investors should stay far away from traditional quant value (whether B/M or P/E). In general, the groupings of equities supposedly attractive by these metrics can be most appropriately defined as overleveraged stocks with secular challenges to their products coupled with a heavy tilt toward the beaten-down sectors of energy and financials.
We believe steering clear of energy and financials may continue to be a source of alpha in coming months, as we said when we removed the Energy Select Sector SPDR and Financial Select Sector SPDR from the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio in August 2019. Value Trap also urged investors to stay far away from the airlines despite the group receiving a blessing from none other than Warren Buffett, himself. As has been said, to become a millionaire investing in airline stocks, you have to start with billions. Airlines are and always will be terrible long-term investments.
Let us now move on.
After our call in December 2018 to go to “fully invested,” which preceded a massive melt-up on the S&P 500 to all-time highs near 3,400…
After our call to add “crash protection” via S&P 500 put options on two separate occasions February 24, 2020, and March 6, 2020, preceding the fastest swoon in market history…
After our call to consider dollar-cost averaging on several occasions near the bottom of this swoon last month…
March 10: https://www.valuentum.com/articles/sp-500-hits-target-range-nibbling-ideas
March 13: https://www.valuentum.com/articles/dow-fell-999-worst-point-drop-history-more-nibbling
March 17: https://www.valuentum.com/articles/buybacks-and-wealth-destruction
March 21: https://www.valuentum.com/articles/boeings-fall-from-grace
March 23: https://www.valuentum.com/articles/fed-and-treasury-efforts-might-not-be-enough-avoid
…today, April 15, we’re now saying that it may be wise for short-term investors to consider taking some profits. Long-term investors, however, may consider continuing with allocations in the newsletter portfolios, with expectations that conditions may get far worse before they get better. Please be sure to contact your personal financial advisor to see if any move or investment strategy may be right for you. Valuentum is an investment research publisher.
Let’s now talk equity prices.
We believe quantitative algorithmic trading has thus far largely been focused on virus data, but we expect this to change. The market may not be completely factoring in the idea that the COVID-19 curve is flattening because the economy is shut down. This is far from the curve flattening while the economy is up and running. Once the economy opens back up, the COVID-19 curve might very well start to spike, and in the event officials choose to shut down the economy for the second time, it is very likely the markets may crash again to the lows. The US remains stuck between a rock and a hard place in this regard. Millions of businesses depend on a re-opening soon but doing so may only bring another shutdown. The next leg down may happen no matter what policymakers do.
In the coming weeks, we think broad equity prices will start to reflect a combination of 1) heightened probability of a resurgence of new cases of COVID-19 as containment policies are relaxed to offer businesses a lifeline of some revenue resulting in another shut down, and 2) pressure from profit taking from those that bought near the bottom of this swoon, exacerbated by price-agnostic trading (momentum, volatility) that may worsen the decline. As we have stated for some time now, the broad equity markets may not get sustainable relief until a vaccine for COVID-19 is broadly available, and that may still be 12-18 months away.
That said, we cannot ignore that the market is also considering long-term inflationary pressures from the Fed/Treasury that may surface on the other side of this calamity many years ahead. In a most optimistic case, we’d rely on the view that price-agnostic trading may take hold of this market on the back of unlimited quantitative easing and runaway government spending causing a blow-off top to new highs in the stock markets in the longer run. What is clear, however, is that a revisit to the old highs of 3,400 on the S&P 500, will not be fundamentally driven, in our view, and only manifest itself from a disconnect between price-agnostic index-driven buying and an ill economy suffering from rampant inflation.
Let’s now talk valuations.
If one weights on a 50/50 basis, 1,785 on the S&P 500 at low end--derived as 15x pre-Trump 2014-2016 average earnings per share numbers, which reflect a pre-corporate tax cut environment and generally lower economic activity that may approximate a post-COVID-19 world--and at the high end 2,940 on the S&P 500—derived as 15x pre-COVID-19 2021 numbers of $196)--one gets to a reasonable probability-weighted fair value for S&P 500 equities of 2,360.
With the market currently trading at the high end of our S&P 500 target range of 2,750, it is factoring in a very, very bullish long-term outcome, weighting a return to normalcy in the markets before 2021, or levels of 2,940, at roughly 80%-85%, by our estimates. It is reasonable to assume that at present levels, markets are starting to get a bit optimistic, a position that may be propelled in part by price-agnostic trading that continues to anchor behaviorally to the 3,400 prior highs on the S&P 500 in driving the recent retracement.
It can be fully expected, in our view, that the market is looking past 2020 numbers and discounting 2021/2022 numbers at this time, with volatility now a function of whether market observers believe the economy will revert to a pre-Trump economy (1,785) or back to “normal” at 2,940, or somewhere in between. As it relates to valuations, the now-zero-interest-rate-policy may mitigate the trillions in additional corporate debt added to balance sheets during the past decade or so, presenting an argument that a more optimistic case of 2,940 on the S&P 500 may deserve a slightly higher probability, but perhaps not one in the 80%-85% range. Regardless of the eventual pricing and valuation outcome, however, investors should expect Great Depression-like numbers in the coming months, with huge GDP declines and large increases in unemployment rates.
What are we doing with our S&P 500 target range as a result of these considerations? Our main concern is that government officials will open the US economy too early and have to shut it down again. In such an event, we believe the lower end of our target range may be most reasonable, and that also means the potential for panic selling to 2,000 on the S&P 500. While we have stated that we could see panic selling to 2,000 on the S&P 500 during the swoon, we’re now updating our target range on the S&P 500 to officially reflect the range of 2,000-2,750, a reduction of the low end of the range from 2,350. Our expectations for gut-wrenching volatility in coming months remains unchanged.
Let’s now talk behavioral considerations.
What we’re after as it relates to the equity markets is not necessarily knowledge of the future data realized, but rather knowledge of future expectations at any point in time that may or may not come to fruition. Howard Marks of Oakmark Capital talks a lot about second-level thinking (maybe such a view is third level), and perhaps anticipating expectations revisions is an extension of the Keynesian beauty contest. Of course, nobody knows for certain what will happen in the future (as it relates to future data and its impact on the markets), but investors can make fairly reasonable assessments as to how market participants may react to expectations of the future.
For example, we didn’t need to know whether the death toll in the United States would be 100,000 or 2.2 million or lower/higher to know that COVID-19 was going to impact market expectations at 3,400 on the S&P 500. However, we knew it was going to cause a big shock/crash to the downside (empirical data in this case did not matter). We can think about this another way, too, as we assess the bounce from the recent bottom. It may not really matter if we don’t have the V-shaped economic recovery. If everybody thinks that we’re going to have a V-shaped recovery, then that is what the markets will reflect, rightly or wrongly.
By the time the markets may come around to a V-shaped recovery not happening, a view that our team holds, we could potentially be closer to a potential vaccine for COVID-19, which further complicates the expected direction of equity prices. The reality is that it is not realized data that matters in understanding stock markets and expected returns, but rather expectations of such data at any point in time. Said another way, it is the market’s expectations of future data that we care about--whether that data turns out to be right or wrong may not matter.
Let’s bring this down to an example. Even scientists that forecast the epidemiology curve with precision may not be able to help investors, if the market never agrees with that opinion. Same with respect to stock calls--the market must agree with you for your call to eventually be right. In investing, the market’s opinion is much more important than future reality, as silly as that may sound, but that’s why markets are behavioral systems that cannot be mapped with past empirical data, as explained in Value Trap. The future of the past will always be different than the future of today, and backward-looking analysis has severe limitations.
As we close on this latest video report, I’d like to applaud the forward-looking thinkers out there. Where the empirical, evidence-based practitioner may have waited for what could have been 2+ million COVID-19 deaths in the United States to assess the severity of the pandemic, the forward-looking thinker built models, set up strategies to flatten the curve, and inevitably saved thousands, if not hundreds of thousands, of lives. We need more forward-looking thinkers. Let us not fight the last war with empirical data and great folly. Let us continue to fight COVID-19 with forward-looking expected data and save lives.
Thank you and God bless.
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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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