Image Source: Daniel Lobo

In this piece, we examine where the economy and stock markets have been recently, where we are now, and where we are going next. We also highlight four key ways to play this volatile market. We think this is a helpful way to think about overall portfolio construction, especially so that one does not overly expose themselves to a particular set of risks that could come to fruition—like an extended downturn in the economy or a rapid discovery of a vaccine for Covid-19 on the other hand.

By Matthew Warren

Macro Matters

When you turn on the television to the stock channel, there is a tremendous amount of discussion about where we are now and where we are headed next. While it always pays to focus on individual companies, industries, and stock selection like we do here at Valuentum, I can understand the fascination with trying to handicap the economy and the overall markets at this stage. Afterall, we are in a situation where sizable tail risks (both very good and very bad outcomes) have been present on both sides of normal.

It pays to take notice when the overall market is frothy on the one hand or undervalued on the other. This can be capitalized on by going underinvested and taking on protection on the one hand, or going fully invested in high quality, high growth and/or high beta stocks on the other hand. The market is also currently very bifurcated with beaten down COVID-tainted names on the one hand, and high-flying, strong secular growth stocks on the other hand. The COVID-affected stocks are trading with tremendous volatility even on an intraday basis at times, meaning that those making macro-economic oriented bets on these names can make or lose a lot of money in a short space of time.

Where Have We Been?

So where have we been most recently? At my last writing on macro subjects in the first part of March, we were descending into what looked very much like another financial crisis. All asset classes were rapidly trading lower and liquidity was drying up even in large, critical markets such as the U.S. long-dated Treasury market. Bid/ask spreads were wide and asset prices were gapping all over the place (but mostly lower). That is when the Federal Reserve and US Congress and Treasury stepped in with all the big guns. Instead of bringing out the artillery piecemeal over time, everything was thrown at the market all at once. The Federal Reserve is now pumping massive amounts of liquidity into all key markets, even down to the fallen angels--or previously (recently) investment grade companies, now rated at junk status. Congress approved multiple stimulus packages amounting to trillions of dollars in the form of enhanced unemployment checks, stimulus checks to US households, and (forgivable) loans to all shapes and sizes of businesses.

Image: The S&P 500 has rallied back considerably since the depths of March.

To say that the market responded would be an understatement. In fact, I would argue that the market immediately ruled out a worsening of the developing severe financial crisis as well as the possibility of another great depression, which material probabilities were very much on the table barring the massive intervention that took place. Essentially, all asset markets rallied substantially off the March lows, and a self-reinforcing positive cycle emerged, with households topped up with some cash and corporations able to raise equity funding and roll over bond funding once again. Even the most leveraged, low quality companies can roll over their debt, with only a few exceptions that have moved into the bankruptcy courts such as Hertz Global Holdings (HTZ) and JC Penney Co. Inc. (JCP).

Where Are We Now?

So that is the recent past, which involved violent swings and lots of opportunities to lose and make money as an investor. Where are we now? In some ways, the current situation is unchanged. Current economic events are being shaped in very large part by the progression of the COVID virus and the collective response to this pandemic. While the initial move to quarantine in effect shut down very large portions of the economy, the move to reopen various state and country economies (all happening at various speeds) marks a return to growth mode, so a dramatic improvement from staring into the abyss. There are signs that unemployment is now declining from the highest levels since the Great Depression and that consumer spending is bouncing in May.

Four Ways to Play the Rally

I would bucket stocks into four groups at this point. There are the previously mentioned secular growth companies that are not overly affected by the pandemic and its economic impacts in the first place. Companies like Facebook Inc (FB), Alphabet Inc (GOOGL), PayPal Holdings Inc (PYPL), and many software as a service companies. There is even a subset of this group that perversely benefitted from the pandemic – companies like Teladoc Health Inc. (TDOC), DocuSign Inc (DOCU), certain growth-oriented pharma and biotech companies that are now also targeting vaccines and/or therapeutics for COVID-19. The fair value estimates of these companies largely stayed stable or even increased during what are incredibly tough times for the many unemployed. This speaks to strong moats, large economic castles, and strong secular tail winds of growth. These companies benefit from lower financing costs and a lower discount rate (cost of capital) applied in a discounted cash flow model. These are good companies to own at the right price and over the long term in general. These are the companies that fill the bulk of the larder in our newsletter portfolios.

The second bucket of companies are directly and substantially impacted by the COVID-19 virus. It is companies like airlines (JETS), cruise operators, casinos, gyms, movie theaters, concert promoters, sports teams, leagues, or facilities, and the like. Not only have these companies been directly affected by quarantine measures, but consumers themselves are unlikely to participate in these activities to varying degrees for the foreseeable future – until there is an approved and effective vaccine and/or therapeutic to get COVID-19 under control. As the quarantines are removed, some wild and wooly consumers will come rushing back to these favorite pastimes, but others will hold back until COVID-19 is effectively knocked out. It is hard to predict whether some of these types of companies can operate profitably at partial capacity. I would argue that, especially in the case of weak or questionable balance sheets and cash flow streams, investing in these companies is very much akin to gambling. You are betting that the many shots on goal for a vaccine or therapeutic will play out very rapidly (vaccines usually take years to come to fruition; but there is clearly a monumental global effort afoot regarding Covid 19) or that these companies will be able to raise equity and roll over debt at favorable prices. Very much a gamble.

The third bucket of companies are those that are affected by the economic impact caused by COVID-19, as opposed to being impacted by the virus itself. Companies in this bucket can be either weak or strong in terms of moat and economic castle. They are generally referred to as cyclicals. They run the gamut in terms of industries, but some key examples would be banks, industrials, and consumer discretionary companies. There are several key questions when it comes to investing in these companies, making it a very difficult place to tread, though the potential rewards can be high. Does the company have a strong balance sheet? How prolific is the free cash flow generation at this weaker point in the cycle? Is there staying power to get to the other side with current shares outstanding (no risk of dilution at an unknown price), considering the spectrum of potential magnitude and duration of this economic downcycle? What is the valuation baking in regarding the prospects to first survive and then thrive in a more normalized economic environment? As you can tell, these are more akin to trading tunas as opposed to eating tunas. That said, there will be some solid doubles and even home runs that emerge from this bucket.

The fourth and final bucket of companies is what the market typically refers to as defensives. These are firms whose prospects are not overly impacted by the economic cycle. Some examples would include consumer staples firms, utilities, and steady-eddy pharmaceutical companies. A subset of these companies have also benefitted (mostly temporarily) from the COVID-19 outbreak – such as large chain grocers and general merchandise stores, and staples companies that sell products like home-cooked food and cleaning supplies through these channels. Defensive companies often trade with higher multiples than the average company due to scarcity value and a lower assigned cost of capital. With the Federal Reserve pumping liquidity into the markets and dropping the cost of financing and cost of capital across the board, and with so many companies affected by either the virus or the downturn in the economy, many of these companies are trading with heroic P/E multiples at this juncture. While some of these valuations will bear out, we suspect there will be a come down for some of the stocks in this space, especially once COVID-19 is effectively defeated and the economy fully normalizes.

Where Are We Going from Here?

Now that we have delineated how we see the recent past and the present setup, where are we likely headed to from here? Barring a substantial selloff and loss of confidence in the Fed and the Treasury/Congress (something we regard as unlikely), we have likely put in the bottom back in March. The US Congress and Federal Reserve must remain “All In” until the economy rebounds to trend for this assumption to hold.

However, that does not mean we will not have volatility as the COVID-119 virus continues to plague our country and the world. Case counts and hospitalizations are now rising in many parts of the country as we exit quarantine at various paces in various states. This of course was to be suspected, especially as it now appears that summer weather does not seem to be having much of an impact in knocking down the numbers of infected. As mentioned previously, we think some consumers will rush headlong out of their houses and back to their normal activities, with or without the masks and social distancing that are being recommended by the health experts. Many others will remain more cautious in their activities and therefore spending patterns. This will impact the second and third bucket of companies for the near future.

That is until one of the many shots on goal trickles (or hopefully gets slammed) into the net. Currently, many of the smartest people and well financed companies in the world are working on vaccines and therapeutics. We suspect that this will allow us to get a handle on the disease before too many months (god forbid years) go by. When this does happen, look out as asset prices and the economy will likely jump into a higher gear. The stimulus from the Fed and Treasury will need to be rolled back in a tricky dance, hopefully not disrupting the party. But that is another strategy piece for a (future) happier time. Meanwhile, let us root on our scientists and the financiers/philanthropists/governments that are backing them. Be careful investing in companies with weak cash flows and stretched balance sheets on the one hand or overvalued defensive companies on the other.

Stay safe out there!

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Related airlines: LUV, UAL, AAL, DAL, SAVE, ALK, HA

Related cruise lines: RCL, NCLH, LIND

Related gyms/exercise: PLNT, CLUB, NLS, PTON

Related movie theaters: CNNWF, AMC, CNK, IMAX, CPXGF, MCS, NCMI

Related (other): LYV, MSG

Banks - Regional and Asset Management: AB, AINV, AMP, ARCC, BCH, BEN, BGCP, BKU, BLK, BMO, BNS, CM, FSIC, ISBC, KKR, LAZ, LM, MAIN, MTB, NABZY, NYB, OCN, PBCT, PFG, PSEC, RY, SBNY, SBSI, STT, TD, VLY, WBK 

Banks & Money Centers: AXP, BAC, BBT, BK, C, DFS, FITB, GS, HBC, JPM, KEY, MS, NTRS, PNC, RF, STI, TCF, USB, WFC