Stock prices rebounded when news of COVID-19 pandemic improved in New York and other parts of the United States, and when the Fed announced a new liquidity bazooka 2.3 trillion dollars. Despite these positive points, several important factors, including long-term market psychology, analysis of the technical cycle, valuation and intelligent investor behavior, suggest that this bear market has not yet seen its low point.
If we were to change our perspective from an anecdotal to a more formal data perspective, the New York Fed conducts regular surveys of consumer expectations. One of the survey questions asked if respondents expected stock prices to rise in the next 12 months. Instead of fear, investors are showing signs of greed. Investor psychology just doesn’t behave that way at the bottom of the market.
MarketWatch columnist Mark Hulbert made a similar point about his sample of market synchronization newsletter writers in a recent Wall Street Journal article. While market timers were frightened at the end of the March quarter, their level of fear was not at all close to the levels seen at the bottom of the market.
Now is not the time to relax. The bear market is not over.
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2. No long-term substantive technical sign: When I put on my technical analysis hat, I don’t see any sign of long-term background. The markets are intrinsically forward looking, and if stock prices start to discount a recovery, we should see hints in cyclical indicators, as well as commodity prices. None of these signals are currently present.
Take for example the copper / gold and platinum / gold ratios. Copper
are all commodities and have inflation hedging characteristics. Copper and platinum also have industrial uses, and the copper / gold and platinum / gold ratios are expected to signal a recovery in the global cycle. In the bottom two funds of the market, the platinum / gold ratio reached a low before the bottom of the stock market, while the copper / gold ratio roughly coincided with stock prices. Currently, these two ratios are plummeting and there is no early signal of a cyclical bottom.
Commodity prices also led or coincided with stock prices in the last two major markets. The CRB index is now still low and shows no sign of any lasting bottom.
Metal prices also display a similar lag pattern with stock prices. While gold has its unique characteristics and ingots work to the beat of its own drummer, silver
, copper and platinum all surpassed stock prices in the last two bear market troughs. There is no evidence of similar buy signals today for these products.
Market funds are also characterized by changes in direction. Bear markets are forms of creative destruction. The old leaders of the last cycle, whose domination has become exaggerated, are weakening and new leaders in the emerging market. Instead, the old US leadership in global stocks, growth in value and large caps on small caps is still in place.
I doubt that a new bull market can start with technical conditions like this.
3. Headwind assessment: Another challenge for the long term bull is evaluation. The sp
s is currently trading at a forward P / E ratio of 17.3, which is higher than its 5-year average of 16.7 and its 10-year average of 15.0. In addition, we are entering the first quarter earnings season and the “E” of the forward P / E ratio will be revised significantly downward.
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How far? Consider that FactSet has reported a bottom-up consensus estimate of 152.81 for 2020 and 178.03 for 2021. In contrast, most of the top-down estimates I have seen for 2020 are in the range 115-120 and the estimate 2021 is around 150. These are very wide gaps between top-down and bottom-up estimates. The discrepancy will be bridged primarily by the decline in bottom-up estimates, rather than by the increase in bottom-up revisions.
As a quantitative equity portfolio manager, I have learned that every time a country experiences an unexpected shock, all quantitative factors stop working. They then start working again in the following order:
First, the technical factors of prices begin to transmit information to the market. Next are estimates from the top down strategist, followed by bottom up estimates. It’s because everyone knows the shock is bad, but no one can really quantify the effects. Descending strategists first run their macro models and offer rough estimates, but business analysts cannot revise their estimates until they have fully analyzed companies and industries to be able to revise their profits. This is where we are now in the market cycle.
The final stage of adjustment occurs when most of the damage is known and fundamental factors like value and growth start working again. We are far from this phase.
With this preface, then consider the valuation of the American market. I returned in 1982 and analyzed the P / E ratio of the market futures in the main funds of the market. The 1982 trough was an anomaly, with the market reaching a forward P / E of around 6 due to the Volcker era nosebleeds. The 2002-2003 bottom saw a P / E ratio before about 14. These are the two outliers. The 1987, 1990, 2009, and 2011 funds all experienced advanced P / E ratios of about 10. All of these episodes occurred in very different interest rate regimes. Can a new bull market start today at an advanced P / E of 15, with an uncertain “E” falling rapidly?
This is how I arrive at the downside potential of the S&P 500, assuming that the downward estimates are 120 for 2020 and 150 for 2021. Suppose the market reaches its low today, or did so in late March, and then in before 12- month EPS would be 75% of 120 + 25% of 150 = 127.50. By applying a multiple P / E range of 10 to 12, we arrive at a range of 1275 to 1530 for the S&P 500. Using the same methodology, a June 2020 floor gives a 12-month forward EPS of 135 and a price range for the S&P 500 from 1350-1620. A September 2020 trough translates into forward EPS of 142.50 and a price range of 1425-1710.
For investors who believe the P / E ratios should be adjusted for interest rates, Callum Thomas of Topdown Charts calculated the risk premium for US stock market stocks based on the CAPE. Although current levels are starting to look cheap, they fall short of the compelling readings that are typically found in the latest lows in the market.
4. What do smart investors do? Here’s another way to think about evaluation. Insiders have stepped up and bought massively in the last downdraft, but this group of “smart investors” has retreated as the market has grown.
Admittedly, insider buying is an inaccurate market timing signal. Insiders were too early and too eager to buy during the initial downturn in 2008. They were also in early 2018.
For the final word on this subject, here is everything you need to know about “smart investors”. At the bottom of the market during the Great Financial Crisis, Warren Buffett intervened to save Goldman Sachs when the Goldman sold a favorite expensive convertible to Berkshire Hathaway
with stock warrants attached to the transaction. When the market recovered, Buffett acted like a bandit.
What has Berkshire done now? It’s raising money. He sold his airline stocks and Bloomberg said he was borrowing $ 1.8 billion in a yen bond issue. In the current economic environment, many companies need to borrow to consolidate their liquidity, Berkshire Hathaway, rich in liquidity, does not belong to this category.
Does this make you want to rush to buy stocks?
Bulls and bears laid bare
This bear market is the result of an exogenous shock that led to a recession. Ryan Detrick of LPL Financial found that recessive bear markets last an average of 18 months, mainly because recessions take time to recede and cannot normalize instantly.
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Although we have known an instant market, for the share price to become an instant bull again, at least one light is needed at the end of the tunnel; that the circumstances that triggered the recession conditions are about to be resolved.
Markets began to take a risky tone last week when the trajectory of COVID-19 cases and deaths began to improve, in the United States and Europe. While such improvements are welcome, they are the necessary, but not sufficient, conditions for the revival of a new bull. In the absence of a miraculous medical breakthrough, it is difficult to envision how the current recessionary conditions can be resolved quickly. Even if the virus were to be under control, no one could just flip a switch and restart businesses in an instant.
Based on the first in, first out principle, we can observe that Asia is starting to see a second wave of infection as governments relax the lock-in restrictions. For example, Singapore, which has been extremely successful in controlling its epidemic, has seen new cases increase as soon as the restrictions have been relaxed.
Governments will be playing the game of fuss with this virus for some time.
Unless a population acquires collective immunity, either by allowing COVID-19 to crack down on its population, or by medical treatment that controls the epidemic, governments will play the rabies game with this virus for some time. In such circumstances, even the top-down S&P 500 estimates of 115-120 for 2020 and 150 for 2021 are only educated guesses and can be revised based on changes in public health policy.
Despite the bleak outlook, I have good news. This recession is not going to become a depression. Fed-watcher Tim Duy wrote a Bloomberg article explaining the preconditions for a depression depends on three Ds: depth (deceleration); enough time for a recession or depression and deflation. Duy observed that we certainly have the depth to qualify as a slowdown, although the duration of the weakness is unknown. However, the world’s central banks have noticed enough that they are doing everything in their power to fight deflation. While this global recession is ugly, it is unlikely to metastasize into depression.
I would also like to clarify my reference that the form of this recovery is likely to be a form of “square root” (see From V to L: what will recovery look like?). The Oregon Bureau of Economic Analysis provided a stylized response. Expect a partial V-shaped initial rebound, followed by a slower growth rate, the shape of which will be subject to policy, demand and the level of permanent economic damage inflicted.
Cam Hui is a portfolio manager and author of the Humble Student of the Markets investment blog.
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