First and foremost, our thoughts are with anyone, or any business, affected by the devastating virus. With lives at risk, we hope that conditions improve as quickly, and as safely, as possible. It has been just thirty-three trading days since the market peaked (February 19th, 2020) and in that time we have seen the fastest bear market on record end a historic eleven-year bull market run. We have witnessed the virus force an unprecedented retrenchment in economic activity as social distancing gained traction around the globe. Event cancellations, school closures, travel restrictions, work-from-home mandates, business shutdowns and a seemingly non-stop flurry of negative headlines have kept investors appropriately anxious.
So, where are we now? Quite simply, in the throes To say the backdrop is unprecedented would be an understatement as today’s crisis has no real precedent or playbook. Visibility is limited given we are in the midst of a global pandemic that has essentially shut down the global economy. However, most of the shutdown is self-inflicted, not structural, and prone to snapping back once social distancing guidelines are lifted.
Currently, signs of optimism are mixing with economic uncertainty. Last month we wrote that the virus-related uncertainty would keep market volatility elevated with higher probabilities of big draw downs, and rallies (see Fatter Tails here). Record volatility indeed! Unfortunately, it has been skewed negative. The first quarter was one of the worst first quarters on record (e.g. the S&P 500 was -20%, the Russell 2000 was -31%!) and the month of March was the worst (March) in seventy years. The outlook going forward will remain highly dependent on the virus path and will be measured both in terms of infection and economic trajectory. While there are signs infection rates are peaking, the economic damage has not.
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental and macro market analyses indicate. Given the output, we exited March more guarded than we have been in several years. Last month we noted that, should the backdrop stay volatile, taking defensive measures was prudent. Prior to the virus, we had been championing a slower, but non-recessionary, growth backdrop temporarily held captive by the trade negotiations. We advocated a view that defensively positioned investors would serve as a backstop to any corrections or pullbacks. Thawing trade tensions supported our economic acceleration view and pushed stocks to a record high reached just over a month ago.
However, over the past couple months we have noted that the virus-induced economic uncertainty has turned that previously positive narrative upside down. Recessionary conditions have quickly taken hold. The past two weeks have seen unemployment claims jump by over 10 million (a record increase) and manufacturing activity fall to levels not seen since the Global Financial Crisis. A fifty-year low in unemployment (3.5% in February of 2020) seems like a distant memory.
We have spent a lot of time analyzing event-driven (e.g. 2011) vs. secular recessions (e.g. 2001 & 2008). The understandable takeaway is that, for the markets at least, the duration of a recession matters more than the depth. So, while we are seeing the sharp retrenchment in economic activity manifested in the incoming data, at this point we continue to define the pullback as event-driven, and therefore, finite.
While the situation remains fluid, it is clear the ultimate economic impact will depend on social distancing guidelines. We continue to monitor confirmed infections and, morbidly, fatality rates to help gauge the potential timing. Recent infection trends are encouraging, particularly in epicenter areas (e.g. Spain, Italy, New York, etc.). New cases in China have grinded to a halt, and economic activity there is starting to pick up. Regardless, last month consensus forecasts for 2nd quarter US GDP moved towards the steepest contraction in history (~20%). While most forecasts project a steep upturn in 3rd and 4th quarter activity, it is clear the retrenchment will set some unwelcome records.
There were only a few developments outside of the virus that received attention last month, but oil was one of them. Oil markets faced a moment of truth due to a disagreement between key OPEC+ members. The disagreement raised supplies just as large-scale demand destruction (due to the virus) was impacting market balances. Oil fell over 50% in March alone! And, given energy companies account for over 11% of the high-yield marketplace, the credit and banking linkage felt some additional pain. Fortunately, recent headlines seem to indicate Saudi Arabia and Russia are close to hammering out a fresh supply agreement.
Our short-term metrics are currently in a neutral position. The historically sharp move down has simultaneously caused several oversold signals to pop up in our work. While a deep, prolonged technical retrenchment (ala 2001 or 2008) is not our base case, recessionary conditions do exist. Those conditions, combined with a breakdown in longer-term technical trends, pushed our long-term view to negative (from neutral) last month. Prior upheavals (e.g. 2011, 2016 and 2018) were harsh with the long-term uptrend line tested or violated. Within a week or two, those trend lines were recaptured, and a new uptrend commenced. We see a more challenging workout period this time around.
We are watching the internals for signs of stability (there are a few) and at this stage believe a complex bottoming process with a number of jerky, erratic, and volatile moves should be expected. Somewhat encouragingly, investor sentiment has already reached levels of pessimism not seen since the Global Financial Crisis (e.g. the AAII bulls vs. bears ratio recently set a fresh low). Stocks are beginning to price in the palpable anxiety of a looming recession, and dislocations for some portions of the market are approaching the limits of, and in some cases have exceeded, what we think is fair value. Currently, only 15% of stocks in the S&P 500 are trading above their 200-day moving average. We would be remiss to not point out that the under-reported catalysts (i.e. an under-invested investor base, dramatic monetary and fiscal policy responses, new virus vaccination options, etc.) may act at any time to push markets up sharply.
Company valuations are now cheap relative to history as valuation metrics (e.g. P/E multiples) have re-rated below fair value. The issue, of course, is that there is quite a bit of uncertainty in the denominator of that equation (earnings). Over the past few weeks management teams have continued to acknowledge the heightened uncertainty - and growing downside risks - posed by the virus. Companies shuttered stores and production, withdrew guidance, announced cost-savings actions, suspended buybacks and dividends and tapped credit lines. The earnings of a variety of sectors, especially those with global business models and a large portion of face-to-face interaction, including leisure, lodging, gaming, airlines, transports, and other service industries, will see significant cuts. In aggregate, we expect earnings to show a sizable decline in the coming quarter (~25%), followed by an equally impressive growth in the second half of 2020.
While we (and the market) fully expect global growth to slow materially in the near-term, the real question is whether future growth will be impacted by one quarter, or several. After all, stocks discount activity levels well in advance. Fortunately, policy makers realize the timing uncertainty and are taking an aggressive stance. Last month the Fed slashed interest rates to zero, announced unlimited and expanded QE (quantitative easing) and unveiled seven facilities to boost market liquidity. The Fed’s balance sheet will shortly be more than three times larger than it was in 2008. Not to be outdone, Congress passed a third economic support package in late March worth more than $2 trillion. We expect more stimulus in the weeks ahead.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. We have remained active in our strategies, holding a de-risked posture where appropriate. Cash levels are elevated, but we stand ready to take a more active approach to strategy positioning in the coming weeks. Of course, should the backdrop not stabilize, we will take a more defensive stance. The potential for rotation (e.g. into value stocks from growth, into small-caps from large, into international from domestic) and snap-back rallies is high given extreme price discrepancies and defensive positioning, but we will wait for volatility to subside before getting too aggressive.
We are in the throes of the crisis. The next few weeks will be mostly influenced by virus-related news flow. Policy response traction and the upcoming earnings season where corporate updates, particularly surrounding liquidity, will also carry significant weight. Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments. Stay safe.
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