Why I’ve turned less bearish now
March 22, 2020
What a weekend! Although we are still reeling from worsening infection statistics, the United States, in particular, has gone from a complacent unawareness and denial to full panic mode in the space of a week. That’s actually a good thing, although it’s going to be economically very painful. Many will lose their jobs. Many will face steep healthcare bills. It’s going to be bad. But it could have been a lot worse and we are finally doing something about it.
To paraphrase Churchill, this is not the end. It is not even the beginning of the end. But I now feel that it is, perhaps, the end of the beginning.
Let’s get the bad news out of the way first. The number of cases is still rising rapidly . The toll in lives, health, and human suffering will be huge. Economic costs will compound human misery.
Unfortunately the Western world was two months late responding and just on the economy, the costs of containment have risen very sharply, probably resulting in a significant recession lasting at least one to two quarters. And yet, I’m somewhat more optimistic after the last two days.
Quite ironically, three human/societal failings that we quants like to criticize will redound in our collective favor here. They are: 1. the fear and risk aversion to the unusual/unknown, 2. the fear of anything foreign, and 3. our highly litigious tendencies (in the USA, which make companies fearful of being held accountable for the spread).
All three have sent Americans into a frenzy of social distancing. This change in attitude, which is palpable, will do more than any governmental pronouncements. While hugely disruptive short term, the best news I’ve seen here in two months.
After two months of dithering and poor decision making, the Federal government also finally acted decisively to stem the virus tide. Admittedly based on anecdotal evidence I’ve read over the weekend, the entire mindset of the country has turned on a dime in 48 hours.
So yes, our system might still come under severe strain but less than it would have been otherwise. The graphic below shows that the US is likely one to two weeks behind Europe in terms of the virus spreading, which gives us a better chance of escaping the situation in Italy. So there is reason to think we have drastically slowed the spreading now and will reap the benefits in seeing better numbers than would have been otherwise possible within a week. I think this also likely makes the stock market correction less severe than it would have been, going forward, despite deepening the slowdown temporarily.
Let us now turn to the market. Estimated gdp output losses could be 5-8% or more over the next two quarters.Say these projections are right, but that contraction is then followed by a V shaped rebound over 3-4 quarters, but with some permanent loss of activity during those quarters. How much intrinsic value is lost from share prices?
Let us posit that 12 months of earnings are wiped out ( we have to guess--there’s no direct formula to convert gdp decrease to profit hits). Keeping multiples constant at 20, that’s only a 5-8% hit to stock market valuation. Of course, the losses could be larger in a bad scenario. But that’s just the beginning.
The US stock market pre-crisis traded at a multiple of around 20. The price to current earnings multiple will take a hit as well, due to a downward expected earnings trajectory, the increase in volatility, and poor sentiment / herd behavior. If multiples shrink from 20 to 15, that represents another 25% drop.
Are stocks a buy yet?
The S&P closed Friday at around 2700. In this base scenario, that puts a floor of 30% loss to the market from precrisis levels of 3300, that is, at 2300 or thereabouts in this case, which should be temporary. Which suggests a base case that it may be time to start buying when market levels drop by -20% to -25% from pre crisis levels, which is where we are.
What could go wrong with this argument? The counter argument is based on extremely high volatility ( requiring lower multiples to deliver the same Sharpe ratios), a sharper downturn in earnings, and investor fear demanding lower valuations. If we double the hit to earnings and impose a multiple of 10-12, we could be looking at a bearish scenario of 1500-2000 on SPX, as I blogged earlier.
This bear case is entirely plausible, but I now consider it less likely ( say not more than 20% to 30% probable) for three reasons.
First, now that Western governments have responded decisively, markets are likely to look through the hit to supply chains, demand, output, and earnings. China is a good case study, though not definitive.
Second, I expect the Fed and Congress/Trump, as well as other CBS and governments to respond with a bazooka I the form of monetary, quantitative and fiscal stimulus. They will not hold back. For example, the Fed just cut to zero, and I expect them to do more quant stimulus, and prop up the bond and repo markets. If the bill in Congress proves insufficient they will do more. It’s an election year folks. So will China and Europe.
Lastly, unlike in 2008, the US banks and financial system are actually liquid and strong with the exception of over issuance and over leverage in certain credit markets. Here some sectors will be in distress and some BBBs, leveraged loans and HY will be in trouble, including the energy, transportation, tourism and leisure sectors. Bankruptcies are inevitable. But this will likely not lead to a systemic crisis of confidence.
Only time will tell if this is too early. So, my parting suggestion? Be careful out there. I mean, stay home if you can, wash your hands, don’t kiss fellow passengers, maintain only eye contact and don’t walk through a cloud of any kind if you see one. Safe journeys to all of you. And be careful with your money as well, but don’t let fear lead to paralysis. My very best.