What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, rose about 20% during Q2.
- The developed markets of Japan, Europe and the UK were all up between about 11% to 15%.
- Emerging Markets and Asia (Ex-Japan) were also up about 18% and 17% respectively.
- Global fixed income returns were mostly positive with US Treasuries performing the worst (+0.5%).
Where Do We Stand?
- We are now officially in a recession, the length and severity of which is still unknown.
- I believe equity markets will see brighter days but a bottoming process must unfold beforehand.
- The opportunities to enhance long term returns will come to those being patient as the economic situation unfolds.
- Portfolios remain in an extremely protective posture with high cash levels to buffer further moves lower and offer ammunition to buy equities later.
- I continue to monitor portfolios for rebalancing opportunities.
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As the second quarter of 2020 came to a close the markets reflected an expectation that global economies were experiencing a v-shaped recovery. Certainly, equity market returns have displayed a v-shape as the S&P 500 index returned more than 20% for the quarter. That strength can be attributed to the massive amounts of stimulus that central banks and governments around the word have provided. Central banks have made it quite clear that they are willing to use all of the resources at hand to keep borrowing costs low and avoid the type of liquidity crunch we experienced in the last crisis. However, the risks to the economy remain rather high and may not be reflected in equity prices today.
Bankruptcies Looming
While liquidity concerns may have dissipated, solvency of corporations is still a real risk. In fact, we have already seen several bankruptcies such as Hertz, J. Crew, Chesapeake Energy and 24 Hour Fitness. Expect these bankruptcies to continue. It is estimated that this year will set a record for “mega” bankruptcies (companies with more than $1 Billion in debt) while “large” bankruptcies (companies with more than $100 Million in debt) will challenge the record set during the 2008 crisis. Expect many smaller and private companies to follow the same pattern.
Many of these companies were poorly positioned coming into the crisis, with high debt loads and struggling business models. U.S. economic growth was deteriorating, prior to the virus. Corporate debt was at an all time high, prior to the virus. An earnings recession was forming, prior to the virus. The virus simply exacerbated all these conditions. Many of the bankruptcies to come now will likely be the result of the pressures of a stop-start-stop-start economy as the world struggles with potential second, third and fourth waves of the virus.
Shock Scars
We have not seen the worst yet. When government programs and existing credit lines expire these weak companies will be forced to burn through their cash on hand. The result will be a ramp of bankruptcies that will likely remain elevated through the end of the year. We can expect that to begin in the next 30 to 60 days. Some of these companies can reorganize themselves and work through it. Some cannot. The shock to employment, demand and supply chains is real and to be monitored closely. The scars from this recession are still prevelent and will take some time to heal.
Pricing to Perfection
In the meantime the Federal Reserve has basically suspended “price discovery” or the ability of the markets to correctly value companies. The result of their massive stimulus programs has been for the market to price in just about perfection on the re-opening of the economy and the availability of a vaccine soon to offset a second peak of the virus. We may well already be into that second peak here in the U.S. and thus the market has been too optimistic.
Other Negatives
Other negatives include the fact that recently, the Fed has paused pumping money into the economy, the China trade deal is almost dead in the water and there is a real chance of Biden becoming president. On the latter, regardless of whether or not you agree with his proposed policies, it does raise the specter of corporate tax rates returning to 28%. Increasing taxes on corporations at a time when they are all struggling with all the above would only prolong the recovery and further increase bankruptcy filings.
A Ceiling on Activity
This will all put a ceiling on economic activity for quarters to come. Incomes here in the U.S. have been supported by stimulus checks and generous unemployment benefits, which are set to expire in July. If these benefits are not extended, many Americans will see a significant reduction in incomes and hence, their ability to spend. This will eventually be reflected in earnings reports on a quarterly basis and will shortly thereafter be reflected in stock prices.
Estimate Revisions
Estimates for earnings are still way too high. Given the depth of the economic crisis we will continue to see as per the above comments. About 30 Million unemployed, negative wage growth, shrinking incomes, and a second wave of the virus will all conspire to drive estimates lower. During prior economic downturns we saw earnings shrink by somewhere between 50% and 85%. Today, earnings are expected to decline by about 34%. At the same time, valuations in equity prices are at grossly elevated levels. If in fact earnings do decline closer to that norm (50% – 85%), one can expect prices to follow.
Fed liquidity can boost stock prices in the short term as we have seen. However, expanding balance sheets from liquidity infusions do not increase employment, wages or economic growth. The Fed can’t force people to spend or companies to invest in capital projects. Lastly, in this environment, we have also lost a major support for Earnings per Share, namely stock buybacks. Without that support, the ability of the markets to shake off exogenous shocks is diminished.
The Next Bull
Putting all of the aforementioned risks aside, today’s market process is simply a precursor to the next bull market. Bull markets are typically founded in the depths of despair and usually begin when no one is looking for them. There will be another bull market, of that I am positive. I am just not sure we have felt the pain of a prolonged downturn or the fits and starts that often pre-empt a new bull cycle. The aggressive downturn we experienced in the first quarter certainly felt bad. However, it was an emotional response to the events unfolding, not a fundamental response to the longer term effects of said events.
The next few quarters will bring fundamental results to bear on the markets and the result may be a period of higher than normal volatility. Volatility can help lead us into the next bull market as the excesses we now are experiencing are cleared. Bear markets cleanse themselves through time and/or price. Possibly the low in March was the clearing price. Now we get to take the time to clear the rest.
Your Portfolio
Understanding all of the above, I have been decidedly conservative with allocations to stocks. Specifically, Small Caps, Mid Caps, Emerging Markets and Developed International markets. One should expect these areas to struggle more than US Large caps in the face of all the risks cited. And certainly, that was true in the second quarter.
In prior posts I have stated, “As one whom is entrusted in the dual mandate of wealth preservation and wealth creation sometimes it is better to protect than to risk assets.” The patience required to not act brashly is often overlooked in investing. As difficult as it has been to remain in a defensive posture as the markets have acted irrationally we remain as such.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
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