May 01, 2020
Meritage Current Market Update
We hope everyone is staying healthy. As most of us will see some moderation to our shelter in place guidelines in the coming days and weeks, we expect our habits of staying safe will remain as essential as ever.
Since much has transpired since our most recent correspondence at the end of the first quarter, we thought we’d take this opportunity to provide a brief update. A nice change to do this when the investment markets have been in an uptrend during April.
As we draft this note, stocks are on the cusp of turning in their best monthly performance since the mid-1970’s. This rally has provided welcome relief from the sudden collapse in March, and in typical fashion, confounded most by the swiftness of the rebound. This reversal was largely prompted by the massive fiscal and monetary stimulus from the government to prevent, by all possible means, a likely depression.
Too far, too fast?
A market now less than 15% from all-time highs is hard to square with an economic outlook that has from most perspectives never looked worse. Noted investor, Howard Marks, recently said, “It seems to me the world is more than 15% screwed up.” Recent statistics back this up, showing over 60,000 COVID-19 related deaths, 30 million jobless claims, a Federal deficit tracking toward $4 trillion, and untold business closings. For an economy that had become increasingly skewed toward services over manufacturing, the social distancing nature of this lockdown has been particularly harsh.
There seems to be a disconnect between the market and reality, and it resides in two areas. First, use of “the market” or S&P 500 to represent stocks in general is sometimes misleading. The broad universe of stocks, particularly smaller and medium size companies have not recovered this year like the S&P 500. We’ve also seen increased concentration in the large cap tech names disproportionately influence the S&P’s return. This is neither bad nor good, but the index has becomes increasingly differentiated from the broad market. The top 5 of the 500 names now represent 20% of the index’s value.
Second, the stock market, regardless of the index, is not a simple measure of today’s economy. Markets are known to be forward looking, pricing in expectations looking out at least six to nine months ahead. In keeping with this, the markets seem to be taking a pass on the lousy earnings reports and lack of forward guidance coming from corporations, expecting instead to see improvement in the back half of the year.
This expectation is a leap of faith that the financial support from the Fed and Congress will be enough to hold the economy together until activity picks up. This relies on keeping the duration of the recession brief. If this is successful, the belief is that the actual depth of the recession will matter less.
State and local authorities are now focused on a timetable to open up their economies. The tangible burden of a shuttered economy on individuals has become a bigger concern than the fear of the virus, which for now, remains at arms-length for most people. Ready or not, select parts of the economy are opening up.
This transition will be slow, uneven, and not without risk. Many believe there will be a reckoning for stock prices once the actual reality of this start-up sinks in. We admit this is a compelling view, especially with the market now pricing forward earnings multiples at yearly highs. We recognize the use of traditional valuation measures are suspect when estimates of future earnings and revenues are unreliable, but what an investor pays for an investment still matters and we believe there should be a process to measure that.
We have looked at earnings estimates for the S&P 500, reflecting year over year declines ranging between 20% and 30%, followed by earnings growth in 2021 in a similar upside range. In order to support material gains from current market levels, either earnings must return to pre-pandemic levels more quickly, or the valuation multiple on reduced earnings must exceed normal ranges. We have seen examples of the latter when markets have rebounded from exogenous shocks, so we don’t discount that possibility. But it becomes a riskier bet from here to depend on these extreme valuations while waiting for earnings growth to eventually catch up.
The challenges to this start-up phase are many and well known by market participants. Key concerns involve further stress in the credit markets, our dependence on global supply chains, lackluster capital spending, muted leisure spending, limited hiring needs, and small firm capitalization levels, not to mention a presidential election cycle. These risks support the view many have: this rally has come too far, too fast, though most investors have been skeptical about this rally from the start.
Wither oil prices
The other major development since quarter-end has been the collapse in oil prices. This alone might have been enough to trigger a bear market and recession. The combination of a growing inventory glut (exacerbated by the Saudis’ ramped up production) with the collapse in worldwide demand resulted in oil prices dropping by over 70% this year. This came to head recently when the capacity to store excess oil had been exhausted, rendering the contract to take possession of a barrel of oil to a negative value.
Since 40% of oil demand comes from road and air transportation, the supply imbalances should eventually adjust as economic activity picks up. In the meantime, $20/barrel oil is unsustainable to support the industry. Bankruptcies of weaker capitalized companies have begun, including publicly traded Diamond Offshore, Whiting Petroleum, and Chesapeake Energy. Pressures will remain on all parts of the energy complex as well as energy related junk bonds.
The next new normal
As the economy reopens, medical experts tell us to expect an increase in COVID 19 infections. There are concerns that a resurgence might result in another lockdown, but Federal and local authorities will more likely emphasize reliance on self-regulation to deal with ongoing health risks. Markets understand that social distancing habits will linger, even as restaurants, department stores, and salons gradually reopen.
Connecting the dots to what a post-virus new normal looks like has relevant investment implications. Broad access to a vaccine is probably 12 plus months away, but change is already taking place. There is a growing belief that important business and lifestyle trends that were in place before COVID-19 have now accelerated.
A commonality of these trends are activities that can take place at home. Consumers have become increasingly comfortable with online services, including retail purchases, grocery and meal delivery services, video conferencing, telehealth services, live streaming of music and theater, and online education at all levels.
Expanded business opportunities involve the technology backbone and software to support these services, new payment options, home delivery of goods directly from the manufacturer (or farmer), new advertising models, virtual reality integration, and new business and social communication tools. Sanitation needs have been permanently elevated.
Industries vulnerable to these trends (travel, entertainment, sports, dining, tourism, retail, commercial office space, etc.) will have to evolve to stay viable. Many businesses, large and small, that were positioned on the wrong end of these trends going into the pandemic will only become more challenged. For a company like JC Penney, the only thing that’s changed is their pending bankruptcy date. The markets are quick to declare winners and losers, and size and scale are seen as advantages in being able to make this transition. The big are positioned to become bigger.
As referenced earlier, we remain circumspect of the sharp recovery in April and would not be surprised to see a near-term retrenchment. The shock stage and the relief rally stage are probably behind us. Ahead is a frustration and reconciliation stage as reality and an eventual recovery come into focus. Through it all, we are no less confident that stocks will provide attractive returns to investors over the coming years, though the absolute level of returns might be more modest. We have found some opportunities to invest a portion of the cash balances inside our equity strategies since quarter-end and expect to put additional cash to work as opportunities present themselves over the quarter.
Traditional business cycles passing through the sequence of economic expansion, inflationary pressures, Fed tightening, and periodic recessions are no longer the norm. The pattern has shifted to cycles driven by market excesses and exogenous shocks, more recently in the form of a tech bubble, a sub-prime debt driven financial crisis, and a global pandemic. These shocks create cycles that don’t fit with traditional economic models in their patterns and in their policy responses.
While we risk overusing the word unprecedented in describing what has happened and what lies ahead, there are still relevant lessons we can take from the past. Though harder to see from today’s perspective, there is a strong tendency to return to old habits. It may take a while, but we will eventually return to more normal socializing activities. Some have observed that routine health screening for public events will be the equivalent of security screening for travel, post 9/11. There was a time after the Financial Crisis where it didn’t feel good to consume luxury goods. Consumers got over it. Complex derivative securities and covenant-lite loans were left for dead after the Financial Crisis, before returning stronger than ever in recent years. No doubt, much will change coming out of this pandemic, but less so the essence of human nature.
What’s not new for us is adapting to a changing competitive landscape and navigating around businesses with undercapitalized balance sheets, dated business models, and sub-par innovation and leadership. We also recognize being in the right place in the midst of a trend shift does not insure a successful business. As important as ever, we will rely on our tools and disciplines to identify companies that are positioned well for this next business cycle and avoid investments that might appear cheap or over-hyped, but instead have diminishing prospects.
Growth driven strategies will more naturally participate in the more identifiable secular leaders, which have again seen the support from investors during this tumultuous event. Value strategies should be positioned to perform better, as they have historically, in the beginning stages of an economic recovery. The balance of these strategies should help us get through the uncertainty of when that recovery is actually in place: a milestone we all look forward to.