“And you may ask yourself, well how did I get here?” ~ David Byrne, Talking Heads
The US stock market went into a bear market, defined as a decline in excess of 20%, in March and has since entered a new bull market, defined as a rise of more than 20%. As we write this, S&P futures are just about 30% off the March bottom. There is an old saying on Wall Street that markets climb a wall of worry. Despite the rise in major US indices, the bears seem to outnumber the bulls and they seem to be growling louder by the day. The market is not doing what they think it should do, and perhaps what they bet on it to do, nor is it doing what most prognosticators are saying it should do as they point out the seemingly obvious irrationality of the rebound.
The key bear argument is that the stock market, represented by the S&P 500, is not reflective of or properly pricing in the deterioration of the underlying economy, which is facing an unprecedented shock. Furthermore, they argue that effects of Covid-19 on the economy are open-ended and immeasurable. Bears point to soaring unemployment, mindbogglingly negative GDP estimates, and complications surrounding the re-opening of the US & Global economies. They also warn of a “second wave” in the fall. Bulls, to the extent they are willing to stick their necks out, point to unprecedented intervention from central banks and governments. They may also believe that the effects of Covid-19 on the economy writ-large may prove to be transitory.
We believe that most forecasts or predictions tell you more about the forecaster than the future. Most of the commentary is centered on how bad the next 3 to 6 months will be economically, and how complicated the year following may be as we begin the re-opening process. The market is a forward-looking, discounting mechanism. To the extent a bad event can be looked through, it often is. We tend to focus on and prioritize what we know over what we think. Our job is to see things as they are, not as we hope or wish for them to be. What does that mean in the context of this most recent rebound?
We think that the shape of the recovery is going to vary by industry/sector and that will influence the broader market. There are some large sectors in the market that are relatively non-impacted in terms of earnings, cash flows, and enterprise value. Some of those sectors and businesses may actually grow in 2020. There are other large sectors of the market that are impacted but we think are more likely to have a “V” shaped recovery. Some sectors have a longer road to recovery, something of a “U” shape, but we believe there should be a recovery and the timeline is more uncertain. There are other sectors that may experience an "L" shaped recovery as their earnings power and enterprise value are more permanently impaired, a few of those sectors are sizable and some are negligible in size. Lastly, there are some sectors, or companies within certain sectors, that may not come back. It is worth mentioning that those sectors and companies had serious issues before this economic shock are also a smaller part of the overall market, and in many instances the planned shutdown simply accelerated the inevitable.
We know that in theory, stocks are worth the present value of the cash flows a business generates. In practice, most people do not forecast forever; they stop after some period of time and put a terminal value on the business. That terminal value is based on growth rates of a key metric and prevailing interest rates. Examples of a key metric may be: earnings, operating income, book value, or the cash flow the business generates. Next, a multiple gets applied to the metric, and in many instances most of the present value of a business is in that multiple. For growth businesses that are reinvesting all of their cash flow, one can argue that all the value resides in the terminal value. So, to frame this in a broad market context, we think we’re going to see a couple of quarters of cash burn for some companies, but since interest rates are much lower and there is the potential for better growth coming out of this due to the massive stimulus, the terminal value for a number of companies may have theoretically gone up.
Similar to almost everyone else, we are surprised by the speed at which the market has rebounded. This recession and the market decline that preceded it are unprecedented and unusual, perhaps the recovery could be as well. As we wrote in our most recent client letter, we thought a recovery in the market could take hold when three conditions were present: a willingness of the Federal Reserve to do whatever it takes, a willingness of the US federal government to do whatever it takes, and some evidence the public health measures we have enacted are bearing fruit. We think those conditions are and have been present for about a month.
While pullbacks or another leg down are always possible, we are more inclined to think the market has entered the “Wall of Worry” phase and disagree with those that are calling the rebound completely irrational. We remember 2009, when many investors were on the sidelines and they tended to stay on the sidelines waiting for some other shoe to drop. Everyone was waiting with cash to deploy in a meaningful pullback that did not really materialize. If investors wait for all of the problems to be completely solved, we think they could be waiting a long time and the market could be even further into a recovery by the time that happens. Simply put, trying to market time a recovery is too hard and we think investors who want to experience it need to be there when it happens.
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