June 5, 2020
By Steve Blumenthal
“You will get business failures on a grand scale.”
– James Bullard, President of the Federal Reserve Bank of St. Louis
(May 12, 2020)
Let’s talk about valuations. Forward price-to-earnings (P/E) sits at 22.4. Median P/E (my favorite indicator, which looks at actual trailing 12-month earnings) sits at 24.6. For comparison purposes, the 52-year average, call it “Fair Value,” is 17.3. That suggests the S&P 500 Index’s fair value is 2,134.06. More than 30% below today’s level of 3,202. And it’s not just price relative to earnings. It’s price-to-sales, price-to-operating earnings, price-to-book. Price-to-everything is expensive. Here’s a look (red is bad):
Source: Ned Davis Research
I like to review valuation data at the end of each month. Valuation indictors are worthless in predicting short-term market performance, but they are of great value in telling us what performance will likely be over the coming 3, 5, and 10 years. Below, we take a look those coming low return numbers. It’s a betting market mindset in the short term and an investment mindset in the long term. Both are OK, just keep that in mind.
Here’s something to put in your good news category: The U.S.’s May unemployment rate fell to 13.3% vs. 14.7%. Economists were expecting a jump to 19%. Yet, the overhang of debt remains the issue of the day. Well, maybe issue number two behind the pandemic—but problematic nonetheless.
Defaults spike in recessions. We are in recession!
This from The Economist:
In America, two-thirds of non-financial corporate bonds are rated junk or bbb, the level just above junk. In April, Goldman Sachs, another investment bank, predicted that over $550bn of investment-grade bonds will fall to junk status by October (adding roughly 40% by current value to the junk-bond market).
Edward Altman of NYU Stern Business School reckons that about 8% of all firms whose debt is rated speculative grade (about 1,900 in all) will default in the next 12 months. This figure could reach 20% over two years. He expects at least 165 large firms, those with more than $100m in liabilities, to go bankrupt by the end of 2020.
At the height of the Great Financial Crisis, the global default rate for junk bonds was 10%. The high-yield market declined by more than 40%. Recall the bad sub-prime mortgage debt, the real estate market crash, Bear Stearns, and Lehman Brothers. That was the last recession. Moody’s predicts the default rate could rise to 20.8% (see the right side of the next chart) in the current recession.
Take a look at the chart again. Now, focus in on the left-hand side. One of the problems we face is that much of the distressed debt is in two of the hardest hit sectors: oil & gas and retail & restaurants. “But Steve,” you say, “what about the magical powers of the Fed’s SPV [special purpose vehicle]?” My answer, yes short term, but I’m worried long term. Every push has a pull.
Recall that the Federal Reserve printed money and bought bonds from the U.S. Treasury. The Treasury took $75 billion in cash and used it to set up an SPV. The Treasury then hired the Fed and the Fed hired BlackRock to use the money and invest it in investment-grade and high-yield ETFs. Oh, and the Fed leveraged that $75 billion up to $750 billion. I sure would like to see who the SPV’s leverage lenders are (which lucky banks picked up that new and likely risk-free gig?), but that’s a whole other issue for another day. You and I could argue until we are blue in the face that this is illegal (which it is) and a fraudulent Ponzi scheme (which it is) but we’d be wasting our breath because our anger won’t change what is.
What does this all mean? Flush with new cash, the ETFs buy in proportionate amounts the bonds that compose the underlying index they seek to track. But there are rules around defaults and company restructurings. You can prop up the bond price, but what happens when a company defaults? You are propping up the price of an empty asset. The loss is permanent. A bond doesn’t typically lose all of its value in default, but let’s say the investor loses 40% (after restructuring). The bonds must be marked down. This time around the covenant quality has never been worse. In English, this means in the next default wave the bonds will lose more than 40%. That money’s not coming back. And that SPV leveraged 10x? It sits at cost on the taxpayers’ books. We eat it.
So, when I look at earnings and I look at price and I look at fundamentals and I look at debt, the only argument I see is the Fed and its ability to print and buy. And I’m concerned that, like the Fed-created bubbles of 2000 and 2007, this one will end badly too. It’s a betting market in the short term and an investment market in the long term. We are in living in “Crazyville.” No wonder Warren Buffett isn’t buying.
One last point from The Economist: “Because America Inc. locked down in mid-March, these do not reflect the pandemic’s toll. Few CEOs have been as blunt as Mr. [Amazon’s Jeff] Bezos about what comes next; 45% have suspended or revised guidance. Analysts expect profits to fall by 20% this year. The futures market is pricing in large cuts to S&P 500 dividends in 2020 and 2021.”
In his Thursday Early Morning with Dave research letter, David Rosenberg said this:
The Fed has expanded its balance sheet more in three months—by over 70% to $7 trillion-plus—than it did in the six years from December 2007 to November 2013. And there is indeed, as we have verified, a 90% correlation between the Fed’s balance sheet and the S&P 500. But how does one tell investors to hold their nose and buy equities? To ignore fundamentals? To throw intrinsic value out the window and caution to the wind? No country for old fundamentalists, that much seems certain.
In any event, as I look at the past twelve months as opposed to the past three, both gold and the long bond have generated positive returns of 30%, more than doubling the S&P 500 over that frame and with a fraction of the volatility and drawdown risk. A three-month rally isn’t really a significant amount of time. I want to remind everyone that we had a 50% five-month bear-market rally from November 1929 to April 1930. How come nobody remembers that? They only remember the crash of October 29th,1929. Many people do know that the market endured an 80% downtrend to the fundamental lows in 1932 and also remember that the Great Depression didn’t end until 1941, which actually was eight full years after the official trough in real GDP. It was a depression because of the secular change in behavior towards balance sheets, savings and frugality. Last Friday’s most important data-point, which was the emergence of a 33% personal savings rate, was no blip but the start of a new secular trend.
Grab that coffee and find your favorite chair. We’ll look at what valuations tell us about coming returns and check out highlights from an excellent article on the bankruptcies ahead. You’ll also find an interesting chart on the “sell in May and go away” data back to 1950.
In the personal section, I share a few bullet points from Leon Cooperman’s Mauldin Economics Strategic Investment Conference presentation. Leon talks about capitalism vs. socialism and communism. He talks about taxes and the wealth gap challenges and his mission to lift others through education. Impressive man.
And finally, I share a fun video that went viral a few years ago about the Honey Badger (hat tip to good friend Chris Hempstead for his commentary comparing the powerful Honey Badger to today’s unstoppable stock market action). Honey Badger Don’t Care!
Praying for peace during these challenging times. I hope and trust this note finds you and your loved ones safe and well.
If a friend forwarded this email to you and you’d like to be on the weekly list, you can sign up to receive my free On My Radar letter here.
Included in this week’s On My Radar:
- Coming 3-, 5-, and 10-Year Return Forecasts
- America Inc. Faces a Wave of Bankruptcies
- “I Remain a Huge Doubting Rosie”
- Trade Signals – Bullish Trend Signals and Sell in May & Go Away Stats (1950-present)
- Personal Note – Leon Cooperman
Investing is a game of probabilities. The idea is to overweight equities when the return odds are significantly stacked in our favor, and underweight equities when those odds are lowest. Valuations can help us understand where we sit in a particular cycle. We can compare them to other points in time to see what happened 3, 5, and 10 years later.
I like to tell my kids about Warren Buffett’s hamburger analogy. Essentially, when the price of hamburger meat is low, you can get a lot more for your money. When it’s high, you don’t get as much for your money. He says investors should think about the markets the same way.
The next three charts look at 3-, 5- and 10-year return data from 1881 through March 31, 2020.
Here is how to read the charts:
- NDR broke month-end price relative to earnings (smoothed 10-year trailing earnings) into five groupings.
- The left-hand bar in each chart represents the “Cheapest 20%” of P/Es, the right-hand bar represents the “Most Expensive 20%” of P/Es.
- The green bars capture the single best subsequent 10-year return result in each of the groupings. The red bars mark the single worst result for each grouping.
- The box in the middle gives you a feel for the potential range of most of the subsequent returns, and the black horizontal line inside each box is the median of all results (the middle result out of all the actual return results).
- We are currently in the “Most Expensive” range (highlighted in yellow).
3-Year Real Annualized Price Returns
Probable coming annualized returns between 9% and -5% with a 3.5% median.
5-Year Real Annualized Price Returns
- Probable coming annualized returns between 7% and -2.5% with a 1% median.
10-Year Real Annualized Price Returns
- Probable coming annualized returns between 5% and -1% with a 3.5% median.
The best of all occurrences in the 10-year “Most Expensive” category was 10% and the worst was -6.5% per year for 10 years.
The current 10-year average P/E is 30.1. That’s the second highest in history. Bottom line: that’s the bet.
There are other ways to look at market valuation. This next chart plots stock market capitalization as a percentage of Gross Domestic Income (GDI) and sorts the current level into five groupings (Overvalued to Undervalued). We are in the “Top Quintile,” or most overvalued category.
- The red arrow in the upper left of the following chart points to the subsequent 1-, 3-, 5-, 7-, 9-, and 11-year average percentage change in the S&P 500 Index (note: not annualized).
- It is essentially telling us to expect returns from this point forward over the coming years to be negative with the exception of the 11-year period. There, your $100,000 will growth to $100,730. In short: the return odds are not in our favor.
- Lastly, note in the following chart the subsequent returns when in the “Bottom Quintile.”
Warren Buffett’s favorite indicator is the total size of the stock market or “Stock Market Capitalization as a Percentage of Nominal GDP.”
- The data goes through 5-31-2020.
- Focus in on the blue line.
- The hamburger meat (stock market) goes on sale at or below the black dotted line.
Lastly, here’s a look at the May 2020 month-end Median P/E chart:
In summary, I remain in the “be patient” camp. I don’t think it’s time to get aggressive on equities just yet. I continue to believe a retest of the March low is probable and represents a much better entry-level point. In hindsight, I top ticked the market top with my February 21 On My Radar note titled, “This is EUPHORIA. Wait for PESSIMISM,” and wish I upped exposure. However, a retest would present a more probable entry, as I believe the Fed is fully prepared to plug every new crack that presents. And we will most certainly see cracks.
It’s a “Support the market, let it attempt to stand on its own two feet, and come back in with the big bazookas when the next crisis presents” kind of strategy. I think that crisis will be a default wave and do believe we are in the “eye of the hurricane” of this recession storm.
Sell euphoria, buy pessimism. Feels again like EUPHORIA right now.
On My Radar is a global macro investment letter where I share what I feel are the most important issues we should keep on our radar’s. With that thinking, debt stands front and center.
From The Economist
“You will get business failures on a grand scale.” So declared James Bullard, president of the Federal Reserve Bank of St Louis, on May 12th. Peter Orszag, a former official in Barack Obama’s White House and now with Lazard, an investment bank, warned that the American economy could face “a significant risk of cascading bankruptcies”. How bad will things really get for America Inc.?
The country has already seen a surge of corporate bankruptcies among big firms that puts 2020 on track to be the worst year since 2009, at the height of the global financial crisis. In recent weeks well-known firms ranging from Neiman Marcus, a department-store chain, and J Crew, a clothing retailer, to Gold’s Gym, a glitzy workout group, have gone bust. Hertz, a giant car-hire firm, and Chesapeake Energy, a pioneer of America’s shale industry, are both on the brink of bankruptcy.
As the American economy sinks further in the coming months, many more firms are sure to get into trouble. This raises three questions. What early-warning signs might reveal the scale of the coming wave of bankruptcies? How does the looming disaster compare to the pain endured during the financial crisis? And are there meaningful alternatives to outright bankruptcy?
First, to harbingers of doom. One is the upheaval in the market for “speculative grade” (or junk) bonds. In America, two-thirds of non-financial corporate bonds are rated junk or bbb, the level just above junk. In April, Goldman Sachs, another investment bank, predicted that over $550bn of investment-grade bonds will fall to junk status by October (adding roughly 40% by current value to the junk-bond market).
Edward Altman of NYU Stern Business School reckons that about 8% of all firms whose debt is rated speculative grade (about 1,900 in all) will default in the next 12 months. This figure could reach 20% over two years. He expects at least 165 large firms, those with more than $100m in liabilities, to go bankrupt by the end of 2020.Treasury yields will move lower and stay low for a number of years.
A measure known as the “distress ratio” also highlights the problem. Distressed credits are junk bonds with spreads of more than ten percentage points relative to us Treasuries. S&P Global, a credit-rating agency, reckons that distressed credits as a share of total junk bonds in America had grown to 30% by April 10th, up from 25% on March 16th. Of the 32 worldwide junk-bond defaults in April, a level not seen since the financial crisis, 21 took place in America. S&P Global estimates that the 12-month trailing default rate for junk bonds in America increased to 3.9% in April, from 3.5% in March. In Europe it rose to 2.7% from 2.4%.
A wave of defaults might unfold with varying severity across different industries. Thanks to the collapse of the oil price as well as other troubles in the shale patch, almost 70% of the speculative-grade debt in the oil-and-gas industry is at distressed levels. Five other sectors have ratios of 35% or higher: retail and restaurants, mining, transport, cars and utilities (see chart).
The upshot is that a second, bigger wave of bankruptcies is on the cards. How would that compare to past troubles? At the peak of the financial crisis, the global default rate for junk bonds was 10%. Moody’s, a credit-rating agency, predicts that if the current crisis is more severe than the financial crisis, as now seems likely, the default rate could rise to 20.8% (see chart). The coming bankruptcy wave could be worse than during the financial crisis because it will be more widespread, reckons Debra Dandeneau, a bankruptcy specialist at Baker McKenzie, a law firm. But she thinks it will take some months to arrive: “We’re in the eye of the hurricane now.”
Another big difference to the financial crisis arises from uncertainty. The nature of this pandemic makes it impossible to know when the economy might return to normal. As William Derrough, a restructuring specialist at Moelis & Company, points out, “It’s very hard to value a company that doesn’t have clear cashflow and visibility on its future markets.” Jared Ellias at the University of California at Hastings argues that “lenders don’t know whether to restructure out of court, grant forbearance or insist on Chapter 11 bankruptcy when you have no idea when a firm will make money again.” Worried about the coming deluge of cases, he organised a group of experts that last week petitioned Congress to appoint more bankruptcy judges and increase budgets for law clerks and other staff.
“It will be very difficult for courts to keep up with the onslaught,” says Judith Fitzgerald, a former bankruptcy judge now at Tucker Arensberg, a law firm in Pittsburgh. Amy Quackenboss of the American Bankruptcy Institute, an industry body, reports that members are busy, which will translate into more filings later on. Larry Perkins of Sierra Constellation Partners, a restructuring firm, thinks a legal bottleneck is “absolutely” possible unless courtrooms “evolve to digest it”. Vince Buccola of Wharton business school thinks part of the solution lies in embracing faster “pre-packaged” bankruptcy deals and debt exchanges (lenders agreeing to swap less onerous new debt for old unserviceable debt) done out of court.
A looming wave of bankruptcy cases points to the third question: how viable are the alternatives? There is good and bad news. The financial crisis saw a massive liquidity crunch and financial-sector implosion. But as Bruce Mendelsohn of Perella Weinberg Partners, an investment bank, observes, “this crisis is the opposite. Capital markets are strong and open with many firms able to access capital from government or from markets, but…the fundamental operations of businesses are disrupted.”
There is a flurry of activity among investors pouring money into so-called rescue funds. According to Preqin, a data firm, distressed-debt funds are looking to raise nearly $35bn. General Atlantic, a private-equity firm, is in the midst of raising nearly $5bn to invest in otherwise-healthy businesses squeezed temporarily by shutdowns. Bill Ford, General Atlantic’s boss, thinks that outside the retail sector, where many business models will prove unviable, “most firms will try to avoid bankruptcy and seek rescue capital instead.”
All restructuring firms are hiring, notes Michael Eisenband of fti Consulting. He observes that there are more types of creditor today than during the financial crisis, so there is “more opportunity to get liquidity into firms in different ways.” He reckons few want to force liquidation because “if you can kick the can down the road, maybe a vaccine comes and…there is a better chance of getting a recovery for creditors.” Many hedge funds and non-traditional lenders (though not stodgy banks) are opting for debt-for-equity exchanges. That is so they “get the upside when the economy recovers”, says Thomas Salerno of Stinson, a bankruptcy lawyer.
So the good news is that many squeezed firms staring at bankruptcy might be saved through restructuring. Mr. Derrough, a veteran of financial crises, explains that this involves five steps: stopping the bleeding; evaluating the injuries; performing the necessary surgery; rehabilitating the victim; and returning it to health. The bad news is that America Inc. is at the start of phase one. As he puts it, “Most of what we are doing is blood transfusions. We haven’t even gotten to stopping the bleeding.
Source: The Economist
“The market is making a statement, for sure, and with an exclamation. I remain a huge doubting Rosie, and still see this within the confines of a classic bear market rally.”
– David Rosenberg
Here’s more from David Rosenberg’s Early Morning With Dave note from May 4, 2020:
Rosie went on to say that in hindsight, the 13.5 forward P/E multiple in mid-March was a no-brainer buying opportunity. He said he should have been much more bullish at the time, but the lack of earnings visibility and the dramatic tightening in financial conditions had him very concerned. And we still lack the earnings visibility and, he noted (as I did above), a wave of defaults and bankruptcies lie ahead of us.
June 3, 2020
S&P 500 Index — 3,080 (open)
Notable this week:
Sell in May and go away? Wikipedia defines it as follows, “Sell in May and go away” is a well-known financial-world adage. It is based on the historical underperformance of some stocks in the “summery” six-month period commencing in May and ending in October, compared to the “wintery” six-month period from November to April. If an investor follows the this strategy, they would divest their equity holdings in May (or at least, the late spring) and invest again in November (or the mid-autumn).
Some investors find this strategy more rewarding than staying in the equity markets throughout the year. They subscribe to the belief that, as warm weather sets in, low volumes and lack of market participants (presumably on vacations) can make for a somewhat riskier, or at a minimum lackluster, market period.
Following is some pretty cool data going back to 1950 looking at small caps (black line) and the S&P 500 Index (blue line) in the favorable October through April periods vs. the less favorable May through September periods.
May 2020 was an outstanding performance month for equities and thus far June is off to a bullish start. It’s notable that the strategy has not performed as well in the last half dozen years or so.
As for the trade signals, high yield is back to a technical buy signal, the CMG NDR Large Cap Long/Flat model remains in a bullish on large cap equities and volume demand vs. volume supply turned bullish this week. The negative (pessimistic) investor sentiment is neutral on the daily readings and remains bullish on the weekly reading (though investors are turning more bullish). The Zweig Bond Model remains bullish on high quality bond exposure. Gold remains in a long-term trend buy signals as well.
It is clear we are in recession (updated recession charts below). Most of the bad stuff happens in recession. Stay on your toes. Risk is high.
Not a recommendation for you to buy or sell any security. For information purposes only. Please talk with your advisor about needs, goals, time horizon and risk tolerances.
Click here for this week’s Trade Signals.
“Success is not final, failure is not fatal: it is the COURAGE TO CONTINUE that counts.”
– Winston Churchill
Following are a few bullet-point notes from Leon Cooperman’s presentation at the Mauldin Economics SIC 2020. Lee is a self-made man—a first-generation immigrant who went on to become an exceptional hedge fund manager. He’s pledged to give most of it away.
- On taxes: He believes this is the greatest country on the planet, and that a 50% tax rate on the wealthy is about right. Speaking for himself, he’s willing to work half the year for the government and half the year for himself and his family.
- He’s worried about class warfare due to wealth inequality. He said, “It really results in large part from income disparity. And I’m very sympathetic to that, but you have to deal with it.” Quoting Winston Churchill, he said, “You don’t make poor people rich, by making rich people poor.”
- Lee believes the way to approach the situation is through education. He said, “My family and I have sent 500 kids from Newark, New Jersey to college. We pay their tuition. We give them up to six years to get college degree. It’s life changing because, you know, the average lifetime earnings of a college graduate exceeds by well over a million dollars, more than a non-college graduate—plus you’re giving them more self-respect and the, the tools to be competitive in our society, I think through education is a way of dealing with it, not through just taxation. I mean, the government has not done intelligent things with the tax money they already gotten from us.”
- Lee continued, “I would tell Bernie Sanders, you know, he talked so favorably about Cuba. I went to Cuba three years ago. Okay. The Cubans are industrious, hardworking people. They’re doing extremely well in Miami. You go to Cuba; they get a quarter of a chicken once a month for their protein rationing. It takes two hours to get from the suburbs to downtown Havana, just to have no organized transportation system. It’s $3 and 85 cents a minute for cell phone service. They can’t afford cell phone service. They have no satellite service, no newspapers, and they live in dilapidated conditions.”
- He added, “Between socialism or communism versus capitalism, it’s very clear which system works better, very clear. For millennials and others who wish for socialism, my good friend Kenneth Langone, whom I have enormous respect for, would like to put a few people on his plane and take them to Venezuela to see what communism socialism is all about.”
There was much more to consider and digest. My conference notes are almost done—I’ll be sending them out shortly. If you’d like to receive a free copy, sign up here.
I believe in this (photo):
Finally, a little fun:
The Honey Badger Market
By Chris Hempstead
“Have you ever seen that funny honey badger video that went viral a few years ago? (34 million views; however, there is some bad language so be forewarned). https://www.youtube.com/watch?v=4r7wHMg5Yjg
This global market, across the board, is the HONEY BADGER MARKET!
Why, because honey badger DON’T CARE!
Nowhere to put oil amid record low demand? NO PROBLEM—prices are back to pre-crisis levels (do you know anyone commuting or flying? What happened to the storage issue?). Honey badger DON’T CARE!
All we have been taught about equity valuations? Nope. This is a new era that should have equity analysts very nervous. I don’t know of anyone who would have suggested that we would be at or near pre-crisis levels with the virus still climbing, the debt-to-GDP as high as it is, lockdowns still in place and spending this low.
Honey badger DON’T CARE… BUY STOCKS ANYWAY!
Record number of bonds in the bottom rung of IG (investment grade) and on watch for downgrade and HY debt at risk of further pain? Honey Badger don’t care! Spreads continue to tighten.
Are you still as bewildered as I am? Unlike the honey badger, I DO CARE!”
Wishing you and your family a safe, healthy, and happy weekend.
Stephen B. Blumenthal
Executive Chairman & CIO
CMG Capital Management Group, Inc.
Stephen Blumenthal founded CMG Capital Management Group in 1992 and serves today as its Executive Chairman and CIO. Steve authors a free weekly e-letter entitled, “On My Radar.” Steve shares his views on macroeconomic research, valuations, portfolio construction, asset allocation and risk management.
Click here to receive his free weekly e-letter.
Follow Steve on Twitter @SBlumenthalCMG and LinkedIn.
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