“These days I’m often asked questions like “will the recovery be a V-shape or a U, W or L?”, and ‘which of the crises you’ve lived through does this one most resemble?’ Answering questions like those requires a historical perspective. Given the exceptional developments [ in the current environment] however, there’s little or no history that’s relevant to today. That means you don’t have past patterns to fall back on or extrapolate from. As I’ve said, if you’ve never experienced something before, you can’t say you know how it’s going to turn out.” 1
~ Howard Marks
“I understand the temptation to go along and become an armchair virologist or epidemiologist, but I’m trying very hard to resist. Look, I don’t know. I have no background in this stuff. Now the economists are jumping in and fitting curves and doing what they do best. It does seem the market, at least, is very strong in its belief that this is going to be over pretty soon. That kind of certainty always reminds me of Voltaire’s wonderful quote, which goes something like, ‘To live in doubt is unpleasant. To live in certainty is absurd’. That strikes me as how the market is behaving right now, acting as if everything is pretty clear cut and certain. The one thing I am certain of is that I’m not certain of that.” 2
~ James Montier
“All those things are telling you everything is not OK, and then you look at the S&P 500- it keeps going up. The market doesn’t care about valuations. With the Fed continuing to step in, the right bet has been to bet with the Fed. The trends are your friends right now, just keep riding it higher and it’s almost a little bit like, stick your head in the sand.” 3
~ Jerry Braakman, CIO, First American Trust
“Central Banks are creating a shortage of kitchen sinks as they load up on what to throw at the virus next.” 4
~ Bill Blain
In looking over my first quarter investment comments, printed in April, I note that I had indicated then that “we are now at least fully on notice about (the coronavirus), and have made steps in the direction of known unknowns, those things we know we don’t know. That still leaves us a good way off from being able to answer the ‘when will it end and from what level?’, questions, the answers to which will in turn help to guide us on the economy, the markers, and the disruptions to our personal lives…”
It seems somewhat quaint now to think that, back then, many assumed that the medical part of the crisis would be over in a few months, or would end when warmer weather arrived. Not only has it not ended, but the recent case resurgences in various Sun Belt states would seem to indicate that we are not much farther along in answering the above questions than we were then, and this despite heroic and accelerated efforts in the Global Medical/Biotech community to find a COVID treatment/cure. I also note in that letter a pledge to help clients “stay the course” and get through the market crisis, by writing shorter updates periodically, until things calmed down. I didn’t do so, because it turned out that the continuing crisis in the markets failed to materialize. Having dropped about 34% from the highs to the lows (so far) on March 23rd, the S&P 500 rebounded a bit to close off “only” about 20% for the first quarter. At April 30th, the market had recovered to a year-to-date loss of about 10.6% (all numbers principal-only), and at the end of May, down 6.5% YTD. The rally continued in June, albeit more modestly, with the Index down 4.8% as of June 30th, and, as of this writing, the Index is down about 1% YTD, and at about break-even including dividends. Crisis, what crisis?
The first quarter was so bad, and the second quarter was so good, that both fall into the Top 10 for best/worst quarters since 1926.
There’s an old saying on Wall Street that goes something like:
In the business world, things generally tend to vary from “pretty good” to “not so hot”, while stocks, (guided as they are by human emotions) tend to vary from “Perfection” to “Disaster”.
Well, we went from perfection in stocks and their prices at the beginning of the first quarter, to something resembling disaster in most investors’ minds a month later, and we are now back to, if not perfection, at least virtually at all-time highs again, even as the economy – all of the stimulus and financial aid notwithstanding – continues to be something of a basket case. And we owe much of this market recovery to the Fed, which hit the “inflate” button on its balance sheet, with stocks following in lock step:
The Fed’s balance sheet went from about $4 Trillion at the end of February to a little over $7 Trillion at the end of May, and Uncle Sam is now borrowing more in a month (via Treasury issuance) than in most prior years…and, notwithstanding a slight tail- off since, with plenty of promises for more, if/as necessary. For instance, Fed Chair Powell gave an interview to 60 Minutes on May 17th in which he indicated:
“We’ve done what we can as we go. But I will say that we’re not out of ammunition by a long shot. No, there’s really no limit to what we can do with these lending programs that we have. So there’s a lot more we can do to support the economy.” 5
By Fed historical standards, any one of those sentences would have been ground-breaking, plain-spoken, and bullish; three strung together like that was unprecedented. And so stocks have continued to scamper higher still.
A big unexpected rally is great, don’t get me wrong, but there are a couple of items wrong with this picture.
For starters, before COVID-19 and its economic fallout, valuations were already stretched. They are stretched even more now. Stocks are back to about where they were last October. Back then, the consensus view on S&P 500 2020 operating earnings per share was about $180, and about $196 for 2021. Those numbers today are about $128 and $164 respectively, and likely to head lower once we get into second quarter earnings results. The P/E multiple for 2020 estimates back then was 18X; at current prices it is 25X. For 2021, what was a 16X forward multiple is now a 20X multiple. 6
We aren’t priced for a recovery, we’re priced for boom times.
To paraphrase GMO’s Jeremy Grantham, we now find ourselves in the top 1% of stock market valuations and the bottom 1% of economic outcomes, based on the annualized rate of decline in second quarter GDP. Part of the reason for this of course is that even as stock prices followed the Fed’s balance sheet higher (top chart) earnings estimates – the normal fundamental underpinning of stock prices – have tanked (bottom chart):
Meanwhile, the stock market has become even more concentrated. The top five companies make up about 22% of the S&P index, while the ten largest now weigh in at almost 30%. For the tech-heavy Nasdaq Composite, those numbers jump to 40% and 50% respectively. These companies have been powering the averages higher, but problems with any of them could have an outsize impact on overall returns, a risk that does not seem widely appreciated currently.
For the moment, as indicated in one of the up-front quotes, valuations don’t appear to matter, and who cares what the levels are anyway, as long as the Fed keeps doing what it’s doing. The problem is that valuations have fairly consistently mattered in the past, and I expect that they will continue to do so, and if those looking for a V-shaped economic recovery are disappointed, because of the virus or otherwise, and earnings don’t “catch up” to stock prices, well then, stock prices might “catch down” to economic realities instead, Fed or no Fed..
At any rate, do you see a “boom” in the making, in the currently constrained world around you?
Many of the folks who have a better finger on the pulse of the economy than most toil in the large commercial banks. Second quarter earnings season just started, and as usual it was led off by some of the major banks. JP Morgan, Citi, Wells Fargo, and Bank of America all reported last week, and generally met earnings expectations due to trading profits, but they also collectively set aside almost $33 Billion in the quarter as reserves for upcoming credit problems, up $10 Billion plus from the first quarter rate.
One might hazard a guess that they aren’t looking for a V-shaped recovery at this point. And, if there was any doubt, JP Morgan CEO Jamie Dimon summed it up on the earnings call:
“This is not a normal recession. The recessionary part of this you’re going to see down the road. You will see the effect of this recession. You’re just not going to see it right away because of all of the stimulus”.
Note that these guys don’t speak off the cuff, and that paragraph on his teleprompter used the word “recession” three times, and “recovery” not at all. His peers at the other large banks sounded equally doleful.
The other problem is the Fed itself, despite all of its largesse. As Grant Williams recently put it:
“Obviously, Equity markets are looking past the current recession to the sunlit uplands beyond, but should the much-vaunted V-shaped recovery fail to materialize, we’ll be in a world of trouble because, while the Fed can print money, they can’t print jobs and they can’t subvert the bankruptcy process.” 7
Powell’s recent 60 Minutes comments notwithstanding, he presciently expressed the same sort of reservations in the FOMC minutes back in 2012 (underlining mine):
“The market in most cases will, cheer us for doing more. It will never be enough for the market. Our models will always tell us that we are helping the economy, and I will probably always feel that those benefits are overestimated and we will be able to tell ourselves that market function is not impaired, and that inflation expectations are under control. What is to stop us, other than much faster economic growth, which it is probably not in our power to produce?
Belief in the Fed has propelled us back to the highs: if the economy doesn’t follow, and that belief is not sustained, and/or the Fed is perceived to have run out of “kitchen sinks” to throw at the situation…well, there is plenty of precedent for markets acting poorly in the past despite the Fed’s ministrations.
Finally, there is the matter of the market’s activity this year, and how it is being perceived by traders and investors. We have gone from the February highs into a swift Bear Market drop, based on the coronavirus threat and the nationwide economic shutdown that it caused. This was followed by an equally swift, and certainly gratifying, recovery (because, the Fed, vaccine hopes, and, economic re-opening). “Buy the dip” works again, vaccine(s) and V-shaped recovery to follow shortly!
The problem, as we sit here at more-or-less “market unchanged” levels (even though there is a lot of damage under the hood) is that Bear Markets are usually a process, not a one-and-done sort of thing.
As I have indicated before, in 15 Bear Markets since 1950, only one did not see the initial major low tested within three months. In the other 14 cases, the low was tested once or twice. Given current and prospective news flow, it seems unlikely that the current cycle will prove to be the second exception to this very long-term trend.
Now 70 years is a very long time, and much has changed in the interim, and perhaps (cue the fateful words) things are different this time. Perhaps so, but a couple of more recent examples- the last two major Bear Markets- certainly argue against this.
First, the action in the S&P 500 after the Dot Com peak in 2000 looked like this:
9/1/00 – 4/4/01 -27%
4/4/01 – 5/21/01 +19%
5/21/01 – 9/21/01 -26%
9/21/01 – 3/19/02 +22%
3/19/02 – 10/9/02 -33%
Or, the more recent Great Financial Crisis era:
10/9/07 – 3/10/08 -18%
3/10/08 – 5/19/08 +12%
5/19/08 – 11/20/08 -47%
11/20/08 – 1/6/09 +25%
1/6/09 – 3/9/09 -27%
For a broader view, note that it took until May of 2007, or almost 7 years, for the stock market to regain the September 2000 highs, and it took until March of 2013, or 5+ years, to regain the October of 2007 highs. 8 In that context, it’s hard to imagine that we’ve regained the prior highs after five months, without further incident but, hey, these are unprecedented times, so I suppose you never know…
Cue also Mohamed El-Arian, former Vice-Chair of PIMCO in a recent Financial Times article:
“Liquidity- driven rallies are deceptively attractive and tend to result in excessive risk-taking. This time, retail investors are front and centre. But it is the next stage we should already be thinking about. That requires more scrutiny from investors than the past few months have demanded.” 9
He seems to be looking at the same data as Jamie Dimon…
And, while we’re at it, and per his “retail investors are front and centre “comment, Schwab just reported that new retail brokerage accounts added in the second quarter rose to 1.65 Million, vs. 1.08 Million expected, and more than four times the tally in the second quarter of 2019. Trading activity meanwhile was up 126% from a year ago. This sort of activity tends to manifest itself at market tops, not bottoms.
With a nod to Messrs. Marks and Montier on page one, where we go from here is not certain. Much of what transpires will depend on the virus, and whether consumers (still about 70% of GDP) can –and then will– get out there and consume, particularly if/as some of the COVID stimulus programs come to an end. As Alan Blinder, former Fed Vice-Chair, said in a piece in the Wall Street Journal on July 17th, “The economy won’t get healthier while America gets sicker”. While there may or may not be prophesy in that, it certainly sounds like common sense to me.
Given present valuations, and the potentialities before us (before we even get into the potential ramifications of the Presidential Election, which will occur in a mere 16 weeks), we are in no particular mood to chase the stock market, although of course in the “market of stocks”, individual opportunities do shake loose from time to time.
In conclusion, a couple of non-investment items:
First, we are still working mostly remotely and, given the time elapsed, we’ve gotten pretty good at it, even if (high class problem alert!) we are getting a bit tired of the whole routine, as you probably are as well. We are looking towards being back in the office on a more or less full-time basis again after Labor Day, but of course that will depend on developments, COVID and otherwise. More on that score as we know it.
Second, I am very pleased to announce that Radnor Capital Management is growing; current COVID dislocations notwithstanding, we have just added two new people to the team.
First, August Gerhardt, CFA, joins the firm as a Senior Portfolio Manager and contributor to our research effort.
Here’s a brief resume for August:
Prior to joining Radnor Capital Management, August was a Vice President at Pennsylvania Trust, where he was a portfolio manager and a member of that firm’s investment committee. In the latter role, he made investment recommendations based on fundamental research for the firm’s Multi-Cap Value and Equity Income strategies. Starting 2019, he also managed the firm’s Equity Income strategy. Prior to Pennsylvania Trust, August was an investment analyst with Spartan Capital, LLC, which merged with Pennsylvania Trust in 2012. August is a Chartered Financial Analyst and a member of the CFA Society of Philadelphia.
August received his B.A. from Hobart and William Smith Colleges, where he double majored in Economics and International Relations. He also attended The London School of Economics.
At the same time, Mary Ellen Gilroy joins us as a Client Service Officer.
Here’s some background on Mary Ellen:
Mary Ellen has over 25 years of experience working with high net worth clients and foundations. Before joining Radnor Capital in mid-2020, Mary Ellen was a Senior Investment Assistant and part of the Investment Department at Pennsylvania Trust, where she worked with investment advisory clients, Foundations and Trusts. Mary Ellen was a Senior Investment Assistant at 1838 Investment Advisors, where she worked with high net worth families and institutional clients of the firm. Prior to joining 1838 in 1996, she was an assistant in the Personal Law Section of Morgan, Lewis & Bockius.
They will be working as a team, while also contributing more broadly to the effort here. When we are better able to do such things, I look forward to introducing them to you in person.
Please let us know if you would like to discuss any of the foregoing, or your portfolio, or if we can be of service otherwise. In the meantime, stay cool, be safe, and enjoy the balance of the summer, wherever it finds you; we will be in touch as the current drama unfolds.
 Memo To Oaktree Clients; Uncertainty; 5/11/20
 As Quoted in Value Investor, 4/30/20
 Bloomberg, 6/3/2020
 Bill Blain, The Morning Porridge, 5/7/20
 Stats Courtesy David Rosenberg, Early Morning With Dave, 6/24/2020
 Things That Make You Go Hmmm, Vol 7, Issue 13, 7/5/20
 Statistics courtesy Howard Marks; Memo To Oaktree Clients, Calibrating, 4/6/2020
 Financial Times, Investors Must Prepare Portfolios for COVID-19 Debt Crunch; 7/15/2020
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