March 9th, 2020

The Intelligent Investor's Market Memo

After the Worst Week Since 2008, Stocks Were Mixed Despite an Emergency Rate Cut From the Fed

Stocks were mixed last week despite an emergency 0.50% interest rate reduction by the Fed. On Tuesday morning, the Federal Reserve announced a surprise 0.50% interest rate reduction to boost investor sentiment and ease financial conditions. Fed Chairman Powell said that the Fed “saw a risk to the economy and chose to act.” He added, “the magnitude and persistence of the overall effect on the U.S. economy remain highly uncertain, and the situation remains a fluid one.” “Against this background, the committee judged that the risks to the U.S. outlook have changed materially. In response, we have eased the stance of monetary policy to provide some more support to the economy.”

After an initial jump due to the unexpected rate cut, stocks closed the day down 2.8%, as investors used the Fed-induced market rally to de-risk their portfolios. In our view, it is a bad sign that investors sold aggressively into the Fed’s surprise move. The market’s poor reaction was due to the Fed’s poor timing,  traders "selling the news," and the belief that monetary policy can't stop a virus.

This week the 10-Year U.S Treasury bond yield plunged by 0.41% to an all-time low yield of 0.70%.  In the past three weeks, the 10-year has dropped by an incredible 0.88% from 1.59% to 0.70% due to the fear that the coronavirus will lead to a global recession.

For the week, the S&P 500 and the tech-heavy Nasdaq 100 bounced by 0.60% and 0.80%, respectively, and the small-cap Russell 2000 dropped by 1.3%. International stocks were mixed, the MSCI EAFE Index (international ex-US and Canada) rose by 0.22%, and the MSCI Emerging Markets fell by 0.96%. 

The economically sensitive commodities were mixed – oil fell by 7.8%, while copper rebounded by 0.80%.  The safe havens performed very well. The U.S. Treasury long-bond (TLT) rose by 7.5%, while gold jumped by 6.75% for the week. While the S&P 500 is up by 8.4% over the last twelve months, it is underperforming gold (up 19.4%) and the long bond (up 37.2%), which indicates a high-risk environment.

The S&P’s sectors were also mixed this week. The defensive sectors performed well, Utilities (up 8.0%), Consumer Staples (up 6.l%), Healthcare (up 4.9%), and REITs (up 4.6%).  The economically sensitive sectors performed poorly, Energy (down 6.1%), Financials (down 3.9%), Communication Services (down 1.85%), and Consumer Discretionary (down 1.0%).

This weekend the markets were hit with more bad news. Saudi Arabia initiated an oil price war with Russia because they refused to reduce production in an attempt to stabilize the oil market. Oil prices plunged by 25% to $30.5 on Monday. While lower energy prices are good for consumers, the oil crash could lead to many bankruptcies and layoffs in the U.S. oil patch. Fears of the virus and the new oil price war caused stocks to plunge Monday morning -- triggering the first trading halt since 1997. The S&P 500 closed Monday down 7.6%, which was its worst day since the 2008 financial crisis. The energy and financial sectors were hit the hardest, plunging by 20.1% and 10.7%, respectively.

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Our View

In the short-term (three-months): stocks are in a panic, and volatility is near record levels. We reduced our cyclical holdings and increased defensive positions. The market is oversold, and investor sentiment is fearful, yet we will patiently wait for improving market breadth and a positive divergence by the bond market before adding to our risk exposure. Our Tactical Asset Allocation turned negative when the S&P 500 broke below its January 31st low (SPX 3215).

In the long-term (more than four years): despite the sharp decline, we continue to believe that the stock market offers a poor risk-reward. Central bank liquidity and not economic fundamentals drove stocks far from their intrinsic value. The global economy was vulnerable before the coronavirus, and now we believe the odds of a worldwide recession have increased dramatically. Because the Fed did not “normalize” interest rates during the economic expansion, they have fewer tools this time to fight an economic contraction. Also, since corporate debt levels are an all-time high, we are concerned that if we enter a profit recession, many corporations will have difficulty meeting their obligations. Our Strategic Asset Allocation is underweight equities relative to our benchmark.

Market Outlook

As we discussed in last week’s memo, the S&P 500 rallied by 18.8% from its October low to its February 19th  high on the belief that the Fed’s aggressive monetary actions (printing money to buy $60 billion of U.S. Treasury bills each month) and the signing of the “phase-one” trade deal with China would lead to an acceleration in economic growth. Instead, the Fed’s massive liquidity injection led to a very overbought stock market and complacent investors when news of the coronavirus first impacted the markets in January. 

While the resilient stock market reached an all-time high despite the uncertainty over the virus, the bond and commodity market signaled that the economy was at risk. Bond yields plunged, the price of oil and copper crashed, and the yield curve inverted while the S&P 500 made a record run.

Our short-term market outlook was reduced to negative on February 25th, when the S&P 500 broke below its January low. We believed that the yield curve and the drop in bond yields and commodity prices indicated an increased probability of a bear market and a recession. We believed that prudent investors should use any Fed-induced rally to reduce their risk exposure.

On Tuesday at 10 am, the Fed tried to surprise the market with an emergency 0.50% rate cut. Stocks initially rallied, which completed a 52% retracement of the previous decline. (see chart below). Instead of increasing confidence, the Fed’s action led investors to “sell on the news” driving stocks down 2.8% on the day.

Despite the emergency rate cut, the bond market indicates that the Fed is still behind the curve. Currently, the Fed Funds rate is 1.00%, which is significantly above the 2-year U.S. Treasury yield of 0.38%, and the 10-year U.S. Treasury yield of 0.50%. According to Fed Funds futures, there is a 65% chance that the Fed cuts in by 0.75% to 0.25% at their next meeting on March 19th.

If the Fed cuts short-term interest rates to nearly 0% next week, the only tool they will have to fight a potential recession is Quantitative Easing (“printing” money to buy bonds), which will have limited economic impact because interest rates are already so low.

Given the yield curve and the sharp declines in stocks, commodities and bond yields, we believe the odds are high that were are in a bear market, and a recession will occur in the first half of 2020. Since the typical bear market is a drop of 32% for the S&P 500, we may be through the bulk of the decline already.

While the strength of the consumer and the robust labor market should lead to a mild economic contraction, we are concerned that the enormous corporate debt burden could turn a mild recession into a financial crisis. Since the last recession in 2008, the Fed kept interest rates artificially low to inflate the stock market and encourage lending. In fact, interest rates were below inflation for most of the past ten years (see chart below).

Corporations took the bait and borrowed to buy back their stock and acquire other companies. This financial engineering -- buying instead of investing and building – led to a record corporate debt burden (see chart below). Historically, excessive corporate debt levels to GDP have led to recessions.

Currently, 50% of investment-grade bonds are rated BBB, which is one level above junk. We are concerned that as the coronavirus slows the economy, debt downgrades and defaults will lead to additional economic pressure. Currently, corporate bond spreads are elevated, but significantly below the level that would indicate a potential financial crisis (see chart below).

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Stocks are Expensive, and Earnings are Vulnerable

On February 19th, the S&P 500 closed at 3393.5, which was an all-time high. Since analysts forecast the S&P 500 to earn $177 in 2020, the market sold at a P/E of 19.2, which was the highest P/E since May 2002. Additionally, the 19.2 P/E was 32% above its 15-year average P/E of 14.5 times earnings.

According to Factset, analysts currently expect earnings to grow by 6.7%, down from 9.2% on December 31st. We believe that profits will be flat to down this year, and we expect that valuations will regress to an average level, given the economic uncertainty.  While it is difficult to have a credible earnings estimate at this time due to the uncertainty due to the coronavirus and the oil price war, we can value stocks based on last year’s earnings.

According to S&P Global, GAAP earnings for the S&P 500 were $139.7 last year. If stocks sold at their average historical P/E of 15.8, the S&P 500 would fall to 2207, which would be a 35% bear market.

In this uncertain environment, we believe that investors should focus on preserving capital and playing defense. Though the Fed is expected to cut interest rates to zero and provide monetary accommodation, we think it will have little economic impact, and the Fed will be “pushing on a string.” We believe that prudent investors should use any Fed-induced rally to reduce their risk exposure and play defense until the virus is contained, the economic damage is known, and stocks have a favorable risk-reward.

About the Author

J. Lawrence Manley, Jr., CFA has always had a passion for investing and has been lucky enough to spend nearly 25 years managing investment portfolios for pension funds, endowments and high-net-worth families. In his experience, there are two major obstacles preventing individuals from reaching their investment goals: Wall Street and Human Nature. Manley Capital was founded to overcome these obstacles and partner with clients to achieve their financial goals.