There’s good news regarding the flattening of the curve; we believe the US peaked on death rates in mid-April.
Although we continue to see high death rate counts (between 1500 and 2500 deaths most days), it is important to point out the rates have not been growing. Several states, many in the south, are scheduled to open or are already open. At GWS, we are watching a unique and simple index to see how much damage has been done to the economy.
The “Waffle House Index”
The Waffle House chain is notorious for keeping its doors open when everyone else’s are shuttered. It might sound fake, but this index actually serves as a great litmus test for infrastructure damage, and FEMA uses it to gauge hurricanes’ damage.
It is a simple index:
- GREEN: Full menu. Restaurant has power and damage is limited or no damage at all.
- YELLOW: Limited menu. No power or only power from a generator, or food supplies may be low.
- RED: The restaurant is closed – indicating severe damage or severe flooding.
This index could be our first indication of COVID-19’s damage to supply chains.
When Will GDP Bottom?
Because GDP is a lagging index, it is more challenging to identify exactly when it bottoms. We are monitoring two systems to give us an indication.
The first is Atlanta Fed GDP now, which captures consensus and their own algorithm on GDP. The green line is the algorithm, but it is admitting it cannot forecast COVID. The consensus is well below with a -4% drop.
The second index trying to gauge in real-time is the New York Nowcast. The index is indicating manufacturing data, surveys, and retail and consumption data is indicating a 7% (annualized) drop the previous week. We will watch to see when the data begins to suggest a bottom and show positive growth.
Market Recap Themes
Let’s move on to our weekly recap of the market. As a reminder, our current themes are:
· Inflation risk is high
· We favor equities over bonds
· We favor US Large Cap as a sub asset class
· And are bearish on Commodities, Real Estate, and International Developed
We continue to follow a V-shaped recovery, though the slope of the V is slowing. This is normal. So far, we continue to “climb the wall of worry,” meaning there is a lot of disbelief in the rally. Still, the market slowly grinds higher, and we will continue to monitor its shape.
Time to Put Cash to Work?
Many clients ask whether they should put money in the market. Long-term, we believe it is prudent to do so and have considered this a buying opportunity through the whole bear market correction.
It is hard to time the market, but it is also painful to put money in and watch the market selloff. We have added a Price Point chart to help visualize the risk of putting cash in the market.
Right now, the S&P is trading at a resistance level of 2950. The next resistance is 50 DMA, which currently is at 3000. The previous resistance is now support at 2850. This does not mean these will hold. But many watch these as confirmation.
If you break resistance, there tends to be a flow of money into the market with a quick shot upward. And if you break support, there is often a large flow of money out and the market moves down. With the help of the Investment Committee, we hope to better identify some decision points for adding cash to the market.
This is a big week for the market as companies are issuing earnings reports. Many of the names we hold in clients’ portfolios are reporting — for instance, Amazon, Google, and Microsoft are all big names and positions.
Earnings are over the 1st Quarter, so it still shows pre-lockdown results. However, we do expect the companies to have lower earnings. Analysts are not worried about this quarter’s earnings or the next quarter; they are looking long-term. And companies know this.
Let’s go over a phenomenon called “Big Bath Theory.” It is common practice to use the income and balance sheet to bring earnings within the company’s guidance. This means there are projects and impairments that really should have been expensed but have not made it to the income sheet. Companies will realize these expenses now while there is cover and blame them on the virus, rather than the company’s management.
We expect non-cash charges to increase pushing earnings lower than otherwise; however, this also means clean and lower balance sheets. Coming out of the correction, we would see higher fundamentals when comparing cash flow or income (earnings) to the balance sheet. There will certainly be real efficiencies gained, but it will be compounded by the lighter balance sheet after the recovery.
This moves us into current valuation. Remember, analyst and the market do not care about next quarter or even Q2. This gets us into 2021 with a four-month forward projection.
- 2019 S&P earnings were $165
- Consensus growth rate was 8% for earnings (2020 expectations 1.08 x 165 = 178)
- Dec 31 S&P 500 3220/178 = 18x forward earnings entering the year.
- Assuming the Big Bath Theory, 2020 is getting thrown away and looking at 2021.
- Let’s assume a 30% decline in earnings followed by a 30% rebound in 2021. 165 x .70 x 1.3 = 150.15 (This is still below 2019)
- Apply 18x multiple 2700 would be a fair value.
- We believe the 150 is cautious, but many may object to the 18 multiples.
Note the Higher Multiple
First, what do we mean by multiple? Let’s start by reviewing what the PE ratio is: simply the price of a stock or index over the earnings. You can determine the fair price by taking the earnings amount times the PE multiple.
How do we justify the PE ratio? Well, there is an equation. I won’t get too wonky, but this basically determines the value of the income stream (future earnings) when accounting for growing income stream. It compares the value of the stock earnings to the value you can earn on a risk-free bond and justifies a PE multiple by making them equal on a risk adjusted basis.
- The denominator is the expected return minus the growth rate of the earnings.
- The r is the required rate of return. And this is determined by adding the risk-free rate (treasuries) and the equity risk premium (how much more you should earn for taking equity risk).
- This means the risk-free rate interest rate is in the denominator. If the risk-free rate goes down, then the justified P/E would go up. Or the multiple goes up.
- Remember 18 was the justified PE when interest rates were higher.
- This may sound strange, but if you get paid less to hold bonds than before, then stocks should benefit.
So, if the justified PE moves to 21, and we still use the cautious 150, then the S&P would have a fair value of 3150.
Market Psychology: Buy on Fear
We’re calling this the “Fear Index” (see graph below). It might seem counterintuitive, but it compares the 30-day futures markets to the 90-day futures market. When we get the spikes up, it means 90-day options are not pricing in as much uncertainty and are higher. That would be a good time to pair with that price point and put it in cash.
Consider the recent issue with oil. The deliveries were negative, but July contracts were still trading at normal levels. This gauges fear in the short-term. So, think of the spikes as buying opportunities.
What about when you need to take money out of the market? Let’s say you were doing a 401(k) rollover. If the market is very volatile, you can miss a lot of return in just a couple of days. When it gets below the red line in the chart on the left, this would be a good time to make those rollovers, as well as the middle group.
We are currently working on an intuitive gauge “Fear Index” to measure this.
What Are the Chances the Fed Will Raise Rates?
The Chicago Mercantile Exchange (CME) shows pricing and future rate hikes. The Fed met Wednesday, and this data shows a 0% chance of a rate hike. However, that statistic reaches out to March 2021. So, for a year, the market is predicted to have no rate hikes for the whole year. This could change, but we find it very interesting.
Now, let’s take a look at the Fed’s balance sheet.
This graph shows how the Fed has been increasing their balance sheet (i.e., “printing money”) through quantitative easing. What I like to do is overlay the S&P 500. It starts out in 2011, and you can see that through 2016 the S&P is following along with the balance sheet.
You’ll notice the relationship seems to separate around 2016. What happened that year? We had substantial tax cuts for corporations. That changed the earnings multiple we were looking at, because the government took in less money, and the earnings went up (all other things being equal). But as the economy rose and the Fed stopped their quantitative easing, you can see a pullback in the market. Basically, those lows start to follow that same pattern.
If you look at the very beginning of the blue line on the Fed’s balance sheet, you see a “hockey stick” shape, where the balance sheet has one again exploded. So, a lot of people ask how we can talk about a V-shaped recovery when we see so much unemployment and difficulty in the current market environment. We think that this relationship is going to help, whereby the Fed continuing to purchase and stimulate the economy will offset a lot of that. Plus, people who are unemployed actually have very good (relative to pre-COVID) benefits. There is still purchasing power out there.
Death rates look like they’ve peaked, individuals and small businesses are benefitting from the CARES Act, and the recovery is still tracking toward a V-shape. Things are looking up for the economy, and we at GWS are here to keep you updated along the way. Please feel free to reach out to your lead advisor with any further questions or to discuss your personal portfolio.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
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