I did a post yesterday on some data points to consider before buying in this market. I’ve been nibbling on the way down, but looking at some of the data points, I have to agree with what Gavin Baker has said in a recent post: this is a tremendous demand shock that we have not seen the likes of before. It will be very difficult to navigate it this time because its almost like a 9/11 and a 2008 demand shock rolled into one (but not a financial crisis like 2008 was).
The market clearly priced some of this in. The chart below shows the Russell 2000 drawdowns in the past. We’ve already surpassed the drawdown of 2001-2002 and did so much more swiftly. If anything, this drawdown is looking like 2008 just from the slope of the line (its steep).
The Fed has acted quickly, congress knows it needs to get its act together, Trump views the stock market as the best polls, proposals are coming together to give every American $1,000 to bridge the gap, and there is plenty of talk of bail outs. Seems like some lessons were learned from 2008… act fast.
But is that enough? Is everything “priced in”? How will the market react to new information of cases vs. stimulus? That’s a billion dollar question. Personally, I think we have further to go before I can say we all need to “back up the truck“. Yes, I view this as temporary and there will be pent up demand, but as I think through what happens over the coming months, it goes something like this:
- Markets have tanked, fear is palpable, there have been runs on grocery stores. Consumers are literally quarantined so the only thing they can think about is the pandemic which drives more fear
- Congress and Fed act quickly, but this also tells people that things are serious. Congress puts together a bill to give $1,000 to every American; agrees to provide some loans to essential industries
- Just like GM – I don’t see why Congress would give a subordinated loan to these industries. In other words, it primes (or comes in front of) existing lenders plus equity holders. It’s hard for me to see how equity holders get out scot-free here, as well as bond holders. Haircuts will be taken.
- Even with Congress taking action, if I work in the restaurant, bar, travel, event hosting, leisure, or any service industry remotely attached to that, I’m thankful for $1,000, but I am worried about my job. I pull back spending considerably. As a consumer, thanks for the grand, but I still am not spending much.
- This ripples through the economy. First pullbacks on major purchases (vacations clearly cut, but also autos and home buying) and that continues through everything else.
- All the while, US count of the virus will likely grow considerably. We likely reach 100,000+ cases as more tests come out. This will cause the market to freak out and people will go from thinking this is a four week thing to a 12 week thing… maybe longer. The market always assumes the bad things will last much longer than they do.
- Media headlines will run rampant.
- You will also see bankruptcies of small and large businesses. BDCs and middle market private equity that invested (& levered up) companies with major customer risk and exposure to small business? See ya later.
- Elsewhere, cases will begin to decline. Markets will take a deep breath that the measures are working, even if they continue to climb in the US. The market is forward looking so they will see hopes for the US.
So what does that mean for equity prices? I think we have further to fall, unfortunately. Don’t get me wrong – I fundamentally do not believe you can time these things (“Well gee, you sure did waste a lot of text writing about what you think will happen…”) and I have bought many names throughout this bear market. As I noted in my cruise lines post, which was really clickbait for readers to see that long-term intrinsic values of businesses will be fine, I think this creates a good opportunity to buy high quality businesses.
At the same time, I look at the market and it is just below / slightly above Dec 2018 lows depending on which market you’re looking at. As a quick barometer or sanity check, that doesn’t seem low enough for truly pricing in a destruction to GDP in Q2 this year and people worrying about systemic issues.
Backing it up to a P/E ratio: If we did $164 in EPS for 2019. There’s probably 0% chance we’re up from that number. We can haircut it though and multiple to see where things could shake out this year. You can argue that because these are depressed earnings and we all likely expect a rebound, that the market should trade at a premium multiple. However, I rarely see that play out in real life. Panic causes people to over shoot. And again, this is a cheapness indicator, not an intrinsic value indicator because one year of bad earnings does little to impact your DCF.
This essentially tells me that my “back up the truck” moment for S&P500 is somewhere around 2,000 and below and I’ll still be a buyer at around 2,300 because I believe the storm clouds will eventually pass and this shows if we go back to 18x $164 in earnings, that is very solid upside.
Ok – I put my thoughts out there. I open myself to being wrong in the future and this post won’t be deleted. Where do you think we shake out? Why?