"LOOK, DADDY, THE STRATEGISTS WEAR NO CLOTHES!"-- A CASE FOR A RETEST OF THE LOWS

During the Great Recession, annual operating earnings of the Standard and Poor’s 500 Index (“the Index”) fell 56% from a high of 91 to a low of 40. As the current recession unfolds, the consensus is that it will be worse in depth than the Great Recession, although highly likely less in duration. If you take 44% of the Index’s operating earnings of 157 during 2019, earnings for 2020 would be 69. So far few strategists have come close to forecasting that low a number.


Here’s how one could envision 2020 earnings dropping to 69. The lockdown of the U.S. economy began just three weeks from the first quarter’s end. Now with 88% of companies having reported, first quarter’s earnings are expected to be 20.23, down 47% from 37.99 last year. We are almost midway into the second quarter, and the lockdown is just beginning to end. And if, during the economy’s reopening, the populace isn’t disciplined about social distancing, many states will be forced back into some semblance of a lockdown. It is not a stretch to envision an Index LOSS of 10 in the second quarter, down from last year’s earnings of 40! In that case, Index earnings for the first half would be 10. Furthermore, most Wall Street strategists now no longer foresee a “V” recovery in the last half of 2020. During the second half last year, earnings were 79. To reach 69 for this year, earnings during the last half would have to decline 25%, to 59. To me, that is not an outrageous assumption.


Wall Street’s Bullish Bias — An Asymmetry


Wall Street in aggregate makes more money in bull markets than bear markets. Strategists’ forward earnings estimates tend to be significantly higher than actual earnings turn out to be. There is a tendency to apply average P/E multiples to peak earnings, which can lead to “buying at the high.” On the other hand, strategists don’t apply average P/E multiples to bottom earnings. For example, before the pandemic, strategists were estimating earnings to be 170 for 2020. At the Index high of 3394, the P/E multiple was 20 — not that high, strategists claimed, with interest rates so low. However, 20 times assumed earnings of 69 would suggest an Index price of 1380! I can count on one hand the number of well-known strategists that suggest that low an ultimate Index price.


I don’t expect the Index to fall to 1380 because: 1)the Fed is doing everything in its power to keep the economy from lapsing into a depression; and 2) the probability is high that a viable vaccine will be available in quantity during late 2020 or early 2021. However, a retest of the March 23 low of roughly 2200 is probable once more reasonable 2020 earnings estimates become the narrative.

document how I manage my family’s assets here: www.pywrite.blogspot.com

WRITTEN BY

Walter Weil

After Harvard undergrad and b-school, I spent 23 years in the hedge fund business. I 

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Today The Standard and Poor's 500 Index reached 2950. I Lowered My Equity Exposure From 30% To 25% Of My Financial Assets.

In my last post I expressed concern that President Trump, due to his overriding interest in being reelected, would urge reopening of the economy prematurely--before sufficient testing would allow the scientists to recommend loosening the restrictions that had closed down the economy.  Unfortunately, premature opening is happening.

As a result, a resurgence in infections and a reimposing of restrictions seem probable near term. And another wave of virus cases late in 2020 is expected by the scientists. I continue to expect a slow economic recovery--a prolonged "U," if you will.

 I do realize  that summer's heat may moderate the rise of cases resulting from prematurely reopening the economy  And there is talk that a vaccine may be available during 2020 for hospital workers and others most vulnerable to the virus, such as the elderly and infirm.

With the Standard and Poor's 500 Index ("the Index")  at 2950,  my calculation of the Index's future risk/reward favors taking some profits. Today I lowered my equity exposure to 25% from 30% of my financial assets. The proceeds of the sale again are placed in short-term U.S. government securities as I continue to consider long-duration government fixed income to be grossly overpriced for those investors with a ten-year horizon.

How I Calculate Index Fair Value

Those readers of my previous posts are well aware that I use Shiller's CAPE ratio to determine the extent that the Index is overvalued, at fair value, or undervalued.  Shiller's mean CAPE ratio is 17; my modified mean CAPE ratio is 20--the average ratio over the last 50 years rather than Shiller's last 138 years. Fair value to me is when mean reversion to a CAPE ratio of 20 occurs.

Shiller takes actual annual Index earnings for the last 10 years, adjusts for inflation using the consumer price index ("CPI"), totals the ten results, and divides by 10.  I consider this to be "trend line earnings."

Shiller's CAPE ratio is available intra-day free of charge. If one divides the Shiller CAPE ratio into the Index price, you arrive at Shiller's earnings. Right now they are  roughly 107. During the Great Recession actual earnings declined 56%.  Last year's actual earnings were 157;  so,  if the  actual earnings decline during this recession equaled  that of the Great Recession, the low in annual  actual earnings would be 69.  The 2010 Index earnings adjusted for inflation are much higher than 69.  According to the way Shiller's model works, those 2010 adjusted earnings will be dropped and the 2020  earnings added. Furthermore, this year I expect the CPI to be negative--deflation rather than inflation.  So at the end of 2020,  Shiller's earnings may fall from 107 to roughly 100.  Fair value at the end of 2020 would then be 20 times 100, or an Index at 2000. From 2950, mean reversion then would imply a depreciation of 32%.

How I Calculate Future Returns

To calculate the Index's nominal compound annual total return for the next ten years, I assume that mean reversion to my adjusted CAPE ratio of 20 occurs at the end of the tenth year.  For example, assume the current CAPE earnings of 107.  I compound 107 at a 5.8% annual earnings increase to arrive at earnings in a decade of 188.  Multiply that by 20 to arrive at an Index fair price of 3760 in 2030.  From 2950, that would be a compound annual appreciation of 2.5%.  Add two percentage points for dividends to reach a compound annual total  return of 4.5%. At fair value the compound annual total return would be 5.8% annual appreciation plus the two percentage points for dividends, or 7.8%.

IS THE U. S. ECONOMY AT THE EDGE OF A PRECIPICE?

Federal Reserve Behavior--A Tell

During 2020 so far, the Federal Reserve on two occasions has lowered the Fed Funds rate between scheduled meetings--once is rare! Last week, the Fed announced that it may be purchasing BB-rated corporate bonds--that has never been done before!  Usually the Fed considers the "moral hazard"* implications before acting.  With this decision it has suspended that consideration. Desperate times call for desperate measures!

I have mentioned in previous blog posts that the "search for yield" would end badly. As interest rates have declined, financial managers have gone farther out on the risk spectrum to reap  higher yields there. The problem is that during a bear market the fixed income market for these riskier bonds has little liquidity.  Recently with bond prices up and stock prices down, financial managers want to rebalance their portfolios by selling bonds to buy stocks.  A financial manager whose fixed income portfolio is in high risk securities has trouble selling because there isn't a viable market.  The Fed's action will unclog that market.

The Fed's behavior signals its expectation of very bad news ahead!  It is trying to counter the negative wealth effect that a deep recession causes.  If both home values and stock prices decline significantly, owners will likely save more and  pull back on consumption, the main driver of the U.S.economy.

Right now, the Fed's ultimate concern is prolonged deflation, a condition few of us have ever encountered. Were that to occur, a vicious cycle might result.  To illustrate: a consumer interested in buying a house or car realizes that prices for those items are declining.  Why not wait for the lower price before buying?  The seller then lowers the price even more, which may encourage the consumer to wait even longer!  Given that the Fed had been unable to raise inflation to its desired 2% prior to the pandemic, its worry about deflation after the pandemic shock seems rational.  The Fed is fighting the tail risk of deflation. I applaud their action.

The Bad Scenario

1) The recession is very deep and lasts longer than expected.   Recent weekly claims for unemployment compensation suggest that the unemployment rate, recently at  50-year lows, may swell to a level only exceeded during the Great Depression!  That suggests a recession even deeper than the 2008-2009 Great Recession.  The shock from the pandemic causes the consumer to save more and spend less.  As a  result, the recovery from the recession will be much slower than expected--more like a  prolonged "U" than a "V."

2) President Trump's decisions are primarily motivated by one goal--to be reelected.  This introduces the risk that he will encourage a  premature lifting of  the sheltering-at-home and social-distancing restrictions now in place in most of the country.  In the best of all possible worlds, the scientific data, not political ambition, would dictate when to reopen the economy. That data involves extensive testing beforehand, which seems unlikely. So the recent plateauing of the virus may continue longer than expected before tapering off. The current price of the Standard and Poor's 500 Index (the "Index")  suggests that Wall Street is expecting a V-shaped recovery after a dismal second quarter.  

3) With few exceptions, Wall Street strategists have not yet built into their earnings estimates the reality of a prolonged  U-shaped recovery.  During the last two recessions, Index operating  earnings fell 32% and 56% respectively.  In 2019 earnings were 157. With those declines in mind,  2020 earnings should range between 107 and 69.  I expect  that actual earnings will be in the lower half of that range.

4) There is a second wave of the virus in the last quarter of 2020.

5) Due to the factors mentioned above, the Index retests the low on March 23; and the low fails to hold.

The Good Scenario

1) A  bona fide VACCINE is discovered soon and is fast-tracked for approval by the FDA--the GAME CHANGER!

2) President Trump listens to the scientists and doesn't urge lifting of the restrictions until adequate testing indicates the go-ahead signal.

3) The Fed's massive support program and fiscal stimulus approved by Congress eliminate the tail risk of deflation.

4) Trump's politically-motivated  decision to open prematurely proves prescient--whether due to warmer weather and/or a natural  tapering off of the coronavirus's cases. No extended first wave  and no second wave occur. A "V" recovery!

5) The Index never retests the low on March 23; that low proves to be THE BOTTOM!

Catching a Falling Knife

Stock markets discount the future. During a bear market resulting from a recession, the stock market will bottom before the recession is over. Bear market bottoms  form when fear reaches a crescendo. when investors tell their brokers “Get me out of stocks! I don’t care what the price!” That is known as the “capitulation phase.” 

Was the Index low on March 23 the capitulation phase?  In many respects this reminds me of October 10, 2008.  At that time TARP was just announced.  The volume of trading on that day was twice the recent volume, and 86% of NYSE listed stocks reached new lows. At that time I wrote that a breadth climax had occurred.  I was in the process of building an equity position, and I completed it soon thereafter.  As it turned out, most stocks did bottom on October 10, but the Index dropped another 26% before bottoming at 666 in March 2009.  The average cost of my equity position in 2008 was at an Index level of  1080. Compared with the previous bull market high above 1500,  that seemed like a good price,  and the position did well in the ensuing bull market,  However, compared to the Index low of 666, I should have done better!

Now a much larger Fed and Treasury effort than TARP and huge stimulus approved by Congress have been announced and will be implemented much faster.  Trading volume during the two weeks prior to March 23 was more than twice recent volume; and the percentage of new lows was 86%.  A breadth climax has occurred! But was that the Index low?

Bear market bottoms occur when there is an extreme of fear. Sentiment indicators measure the level of fear among investors. At extreme levels they are contrarian in that the higher their level the more bullish one should become. There are two sentiment indicators that are primarily relevant for traders: 1) On March 23 bearish sentiment at AAII was at levels last seen at the bottom of the last bear market in March 2009; and 2) the volatility index,VIX, was  at new highs. As an investor with a five to ten year horizon, I pay more attention to the percentage bears at Investors Intelligence’s weekly Survey of Advisors’ Sentiment. For the week ending March 20, that percentage reached 41.7%, not near the October 10, 2008 level of 53% and below the levels at each of the last five bear market bottoms. However, it is at the highest level in eight years! So the “fear gauges” were flashing a trading “Buy!” but not quite yet an investor “Buy!” As it turned out, a vigorous rally has ensued. 

What to do now?

With the great uncertainty that the pandemic has caused,  it is difficult to determine which scenario is more probable.  I am risk averse.  My inclination is to  go with the bad scenario.

In my Medium post entitled "A Case for Cash,"** published January 1, 2020, I suggested that both the Index and bonds were so overvalued that  they would produce subpar returns over the next ten years. So a large cash position was warranted until prices reverted to the mean.  At that point, the Index was at 3230.  In that post, I assumed compound annual Index earnings growth of 6.3% over the next decade. I assumed stock buybacks would continue to contribute one to two percentage points.  The Democratic party has been quite vocal against these buybacks, and that has become part of the current narrative.  Therefore I have reduced my expected annual  Index earnings  growth to 5.8%.   Were this rally to continue into the 2900-3000 range, I would reduce my equity exposure from 30% to 25%.  At 2950 the Index would generate a paltry 4.4% compound annual total return (including dividends) over the next decade.    

Given  my experience during 2008 and the lack of extreme bearishness,  I believe there will be a retest of the March 23 low;  and if the bad scenario becomes the narrative then,  a further downdraft might happen.  If the Index gets low enough,  I would raise my equity exposure to 70% in two tranches: the first 40% of my open-to-buy at 2,000-2200; and the remaining 60%  if the Index breaks through 2000, thus signaling another leg down.

*In the long run,  this Fed action encourages bad behavior.   Financial managers will expect the Fed to bail them out  again,  so why not buy the riskier bonds? And perhaps the Fed will buy stocks as well, so why not buy the Index no matter what the P/E multiple?  (Japan's Central Bank has tried this.)

**The URL is https://medium.com/@walterweil39/a-case-for-cash-e2819905137c

A Reason To Rebalance My Equity Exposure Now

It has been several years since I rebalanced my equity exposure back to my core position.  I had been waiting until Shiller's CAPE ratio had reached the January, 2018 high of more than 34; and the Investors Intelligence percentage bulls had reached 60%.  Neither has happened yet.

That notwithstanding, to me, a possible exogenous event, a pandemic, if it were to occur, would wreak havoc on  the worldwide economy and stock markets.  I have no way of assigning a probability to that event. Due to this uncertainty, I have rebalanced my equity exposure back to my core level.

How Shiller's CAPE Ratio Is Important In Managing My Grandchildren's Section 529 Accounts.

When my two grandchildren were born, I established a Section 529 College Plan for each.  As you probably know, these are attractive because the capital appreciation in the account is tax-free, as are the distributions out of the account if they go toward financing the beneficiary's college education.

To illustrate how I use Shiller's CAPE ratio to help me manage these accounts, let's consider the account for my grandson.  It was just dumb luck that he was born in November, 2008--right after most stocks bottomed in October that year.  I began investing right away, and ultimately put in a total of $154,000.

The New York State 529 College Plan is managed by Vanguard, which allows the money to be invested in a number of their no-load mutual funds.  Unfortunately, Vanguard's Standard and Poor's 500 Index Fund wasn't one of the choices. I asked Vanguard to determine a mix of available funds that would correlate highly with the performance of that Index.  I invested in those funds.  As of last Friday, the account now totals $396,000.

I called my alma mater to find out what tuition, room, and board costs a freshman this year, which is
$70,000. And one could expect that number to compound at an annual rate of between 3% and 7%, he said. (At my fiftieth reunion, the compound annual growth during that half a century was 6.3%.)
So for planning purposes, I assume the worst--that college costs compound at 7% a year.

Now you might think that I would relax since my grandson's account already  has almost $100,000 a year in it, and there are almost ten years left before he enters college.  Wrong!

As you know, I have adjusted Shiller's mean CAPE ratio to take into account only his last fifty years of data.  My adjusted mean P/E ratio is 19.8, well above his 16.8.  As of Friday,  Shiller's CAPE ratio was 34.8, which means the Index is 75% overvalued using my adjusted mean P/E.  So, if mean reversion were to  occur immediately, the Index could fall 42%.  In that case, rather than $100,000 a year available, my grandson would only now have $58,000 a year--well below the actual cost of $70,000.  So rather than being well ahead, the account is really "behind the eight ball!"

Furthermore, the compound annual total return for the Index (inclusive of dividends reinvested) during  the next 10 years until he enters college is likely to be, at best, little more than 3%.  Meanwhile, annual tuition, room, and board could be $140,000  ten years from now.

So what's a grandfather to do?  I could take my chances and keep the account fully invested in equities.  Or I could reduce the equity exposure and bet that I can buy back at significantly lower prices.  Last Friday, I reduced the equity exposure to 50%.

This outlook is daunting for other long-duration accounts as well.  Most notable are the government pension funds who can't meet their future obligations without assuming an annual return of 7% over the next ten years.  They will be lucky to achieve 3%.  The difference must be made up by a combination of increasing taxes, borrowing more, or cutting entitlements.  Not a pretty picture!

I REMAIN A CAPE CRUSADER!

As you know, I rely on  Professor Shiller's CAPE ratio to determine when I rebalance my family's financial assets.  Yesterday it reached 33.5--roughly the high of the bull market that ended in 1929, before the stock market crash in October of that year. The only other time the CAPE was above this level was during the bull market that ended in March, 2000, when the CAPE reached 44.  (In a post called "WAITING FOR GODOT" written December 2, 2016,  I explained why I think the CAPE won't reach that lofty level this time.)

CAPE detractors are numerous and tend to become vehement at major market tops.  Why?   Professor Shiller recognized that business cycles exist, resulting in  profit margin cycles.  Wall Street practitioners in general have a bullish bias.  They tend to apply mean P/E ratios to peak earnings to determine fair value,  rather than the more reasonable approach -- applying them to mean earnings.  Thus, to them the market appears still cheap at market tops.  Shiller's CAPE concept "curbs the enthusiasm" of the bulls.

Recently CAPE logic seems even more under siege.

As I mentioned in my last post of October 23, 2016, the denominator of the CAPE ratio is the ten-year average annual earnings of the Standard and Poor's 500 Index ("the Index")  adjusted for inflation.  Because of this moving average construct, during the next two years the depressed earnings of the Great Recession will be dropped, and earnings during 2018 and 2019 will be added.  Hypothetically, even if actual earnings during the next two years were flat, the CAPE ratio,with the Index still at 2751, will have declined to the high twenties just because the ten-year average earnings would have increased.   This argument is valid, but it relies on a vagary in how the CAPE is calculated.  Once the U.S.  economy experiences the next recession, this effect will be reversed!

Also recently, one of the money managers I most respect hinted that recent elevated profit margins may be the "new normal" -- or  at least that these profit margins will be extended many years going forward.  He might be right. But to me he has uttered the most dangerous phrase in a money manager's lexicon, "This time it's different!".

Yesterday, the CAPE ratio reached 100% overvaluation.  As a CAPE crusader, I rebalanced. The sale proceeds remain in cash equivalents.

So long as the yield on the ten-year U.S. Treasury note remains under 3% (it is now at 2.58%) and earnings increase, the Index will have an upward bias. Once 3% is breached, a bear market should quickly ensue. As the Index becomes more overvalued, I shall continue to rebalance--next stop 110%.

"BULL MARKETS GO UP LIKE ESCALATORS; BEAR MARKETS GO DOWN LIKE ELEVATORS!"

Another man's vivid image of markets which resonates with me.  Bull markets die hard!  It takes time for one to form a top.  Bear markets, on the other hand, generally end with what I have called a waterfall decline, a "puking" phase, or a selling climax. (See my posts during 2008 and 2009.) This asymmetry of stock market phases has dictated my asymmetric money management approach.  During the bull phase, I rebalance my equity exposure back to my core 30% position as the Standard and Poor's 500 Index (the "Index") becomes more and more overvalued according to Shiller's CAPE ratio*.  On the other hand, during the bear phase, I rely only on technicals --trading volume, market breadth, and price -- to confirm a market bottom.  At that point, time is of the essence; and my adjusted CAPE ratio determines how much I add to my equity risk exposure.

At  2578 today,  the Index became close to 89% overvalued according to Shiller.  In previous posts, I have mentioned that 90% would be a call to action.  To me, the tax decreases likely to be passed have already been discounted by the market. And any meaningful tax code overhaul will be a long slog.   Today I rebalanced my equity exposure back to my core 30% of financial assets.  Next stop: Shiller's 100% overvaluation.


The "Search For Yield" Trap

As you know, I believe in mean reversion in both stock P/Es  and bond yields.  I also feel that Shiller's CAPE ratio is helpful in determining how far stock P/Es  have strayed from their mean.  As stocks and bonds both become more overvalued, I reduce risk in both of these asset classes. In  certain circumstances, like now,  cash becomes a legitimate asset class.

A good example of this is how I have managed my two daughters' financial assets. Their core equity exposure over the last several decades has been an aggressive 100% of their financial assets.  Originally, the money was invested equally in four no-load equity mutual funds--a Standard and Poor's 500 Index fund, and three T. Rowe Price funds with a higher risk: New Horizons, Small Cap Value, and New Asia.  So 75% of the accounts were then in funds with a higher risk  than in  the Index.

As the Index became more overvalued, I have been reducing the equity risk exposure in these accounts, with the proceeds invested in cash equivalents because bonds are overvalued as well.  Now the equity exposure is 55% of financial assets, with 45% in cash.  Furthermore, the composition of the equity exposure has changed.  Now 50% of the accounts are in the Index fund, with only 50% in the higher risk funds.

As stocks and bonds become more overvalued,  many money managers are compelled to do the  opposite: they are increasing risk in their clients' accounts. This is due to managers' abhorrence of
cash.  In fixed income, their search for higher yield takes them from U.S. government bonds to investment-grade U.S. corporates to high-yield U.S. corporates to emerging market corporates.  In equities, as the Index becomes more overvalued, they go farther out on the risk spectrum by investing in, for example, emerging market funds.

This makes no sense to me; for their clients, this will end badly!



* An arcane point--in calculating his CAPE ratio, Shiller uses the average earnings (adjusted for inflation) over the last ten years.  During the Great Recession which began in late 2007,  Index annual operating earnings fell from 91 to 40 in eight quarters. During the next eight quarters these depressed earnings (adjusted for inflation) will be dropped and the expected strong current earnings will replace them.  Absent a recession during this period,  the result will be  an additional significant temporary jump in Shiller's earnings  in each of the next two years -- thus putting downward pressure on the CAPE ratio.  However, during the next recession,  this positive impact on Shiller's earnings will ultimately be reversed. Nevertheless, short term, this will be grist for the bulls' mill.