The news keeps coming thick and fast: the US plans to open the country up soon, oil prices have crashed to $11 a barrel, Trumps approval ratings have crashed. The Covid-19 cases worldwide have surpassed 2.4 million and, tragically, over 165,741 deaths. It’s a tough old world out there.
In this environment I think it might be helpful to break down key economic metrics into a few easy to understand categories based on your personal beliefs about what the future holds. I will try to summarise three scenarios for you: the Bull case, the Middle Ground, and the Bear case.
Corporate Earnings
This week we will get a glimpse of corporate earnings from 10-15% of the US stock market and it isn’t going to be pretty reading.
In order to navigate these troubled waters you need to have conviction about what you are investing in if you’re a bull (believe the market will rise) or a bear (believe the market will fall). Have a look at this chart to understand where the stock market is and where consensus earnings estimates stand from analysts:
The price line indicates the value of the S&P 500 index and the Forward EPS line shows the consensus forecasts for earnings by analysts. After all, profits generally drive the price of the index over the long term.
The Bull Scenario – Buy Stocks With All Ya’ Got
Let’s put ourselves in the mind of the people that are pro-stocks.
Analysts predict that earnings will decline 10% in Q1 and recover by next year, driving the index back to above 3300. That’s a fairly optimistic scenario and it is really what we mean by a “V” shaped recovery. Overall, that implies a -8.5% decline in earnings for FY 2020, followed by an 18.2% rise in earnings next year in 2021.
This is entirely contingent on the US economy opening up between May and June 2020, getting back to at least 50% capacity and returning to normal business as usual. After all – that’s what consensus opinion is, given that we are estimating that the economy effectively has “a bad quarter” but doesn’t lead to any structural damage or long term unemployment. The view here is: get in before stocks rise.
Unemployment could reach 22 million jobs by the end of this week. The reason that this hasn’t led to massive falls in asset prices is that it is perceived of as a temporary situation. Based on a v-shaped recovery, 80-85% of the jobs are believed to be quickly re-instated before the end of the year.
Science is going to prevail over Covid-19 and ultimately we are well on our way to having a cure and beating the disease over the next 2-3 months.
Investor approach: you’ve been 60-80% equities, doubled down on your losses, and possibly made money on the upside. You might be 90-100% equities now.
Belief: we are going to have a V-shaped recovery and, if anything, it’s time to buy more stocks because this is a lot like the brief bear market during the 1987 crash.
The Middle Ground – Buy Cautiously
Investors that sit in the middle ground don’t necessarily have a strong view one way or the other. This isn’t the time to sell everything, nor is it the time to buy like there’s a fire sale going on.
In fact that’s the Frugalist Investors’ current viewpoint – the future is simply unknowable right now, and people who believe they know how the virus is going to develop either have the gift of foresight or have a confident guess as to what scenario is more likely. Nobody knows.
The strongest indication of this position being held came from Warren Buffett’s business partner this weekend. Charlie Munger really nailed it in his interview with the Wall Street Journal, when he said the following:
“I would say basically we’re like the captain of a ship when the worst typhoon that’s ever happened comes. We just want to get through the typhoon, and we’d rather come out of it with a whole lot of liquidity. We’re not playing, ‘Oh goody, goody, everything’s going to hell, let’s plunge 100% of the reserves into buying businesses.’”
Charlie Munger – and by extension Berkshire Hathaway – indicate that they are taking a risk-off approach to managing investors’ money. They prefer to be cautious about buying stocks or businesses at today’s levels until they feel we are further through the typhoon. As he stressed in the interview, his “phone isn’t ringing off the hook” because CEO’s and business leaders are currently “frozen” and shell-shocked from the crisis.
Given that Warren Buffett and Charlie Munger have a $130 billion cash pile to spend, that should make you wonder about your own risk tolerance levels in this environment.
Regarding the Covid-19 health crisis, which is driving all of this, we are going to see a slow and steady road to opening up the economy however we will ultimately get there and find a cure with a vaccine by end of year, or early next.
Investor approach: you may be in 50% or more cash and you’ve taken a cautious view of the recent market rally. At the same time you don’t know what the future holds so you’ve held onto quality companies.
Belief: we are much more likely to have a U shaped or even L, W, or some other letter of the alphabet. The road to recovering unemployment from these levels will be long and hard but ultimately return by 2021-2022. At the same time the development and spread of Covid-19 is highly uncertain.
The Bear Case – Sell Stocks
The view from certain corners of the market is simply that, since 2013, but especially since 2019 this has been a ludicrously inflated stock market. Frugal Investors tipped this on 19th January 2020 and warned that there would be volatility in the markets, which has subsequently held true and continues to hold true.
The bear case is that the US government, and following their lead other advanced economies governments, are effectively trying to spend their way out of this problem by running a massive budget deficit that is propping up GDP growth. You only have to glance at the balance sheet of the Federal Reserve to realise how drastic their measures are:
The balance sheet sits at $6.3 trillion and the government has purchased not just government treasury debt, but corporate bond debt and even back-stopped junk bonds. What does this mean in plain English? The government is bailing out highly leveraged corporations and businesses that spent recklessly on share buy-backs during the good times, only to be saved anyway during the bad times (i.e. now).
The Covid-19 crisis is going to extend and we are likely to see another “second wave” of infections. This is backed up by data coming out of Singapore that suggests by trying to open up the economy they are already experiencing an early second wave. There won’t be a clear vaccine and if there is it will take a long time to come to market.
Investor approach: you are more or less 60-80% in cash and spending most of your time drawing up a list of stocks to buy on the further downside.
Belief: there is absolutely NO chance of a v-shaped recovery, and we are going to have a U shaped recovery if we are lucky. You back Charlie Munger’s comments and think it will be a long, long time before we return to full employment.
Conclusions
Frugal Investors continue to maintain a Middle Ground approach to the market. There simply is no way of knowing exactly how the next 2-3 months will play out, let alone the next few years.
That being said the consensus view a few weeks ago was that the S&P 500 may return to the end of March lows, and hit 2000 or so before this bear market is over. We believe that this is a distinct possibility as investors come off of the sugar-high induced from the Fed stepping into the market in a big way.
Stay cautiously invested in dividend and income-paying companies with rock solid balance sheets. Invest regular and often during this unstable time period and consider drip feeding in money over the course of the summer. You haven’t missed the bottom of this market!
