If I told you that the worst Christmas Eve ever would be followed by the biggest rally in Dow points ever followed by the biggest market reversal in 10 years would you have believed me? And we still have two days to go before the end of the year, two days when many traders will be on vacation or will have closed their books for the year. Hang on to your hats.
If you read the Wall Street Journal or listen to CNBC you will be offered a whole slate of fundamental explanations. You have heard the litany ad nauseum. The Fed. Trump. Tariffs. Global uncertainty. Brexit. The list seems endless.
But stop and take a breath. Our economy is growing 2.5-3.0%. We just finished the best Christmas season in five years. Tax refunds in Q1 will be higher than in the recent past. Consumers are both spending and saving, about as good as it gets. Europe is slowing but the demographics tell you Europe is destined for years to come to have GDP growth close to 1% plus or minus. Japan is back in recession. Again, demographics is the villain. Without huge government stimulus or massive improvements in productivity, Japan’s GDP is going to decline. That doesn’t mean, however, that GDP per capita is in permanent decline. China is slowing. It is convenient to blame tariffs but China is running into two problems; the law of large numbers and demographics. China’s one child policy combined with no safety net for the elderly is starting to become a more dominating factor. The government has been using debt to stimulate the economy but that can’t go on forever.
So, what are the problems? As I see it looking ahead, not behind, there are two significant issues. One, market liquidity, has been a topic of increasing focus lately. When markets start to fall, many investors hunker down. Not the algorithmic traders, however. For them, volatility is the fuel that ignites opportunity. Every firm that relies on computers to find anomalies that give them better odds of success, springs into overdrive. The problem is that the patterns they each find turn out to be the same or similar. As a result, they are all buying at the same time and selling at the same time. Fewer participants all leaning in the same direction brings chaos. Thus, what happens is exactly what you have been witnessing the past two weeks, violent swings up and down with most of the violence happening during the last hour. The supporters of algorithmic trading like to say that the volume they add provides liquidity as if volume and liquidity are synonyms. That is clearly not true. Liquidity comes from the number of participants more than from the volume of trading. Clearly, rising liquidity chases many investors away. You only have to look at the massive amount of mutual fund selling that has been happening in December to see my point.
But since computers and passive investors don’t rely on fundamentals to any great extent, the volatility they add doesn’t change ultimate values. What is does is extend the overshoot in either direction. That is why I suggest to identify those stocks you want to buy and begin to nibble as they fall to your buy points. I realize that, emotionally, it is hard to buy into a market falling 2-4% per hour. That is why you simply can’t be a hero and identify the bottom.
Look at where we are at the moment. Stocks were down about 20% at Monday’s close. Stocks of smaller companies or high beta (meaning volatile) names were down more. Rallies on Wednesday and yesterday recovered about 6%. Fair value based on 15.5-16.0 times next year’s estimated earnings is somewhere around 2650 for the S&P 500. In September, the S&P was about 300 points or more than 10% over fair value. At Monday’s close, they were about 300 points or a little over 10% below fair value.
Now, with two good days in a row (my simplistic 2-day rule), it appears the worst of the storm is over. The S&P, around 2500 is still moderately below fair value. That doesn’t mean every stock is cheap. But it does mean there are some good bargains still out there.
There are three ways to go:
- The most conservative is to find companies with solid growing dividends yield at least as much as 10-year Treasuries (now about 2.8%) that have conservative balance sheets and are selling below historic norms. i.e. they are cheaper than normal.
- You can focus more on earnings than dividends. Find companies capable of achieving 10%+ growth next year regardless of our economy’s rate of growth. Again, make sure these names have strong managements and good balance sheets. Of course, valuation matters.
- Take some of your cash reserves and try and hit a home run or two. Look for names really beaten up over the past few months and take a shot recognizing that these will all have warts that could turn into cancers. What earnings power will GE have left after selling enough assets to get its balance sheet back in shape. Answer that question right and you could make a lot of money. Get it wrong and you lose a lot. Oil prices have gone from over $70 per barrel to close to $40. OPEC cuts start in January and the growth of U.S. production will slow if prices stay low for long. Some oil stocks are down 50% or more since September. If prices rebound, these will be winners. Again, take one or two shots here; don’t speculate with all your cash reserves.
I noted earlier that there were two problems I see looking ahead. Liquidity was just one. The other is debt. U.S. households today have levels of debt-to-GDP about in line with what they were in 2007. That isn’t all that comforting, but it isn’t all that alarming either. Unemployment is really low and, with lower interest rates today, the cost of debt service isn’t overbearing. Financial institutions have brought down the ratio of debt-to-GDP significantly. Credit Dodd-Frank for that. However, non-financial corporate debt has risen from 75.9% at the end of 2017 to 92.3% today. Much of the incremental borrowing has been to support share buybacks or large acquisitions. Low interest rates have buried the problem so far but if rates rise and debt service coverage decreases, the troubles start. Much of the post-recession debt is BBB rated. If conditions tighten and debt service coverage decreases, as much as a trillion dollars of BBB debt could sink to junk status. What that will do is explode credit spreads meaning the cost to borrow for the vast number of U.S. companies will go much higher. You can figure out the consequences from there.
The same problem exists at the government level. Debt-to-GDP was 58% in 2007. It is now over 86%. This doesn’t take into account off-balance sheet obligations like future pension payments. Problems associated with a rise in debt have been masked so far by two factors. First and foremost, low interest rates have contained the debt service obligations. Second, under President Obama, defense spending as a percentage of GDP declined significantly. But now defense spending is rising, entitlement spending continues to grow and interest rates are increasing. The U.S. had to raise $1.3 trillion of new debt in 2018 and to that total you have to add the $400 billion reduction to the Fed’s balance sheet. In 2019, according to current plans, the Fed will reduce its balance sheet by another $600 billion while Treasury will have to add another $1+ trillion in new borrowings. You can do the math. $3 trillion of new debt at 2.5% adds $75 billion to the deficit. A half a percentage point of incremental interest on $16 trillion of existing debt adds another $80 billion. That’s over $150 billion of added government expense in just two years. Eventually, deficits will matter. When is the obvious question. The only thing I know is that when happens, it is going to be nasty.
But when isn’t tomorrow. Right now, there are signs that the headwinds of angst are coming to an end. That doesn’t mean clear sailing. Trump can upset the apple cart at any time with a tariff statement or whatever. Brexit fears could ignite selling although I don’t want to overstate the impact of a hard Brexit on most U.S. companies. Most importantly, even after two very strong sessions, valuation is on your side for now. With that said, think of 2700 as the red line in the sand. Once you cross it, valuation is no longer a tailwind. That’s less than 10% from where we sit today. If I presume 2020 earnings of $180 for the S&P 500 and a normal 15.5 p/e, a logical target for the end of 2019 is about 2800. If stocks rally above that level in 2019 (and they could without a recession), then it will be time to take some money off the table. Thus, we can develop a simple macro rule for now. Assuming on recession, below 2700, stocks are attractive. Above 2800 they become unattractive.
Today, John Legend is 39. Denzel Washington turns 63. Maggie Smith is 83.
James M. Meyer, CFA 610-260-2220
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