The New Abnormal

This article has been excerpted and edited from our quarterly newsletter to clients dated November 20, 2020.

A new normal is the norm. Changes are inevitable and therefore imaginable, even during this era of ever-growing technological breakthroughs such as cryptocurrencies, blockchain, roboe-verything, 5G, EVs, AVs, AI, VR, AR, and IoT.¹ We remember when ecosystem referred to a Costa Rican rain forest.

But when changes occur so rapidly, resulting in a considerably altered state, it seems anything but normal. In a recent Saturday Night Live skit, Kate McKinnon reads the palm of a fellow castmate in ’19 to offer visions into this year. She reveals his friends stop talking to him because he eats at a restaurant. This is our new altered reality.

The pandemic clearly tops the list of today’s abnormalities. While wearing a mask everywhere (except ironically on cancelled Halloween) still seems strange, certain aspects, such as work-from-home and video communication, have quickly become conventional.

Other societal aspects may have permanently shifted too. Sports came back but few watched them. Food is now delivered. Chipotle is starting a takeout-only digital restaurant. Faster food. Unless it’s being delivered by bicycle. Remember neckties? How about live performances? At this point we’d settle for piano recital.

We’ve had structural financial changes which have persisted too. Examples include negative interest rates and SPACs²—a now popular corporate structure that has some legit backers but that’s somewhat akin to pin the tail on the donkey, for adults.

Kidding aside, the virus and related lockdowns have ravaged economies—the U.S. unemployment rate rose from its ’19 low of 3.5% to a peak of 15% in April. While the economy is on the mend, the infection rates in North America and Europe are currently at their highs. Thankfully, medical professionals are better equipped to treat patients effectively and vaccines are on the way.

WALL OF WORRY?

While people remain worried, the stock market’s recovery from its March bottom has been astonishing. Where’s the normal double-bottom? Where’s the typical undervaluation relative to Fair Market Value (FMV) that usually prevails as the market climbs a wall of worry? Where’s the volatility that one would expect to accompany the uncertainty surrounding a worsening pandemic and the emergence from the recession?

The markets are reacting like this is all a mere blip. Simplistically, the S&P 500 is about 30% above its average PE valuation of the last 25 years. Given today’s ultra-low interest rates, relatively higher profit margins, and strong returns on capital, a higher than average multiple is justified. However, during times of stress the market generally trades below fair value and is at best constrained by its FMV.

Based on our models the markets are somewhat overvalued. Therefore, a cap on valuations may now be in place and any temporary shocks could take prices back to a discount. Profit margins have been bolstered by muted labour costs, technological advances which enhance productivity, lower interest expenses, and considerably lower corporate tax rates. Wages could be headed higher and taxes too. Both positive for a more stable U.S. balance sheet but negative for corporate earnings and market prices.

EMBRACE DEBT?

Massive amounts of government debt will be the norm for the foreseeable future. Governments around the world have had to spend significantly ($11 trillion of total fiscal stimulus this year) to offset the gap in demand. Because individuals’ savings rates have been elevated, the record debt-to-GDP levels induced by ballooning budget deficits may not have negative implications. It’s been picking up the slack. But the debt will need to be suitably unwound, i.e., not too quickly as to cause a double-dip recession and outright deflation, and not too slowly which could result in excess demand and unwanted inflation.

And here is an unconventional concept for abnormal times. Unlike with corporations, higher government debt levels are associated with lower interest rates. It’s debatable whether the lower inflation and slower growth that accompanies substantial government debt allows for, or causes, lower interest rates. Either way, many countries over many years prove the inverse relationship. And just because debt is so high doesn’t mean that the currency is doomed, or that an inflationary outcome will result. Japan, over the last 20 plus years, is a prime example.

Governments can afford to take on significant indebtedness to fill demand gaps particularly when savings rates are high and especially if debts are denominated in their own local currencies in order to facilitate repayment if need be.

On the other hand, individuals and corporations should be relatively debt averse. They can’t merely print money to repay obligations. And while the individual savings rate is high, corporate balance sheets are debt laden. The recession has caused U.S. corporate default rates to double to around 6% in the last 12 months. Rating agency S&P is calling for another doubling by mid-’21.

With corporate debt at record levels, debt refinancing may not be easily accomplished. A wall of maturities of corporate debt remains in place with $4 trillion coming due over the next 5 years. Rating downgrades from investment grade could worsen this issue as institutions precluded from holding lower-rated investments are forced to sell. Meanwhile, like the stock market, the high-yield bond market is at all-time highs.

All of this is a reminder that our process will need to continue to be a good balance between bottom-up security selection and top-down economic analysis.

Valuations Don’t Matter?

Since the 1930s, 6 months into a new bull market the average earnings multiple of the S&P 500 was about half of today’s. And the average rebound from the bear low was 28%. In September, at the 6-month mark, the S&P 500 was up 46% from its March low and it was up 62% at the recent high. For context, the highest 6-month gain from a trough was 53%, reached on September 9, ’09.

This has led to lofty valuations. At just shy of 23x forward earnings the S&P 500 is well above its 10-year average multiple of about 16x and ahead of our own FMV estimate. The forward P/E of the Russell 1000 Growth Index, while off its highs, is 30x, also far above its 20x average since the dot-com bubble. In bubble-like fashion, over 120 companies that sport at least a $10 billion market cap trade in excess of 10x revenues. For reference, fewer than 10 companies made that list in 2012. In the short run security prices movements are often driven by investor psychology. In the long run, fundamentals prevail. Valuations don’t matter—until they do.

Numerous other stats point to overexuberance by investors. Call buying relative to put buying is at an extreme. Stocks trading above their 200-day moving averages are at highs. Surveys show elevated bullish sentiment and low bearishness. Short interest is at multi-year lows. Insiders are selling and corporate buybacks remain at a 20-year low. And the mega-cap stocks, which represent a disproportionate amount of the S&P 500, have led the way—an average of the top 5 up nearly 50% this year. On an equally weighted basis, the S&P 500 only went positive for the year on November 9, on the heels of the announced Biden win and Pfizer vaccine.

We are not suggesting a new bear market is coming. Economies around the world are still just emerging from recession. And this synchronized global growth should be a tailwind for share prices. However, given implied growth rates are also near all-time highs (some implying perpetual unachievable growth rates), high expectations are already baked-in. As a result, volatility should pick up, an outsized correction could occur, and overall index results are likely to be lacklustre. Therefore, this is a time to be highly discriminating with security selections.

Proponents of passive investing—now the majority—believe stock picking is passé and that value investing is a waste of time. But purchasing just about any quality asset at a discount to its true worth is almost always rewarding. Sure, long periods can endure when buying high and selling higher works too. Sometimes, as in the last several years, it trounces a value-based approach. We don’t believe growth investing will remain in vogue. But its length of outperformance versus value makes it part of the new abnormal. Growth has outperformed value for the longest stretch in market history, when it’s normally the other way around for extended periods.

GETTING BACK TO NORMAL

U.S. GDP is now only 3.5% below last year’s run rate. Most countries collapsed together, and the lift back is occurring simultaneously too. Coordinated growth is a huge positive. And jobs are returning. The U.S. unemployment rate has shrunk back to 6.9%.

Though quarterly earnings for the S&P 500 aren’t expected to top any quarter from ’19 until Q3 next year, every quarter going forward is estimated to show sequential quarter-over-quarter growth. The level of earnings might not justify current valuations, but earnings are certainly moving in the right direction.

Industrial commodity prices, a key economic signpost, continue to rise as well. And pent-up consumer demand should provide a material economic boost once we’re all free to spend again. We really hope dinner and a movie resume as part of the new abnormal. And a travel boom is coming. Who doesn’t need a vacation? With nowhere to go right now, we’ve extended the use of some vacation days for our own staff into next year.

Unfortunately, it could take well into ’22 before the U.S. returns to its Q4 ’19 GDP peak. The expected additional stimulus should help; however, we expect the immense government debt to restrain growth thereafter.

After a period of weakness, the U.S. dollar has strengthened somewhat which could continue because relative interest rates are favourable, inflationary expectations are pulling back, and election uncertainty has passed. This could arise from risk aversion too if investors begin to prize cash. Maybe Gold and Bitcoin will take a breather.

BETTER SAFE THAN SORRY

In this abnormal environment that adage hasn’t really worked. But we have been comfortable hedging our long positions with a short on the overall U.S. market because of the risks from stretched valuations, an increase in coronavirus infections to new highs, and the direct impact it has on small businesses, commercial real estate, retail, entertainment, dining, and travel, which together represent 40% of GDP.

Unusually, the market didn’t suffer a retest of its lows. Normally we experience a double-bottom, a retest of market lows which can occur up to a year after the initial low.

The most recent news of the Biden win and pending vaccines provided the market with another jolt higher. The Biden win boosting the market was counterintuitive to some. But, despite the spectre of higher tax rates and a less business-friendly government, we believe the financial markets much prefer the President-elect. There’s increased likelihood of additional stimulus. More comfort from a more Presidential, less volatile, leader. And we believe that most investors got what they wanted. We calculated that of the counties that represent the top 50 U.S. cities by population, ranging from New York City (pop. 8.8m) to Bakersfield, CA (pop. 390k), all but 2 (Oklahoma City and Tulsa, OK) voted for Biden. The dancing in the streets we witnessed in major cities when Biden was declared followed into the stock market. And the fact that it appears the Senate will remain Republican helped relieve anxiety around major policy changes.

Markets were already buoyed by a brisk economic recovery and next to zero interest rates—the lowest long-term rates in the last 5000 years of civilization (who even kept those stats?). And interest rates should remain low, supporting relatively high valuations. Inflation drives interest rates and we believe we remain in a disinflationary environment. Certain trends aren’t simply going to fade away. We believe poor demographics, price competition, and Internet-driven price comparisons, amongst other factors, should continue to suppress inflation, despite the Fed’s desire to reignite it.

Structurally, the high-flying tech stocks look vulnerable to a correction, with most of them at ceilings or having already given sell signals in our TRAC^TM work. As much as we expect to see rotation into more industrial/cyclical businesses, in our view it would be difficult for the market to continue its ascent if the bellwether tech companies sell off.

Even though markets are already near all-time highs, we are mindful that they could continue into a real bubbly blow-off phase. We will do our best to react to any temporary market buy signals in our work to reduce our hedges. This needs to be a concern of ours since FMV, which normally acts as a magnet attracting prices, seems currently to be repelling them. Hard to believe that is the new abnormal but it certainly qualifies as abnormal.

OUR STRATEGY

A meaningful correction could start at any time. While we don’t see a particular catalyst to cause a correction, the optimism appears too excessive. And with valuations so high, most of the stimulus spent, pending vaccines announced, and reported quarterly earnings that exceeded expectations by a wide margin, we don’t foresee much in the way of immediate upside surprises. As such, we remain comfortable with a defensive posture.

It seems appropriate currently to be more market neutral. So, we remain invested in high-quality companies with competitive advantages and solid earnings prospects yet are priced at significant discounts to our FMV estimates. At the same time, we are holding market hedges where, by definition, we’re short the average company trading at high valuations.

While we continue to hedge against a market correction, we have our sights on additional undervalued positions, but we fear (and hope) better entry points are ahead.

Here’s to Normalcy!

We all need to embrace change but when it impacts our ability to embrace grandparents, something’s clearly amiss. It’s just too much.

And in the financial world, the response has been unexpected. Stocks have risen to all-time highs, at a time when you’d think the uncertainty would restrain them. An abnormal reaction.

While markets could continue their ascent, we believe that extended valuations and exuberance should at least temporarily cap market indexes.

We remain defensive, holding some cash and/or a reasonable sized hedge, while we continue to hunt for undervalued high-quality businesses, both here and abroad, especially since overseas investment options are cheaper than comparable U.S. shares.

In the meantime, we look forward to simple things, like eating with others inside, seeing smiles, blowing out candles, wearing dress clothes, walking on a beach, and not having to cross the street to the other sidewalk. A market correction which resets prices and provides more opportunities wouldn’t hurt either.

1. EVs (Electric Vehicles), AVs (Autonomous Vehicles), AI (Artificial Intelligence), VR (Virtual Reality), AR (Augmented Reality), and IoT (Internet of Things).
2. SPAC (Special Purpose Acquisition Company).