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Commentary

Whoa Dude, Check Out This Stock - 3Q 2020 Outlook

By David Cleary, CFA | July 2020

Since March, the US stock market has enjoyed a 20% bounce from its bottom seemingly on the vague promise that the US economy was going to re-open and life would resume somewhat normally.  To a subset of investors, the notion of recovery has seemed preposterous as the economic damage inflicted by COVID-19 has been so large, so unprecedented and to a great extent not fully digested by the overall economy today.   A second COVID wave, unemployment, commercial real estate, municipal finances, consumer spending, et al, are at the top of their very long worry list.

 

Yet another subset of investors has found reason to rejoice as the opportunities afforded them during the market meltdown seemed too good to pass up.  In another instance of populists versus legacy powers, Robinhooders and other seemingly inexperienced retail investors have flocked to the stock market to take advantage of the recent surge in equities while many institutional investors preached caution.  In a somewhat infamous twitter rant (warning explicit language), David Portnoy, the founder of Barstool Sports, turned day trader took a swing at the vested powers of the institutional investment community, particularly Howard Marks and Oaktree Capital.  More so than many other endeavors, the investment business is built on the premise that talk is cheap, and your returns define you.  If that truly is the case, I would mark the 2Q scorecard Portnoy-1, Marks-O.

 

At Timber Point Capital Management, we too have enjoyed the recent market recovery.  In our outlook piece from last quarter, we expressed modest optimism that both life and the market would improve as the COVID crisis diminished.  We preached perseverance and an active approach to finding opportunities among the carnage.  I would like to say that we were all in on equities and other risk assets but that is not entirely true.  We did however find many interesting and very profitable investments in our basket of recovery stocks (more on that in a subsequent blog post).  Franchise US companies, trading down 50% or more from previous highs with strong balance sheets and financial flexibility were too good to pass up, despite a multitude of meaningful macro worry points and risk factors.  Investments in these companies and a general bias towards other cyclical investments drove our portfolio’s returns, over the period.

 

On a going forward basis, we remain (I hate this term➡) cautiously optimistic.  When evaluating our key economic and investment drivers there are both signs of a v-shaped recovery and continued risk variables and headwinds.



2020 3Q Key Economic and Investment Drivers

Real Economic Growth

Rising

Stable

Falling

The shock of COVID-19 and the subsequent shutdown have been devastating to the US economy.  Once normalization occurs the economy should recover sharply from today’s depressed levels.  Dramatic fiscal and monetary stimulus should provide meaningful help, but secondary effects of the shutdown will have an impact.

Inflation

Rising

Stable

Falling

Given the collapse of demand across the economic spectrum, inflationary pressures will likely remain muted.  Supply disruptions may occur across pockets of the economy as “opening for business” will not be an instantaneous process.

Real Interest Rates

Rising

Stable

Falling

The Federal Reserve has been proactive in dealing with COVID-19 by initiating a wide range of stimulus measures, including a resumption of quantitative easing.  Purchases of private corporate bonds, both high grade and high yield are a new feature of QE-COVID.

US Dollar F/X Value

Rising

Stable

Falling

The dollar has remained a safe haven among global currencies but will only remain so if the US economy can re-open quickly and recover in meaningful fashion.  Interest rate differentials which have favored US government bonds have narrowed in the recent period.

Taxes and Regulations

Rising

Stable

Falling

The fiscal response to the coronavirus has additionally been meaningful with over $2 trillion of aid being allocated to taxpayers, small businesses and corporations by way of direct cash outlays, payroll protections and subsidized low interest loans.  Government intervention in the private sector is increasing and will likely continue.

P/E Ratios

Rising

Stable

Falling

Earnings will fall sharply over the near term resulting in “excessive” valuations across many equity investments.  Uncertainty will remain on the earnings front as 2020 S&P 500 earnings are unlikely to get back to their previous year’s peak.

Fixed Income Risk Premiums

Rising

Stable

Falling

Supported by Fed policy, broad credit spreads should fall sharply upon the re-opening of the economy.  Security specific risks will remain across credit investments as defaults will be inevitable among weak players in stressed industries.

Volatility

Rising

Stable

Falling

Volatility spiked to near record levels at the depths of the COVID driven equity market decline.  Although volatility has fallen sharply since then, the futures curve remained in backwardation for a long period and is unlikely that spot VIX returns to 2019 levels.

      Bullish    Neutral    Bearish

 

The monetary policy response to COVID is among our most optimistic variables and should continue to be highly supportive of risk assets over the near term.  For the umpteenth time over the past dozen years, central banks have come to the rescue of investors.  In this instance the Federal Reserve has expanded its balance sheet to $7 trillion and added the capacity to purchase not just government backed securities, but for the first time both high grade and high yield corporate bonds.  In our viewpoint, this creates a meaningful floor to risk assets as the Fed truly is the buyer of last resort of corporate debt.  In turn, this opens the high yield issuance market and allows companies to refinance and shore up balance sheets.  This has been crucially important to supporting markets.

As indicated, this flush of cash provided to the markets by the Federal Reserve has reduced near term financial market risk which has been a boon for asset class returns, most notably high yield corporate bonds and by extension US equities. 

When looking objectively at equity market opportunities today, however, one most definitely needs to be mindful of valuations.  We do not often let valuations be the exclusive variable in which we make investment decisions.  Furthermore, we do believe that the marketplace is mostly efficient, and the markets reflect a view on the future, not the past.  Yet at extremes, one needs to pay attention and today’s equity market valuations are extreme.  Bears will look at these valuation metrics and presume that any equity investment made today is being purchased at too high of a price.  Bulls will concede that prices may be high but that the marketplace is discounting a v-shaped recovery in earnings not dissimilar to the v-shaped recovery we are seeing in employment and several other key economic variables.

Today, our opinion on earnings and valuation is a show-me viewpoint.  We recognize the extremes in valuations but also see a scenario where companies can grow into these valuations.  S&P 500 earnings have cratered due to the COVID economic shutdown, but it is possible that expectations are now too low.  To the extent that the monetary and fiscal stimulus continue to provide support and stimulus to the real economy, earnings expectations could increase sharply over the next few months justifying today’s lofty stock market valuations.

Among equities we have seen a modest rotation among sectors as energy and consumer discretionary stocks have bounced from lows.  Technology, however, remains the leadership asset class which makes intuitive sense as we think through what the economy will look like post COVID.  Technological solutions have been crucially important in the growing work at home movement and will likely continue to lead the market higher as technological innovation will increasingly be required in a  re-engineered workplace environment.  By extension, other sectors such as commercial real estate will be challenged in this new post COVID economy as workplaces evolve from centralized urban campuses to smaller, decentralized work environments.

 

All of this continues to argue for an active approach to investing.  Over the past several years, passive approaches to investing have seen an increase in popularity and efficacy.   Owning the S&P 500 has been an extremely cost-efficient approach to investing.  Yet, on a going forward basis we continue to believe that a more active approach is going to be needed across asset classes, countries, sectors and securities.  The COVID crisis is forcing significant change across the economic landscape.  Companies which can dynamically alter their operating framework to adjust to this new environment will be industry leaders and likely stock market outperformers.  Companies that do not aggressively alter their business models will underperform.  Investment decision makers will be required to understand these rapidly changing dynamics and alter portfolios appropriately.

 

Overall, for the third quarter we continue to favor risk assets over defensive assets with our viewpoint being driven primarily to today’s monetary policy stance.  We remain overweight equities broadly, and particularly smaller capitalization stocks.  We continue to overweight domestic equities over international stocks as the opportunities outside the United States seem somewhat unspectacular and typically opaque.  China is experiencing its own post COVID v-shaped recovery but not so much for the rest of the world.  Given our expectations for dynamic change and expanding of economic winners and losers, we continue to emphasize weightings in alternative investments.  The flexible, opportunistic nature of non-traditional, alternative strategies should be beneficial in this volatile investment environment.

 

We are very aware of the risks ahead of us, including a very uncertain political environment and presidential election in just a few short months.  Our somewhat optimistic viewpoint may require a future alteration if some of the more worrisome variables surrounding COVID and the re-opening of the economy become paramount again.  In the meantime, we are prescribing to theme of “Don’t Fight the Fed”.  Economic execution will be required at both the macro and micro levels but the extraordinary size and scope of the Fed’s response to this crisis is the differentiator and should support investment markets in the near future. 

 

Topics: Market Outlook

Written by David Cleary, CFA

David Cleary, CFA is the Founder and Lead Portfolio Manager at Timber Point Capital Management. Previously he spent 23 years at Lazard Asset Management where he held a series of senior portfolio management roles over multi-asset and global fixed income strategies. Additionally, he served as the firm’s global head of fixed income, a $26 billion platform. Prior to Lazard, David worked at UBS and IBJ Schroder, mostly in fixed income asset management roles. He began working in the asset management field in 1987 upon his graduation from Cornell University, with a BS in Business Management and Applied Economics. He is a CFA charterholder.

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