Past
Commentaries
3/15/2020
Current Commentary
To My Clients, Friends, & Observers
In the interest of brevity many facts and figures herein are without attribution. We are in a bear market, a drop of >20% from the highs, the first in 11 years. I want to address the depth and length of the bear and the indications for recovery. Will a recovery be L-shaped, U-shaped or V-shaped?
There have been 11 bear markets since 1956. They have averaged 12.2 months in duration; the shortest lasting 2.1 months; the longest lasting 20.7 months (1973). Some have occurred without recessions. The corona virus has come like a thief in the night to an expanding economy at full employment. There is so much mandatory cessation of economic activity that a recession appears unavoidable to me. What growth engines are there to make up for the losses? Corporate profits, which were expected to resume modest growth, are checked.
Triggered by a virus that initially appeared less dangerous than flu, the markets have experienced a series of negative feedback loops, each reinforcing negative momentum to the point of full on mode lock (like a room full of clocks all ticking in sympathy at the same time.)
The economic loop: fear of a pandemic feeds fear of recession.
The media loop: reinforces the fear.
Technical trading loops: stocks fall below their 120 day moving averages triggering automated sell programs and repeating as they fall through 150 day and 200 day averages.
Market loops: stocks go up when they are going up because of greed chasing higher prices; they go down when they are going down because of fear of lower prices.
All of this mode-lock selling is exacerbated by ETF index funds that sell the entire index, dragging down every stock in the index indiscriminately.
The momentum is irreversible until stock distribution is exhausted and buyers return to start a new cycle of accumulation. Buyers won't return until it is perceived that:
Stocks are well-valued, cheap;
Dividends are high;
Interest rates are low;
Corporate earnings growth has resumed;
Consumers are spending and the economy is not so bad.
We have some of those conditions in place. The S&P 500 is priced at 19 times trailing earnings; the dividend yield is 2.15%; the 10-year U.S. Treasury yields .9%. Fed funds is at 1.25%. Certain buyers are returning. Those are corporate insiders, employees, directors, officers and concentrated shareholders of public companies that must report their transactions in their own company's stock to the SEC. On most trading days corporate insider sells are ordinarily greater than buys, for a variety of reasons. This past week the ratio of buyers to sellers was greater than 1:1. On Friday 3/13 it was greater than 2:1 buyers to sellers.
Seller exhaustion is indicated by capitulation - an irrational fall of all asset prices (sell everything). We may have seen it this past week as stocks, safe-haven Treasuries, and even gold all fell in price. While prices may fall further, capitulation (exhaustion) is short-term.
Factors I am looking for to confirm a market bottom include:
Extreme prices: 10% drop Thursday; 26% over 16 days.
Extreme volume: NYSE declining volume as a % of total was 80% to 90% five of the last six sessions until Friday, clearly indiscriminate selling.
Extreme volatility: The volatility index (VIX) closed at the highest level since 2008 on Thursday.
Extreme sentiment: Bearishness. While extreme negative sentiment is in place (panic selling) it still hasn't reached the levels seen in December 2018. Yet it could get worse - fed by media and politicians who want it to get worse.
After a bottom, I'm looking for several indicators that it is time to re-enter the market.
They include:
Reduced volatility; supply/demand volumes reverse; earnings and price targets are revised higher; merger and acquisition activity increases; credit swaps prices fall; trading breadth expands. It could be a while before we see all of these things - and the market could take off (rise) anyway, without us.
J.P. Morgan Asset Management reported in yesterday's Wall Street Journal (page B-14) that for the 20 year period from 2000 to 2019, an investor who missed the market's 10 best days over that period had an annual return of 2.4% versus 6.1% for the investor who stayed in the market. If you missed the 20 best days your return was 0.1% annualized. And if you missed the 30 best days, you lost 2% annualized. They also not that during the period cited, within two weeks of the S&P 500 10 worst days came 6 of its 10 best days.
Also in yesterday's WSJ, same page, Nomura Securities reported that weeks with stock-market drops that are 7 standard deviations from the average normal distribution (so extraordinary that they should almost never occur), see faster recoveries. Last week was in fact 7 standard deviations from the mean. A 6 std deviation fall - still rare - has historically been followed by a grinding stagnation.
The good valuations I'm seeing in many stocks could disintegrate if corporations cannot adapt to the challenges this virus is causing. So that requires diligently monitoring revenues, earnings and managements of the companies we own.
Finally, I'm given to understand - and this could be wrong - that some 60% to 70% of the population may have to become immune to this virus before it becomes manageable. I really don't know. It could be brief, it could last a long time. It could get better, might get worse. I personally want to own companies, in good times and bad, that are systematically managed by intelligent people to generate profits despite the daily challenges they face every day.
Nothing is guaranteed and securities are risky assets. If you feel the need for higher cash balances or if your investment goals or risk sensibilities have changed please let me know or call to discuss.
Best regards,
Dennis M. O’Connor
