Market Strategists Focus on December 2018 Lows For Support, Does That Make Sense?

It might surprise many investors to know that despite the violent stock market correction over the last few weeks, the S&P 500 index remains above the trough made during the late 2018 decline. Recession fears during Q4 2018 led to a 20.2% bear market from peak to trough over a three-month period, resulting in an intra-day low for the index of 2,346.

Given that 2019 corporate profits were only modestly above 2018 levels, and considering that the economic weakness from COVID-19 is tangible and not just a “growth scare” (like 2018) market watchers who believe a drop back to that 2,346 is possible, or even likely, do not seem out of line to me. Even at this week’s low point (2,478) it would mean another 5% lower and a full 31% drop from the February market peak.

So if the market today is still above the 2018 low, how does it compare to recent years’ lows? I decided to take a look and the data really sheds light on how far the bull market had come before the novel strain of coronavirus crashed the party.

Below you will see the yearly low for the S&P 500 going back to 2014. I have included the peak-to-trough decline in percentage terms, assuming the current bear market reaches each of those price levels.

Despite an enormous drawdown in 2020, the market remains above the December 2018 lows.

While the percentage drops are severe, it is interesting that even a 34% decline only takes us back to 2017 levels. While that might not sooth investors’ anxiety at the moment, having some context about where we have been does serve to reinforce the long-term equity market trends we have endured during the latest bull market.

I suspect we would see material buying pressure if the S&P 500 dipped down to the low points of 2017 and 2018, unless the virus was truly getting out of control even after governments around the globe took strong and decisive steps to mitigate its spread.

*****

The next logical question to me is what the valuations were at each of these market’s troughs, which can possibly shed some light as to the ultimate magnitude of the current bear market. Below is a chart that shows the P/E ratio on the S&P 500 at each of the low points shown above. I used the actual full year profit figure for each respective year (e.g. the 2014 P/E reflects the low price no matter when during the year it occurred, paired with actual full year 2014 earnings).

Based on the last 5 years, buyers tend to jump in whenever the market P/E nears 15x.

I have heard a lot of commentary in recent days about how the market might actually be more expensive now than it was a month ago, despite a 25-30% market decline. Their reasoning is that earnings are likely to fall dramatically in 2020. For instance, at the high near 3,400 on the S&P 500 stocks fetched 21.6x trailing earnings. However, if earnings fall 25% this year, the S&P at 2,600 would trade at 22.2x earnings.

I find that argument bizarre. The stock market is forward-looking and during a recession really doesn’t trade based on real-time earnings because those figures are depressed and temporary. I much prefer to use actual 2019 earnings to value the market right now, since we don’t know what 2020 profits will look like and they likely won’t stay depressed for very long. While we also don’t know what 2021 earnings will be, a good starting point in my view would be 2019, if we think the world will normalize again sometime within the next 12 months.

At any rate, if we take 2019 S&P operating profits of $157 and use a 15x multiple, we arrive at a level of 2,355. That level just happens to be right at the December 2018 low (2.346) and 31% below the 2020 all-time high. We will see if that kind of level brings out buyers in force in the coming days and weeks. I would guess the virus pandemic/economy would have to get really bad to materially break those levels for an extended period, but that is only an educated guess and prices can pretty much touch any level on any given day.

As Plummeting Oil Prices Compound Economic Concerns, Here Are 2 Things To Do This Week

Two weeks ago we saw a severe stock market decline, which was followed up with whipsaw volatility but a leveling off of prices overall last week. We are starting this week off with what appears to be somewhat of a panic by short-term market participants, with stock trading halted within minutes of opening Monday morning after a 7% drop (due to a exchange-imposed “circuit breaker” 15-minute trading halt - a rule in place, but never triggered, since 2013). As if the virus was not enough, now we have collapsing oil prices threatening the viability of an entire sector of the economy.

If this week is the first time during the coronavirus scare that stock prices meaningfully diverge from the underlying businesses they comprise (a 2,000 point drop in the Dow in a matter of minutes can do that), I would offer two actions investors should consider:

1) Don’t sell stocks simply to try and relieve the pain and prevent further paper losses in the near-term

While it is never reassuring to see stock prices diverge from corporate fundamentals and traditional company valuation metrics, selling securities when prices are irrational rarely pays off. In order for that bet to work, you need to be able to buy back the stock at lower prices (i.e. at even more irrational prices) in the future.

Not only is such a task extremely difficult when it is one’s main objective, but the very fact that somebody wanted to sell during a period of intense pain probably greatly reduces the odds the same investor would be able to buy back those shares after that pain has intensified.

The two smartest options during periods of near-term market dislocation/panic are to either buy mispriced securities with the intention of holding them for (at least) a year or two if needed, or wait things out until normalcy returns and any transaction you want to consider can be consummated at a fair price.

2) Strongly consider refinancing your mortgage

Mortgage rates have now hit all-time record lows, with the average 30-year fixed rate pushing towards 3.00%. I recommend getting a quote from your mortgage broker to see if the monthly savings from refinancing now is meaningful for you. To get judge the return on investment, I always try to see what mortgage rate I can get that offers a lender credit roughly equal to the closing costs. That way, the deal not only costs you close to nothing out of pocket (excluding the funding of an escrow account, if required by the lender), but also maximizes the ROI on the transaction.

Coronavirus Correction: How Far?

So how far will the U.S. stock market fall as the fear of a coronavirus pandemic tightens its grip on daily trading activity? Since there is no way to know, there is little sense to making a prediction on that front. But that does not mean that we cannot set our expectations based on market history, even if there are no assurances that the actual result will be no worse than said expectations.

Without full blown recessions, market corrections are typically in the 10-20% range. Today I updated a graphic that I had last posted on this blog in early 2016, which summarizes recent corrections in the S&P 500 index. The data now goes back 10 years:

If the virus starts to slow in the coming days and weeks, the market might stabilize soon, whereas an acceleration will stoke more fear and likely result in moving towards that 20% threshold. A full blown global recession puts 20-40% declines on the table based on historical data.

Editor’s Note (3/6/20): To put these levels into perspective, the S&P 500 peaked on 2/19/20 at 3,393. Corresponding corrections are as follows: -10% (3,054), -15% (2,884), and -20% (2,715). The low point reached so far during the virus-induced market decline was 2,856 (-16%) on 2/28/20.

I have no idea how this virus will play out. If we look at SARS from the early 2000’s, the 10-20% range was adequate and assets rebounded quite quickly. The same is true of the zika, ebola, swine flu, and bird flu outbreaks. An important aspect of investing is using historical data to inform probability-based decisions. Without a crystal ball, all we can really do is try and stack the deck in our favor as much as we can with that data and prior experience.

All in all, my inclination is to buy quality companies on sale, expect that the market decline will mimic those of the last decade, and take a multi-year view on my investments as things get back to normal. While there are no guarantees that strategy will play out as I expect, making an alternative bet of some kind does not have a better chance of success based on market and economic history, which means I have little interest in exploring such paths.

When my clients reach out and ask if I am worried, my simple answer is “no.” Barring a permanent material change in how we live our lives, or how many people there are to fuel the global economy, the economic and financial output of the corporate sector is likely to snap back after a number of months, in which case the market will move on and look ahead to the future.

As 2020 Begins, Low Volatility and Investor Complacency Warrants Some Caution

As the new year has begun the same way the prior one ended (a slow melt-up in stock prices without much in the way of concern from any corner of the market), I can't help but get the feeling that complacency is extremely elevated and investors are mostly bullish.

Can the U.S. equity market keep up this trajectory:

Can market volatility remain this benign, as the Wall Street Journal reported this morning:

"The S&P 500 is in one of its longest streaks without a 1% daily move in the past five decades, highlighting how the latest leg of the stock-market rally has been a gradual climb rather than a euphoric surge. The broad equity gauge hasn’t moved 1% or more in either direction since mid-October, its sixth-longest streak since the end of 1969 and third-longest since the end of 1995, according to Dow Jones Market Data. Driving the extended period of calm trading: An initial U.S.-China trade deal and lower interest rates around the globe that have eased fears of a sharp economic slowdown."

A big indicator of investor complacency continues to be the popularity of index funds. The sheer number of indexes being created should give us all pause. Consider the following two stats:

1) As of the end of 2017, there were more than 3 million stock market indices worldwide, more than 70 times more than the number of public companies (43,000).

2) The story is similar in the U.S. alone: as of 2016, there were about 4,000 U.S. stocks but more than 5,000 indices containing them, according to Bloomberg:

While I don't have updated data, it is safe to assume the gap is even wider now that a few years has passed and the trend is not slowing down. It boggles the mind, really. Imagine a professional sports league with more teams than actual players. It is just not logical.

After a decade where the main index, the S&P 500, posted 14% average annual returns, it is easy to see how recency bias is forcing investors to conclude that indexing is the only strategy worthy of consideration. But let's not forget that the markets are cyclical, just like the economy and investor sentiment. With the P/E on the market now above 20x, a level that historically has warranted caution, and the 5 largest stocks now comprising nearly 20% of the S&P 500's market value, there are real signs that investors have set everything to auto-pilot and expect the tech sector to continue to drive the indices higher indefinitely.

All of these factors taken together make me nervous. That is not to say that it has top end soon and in dire fashion (there are plenty of plausible outcomes), but I would not want to make a strong consensus bet that the next 1-0 years will look similar to the last 10.

Guess The Valuation - Inaugural Edition

As a fundamentally and valuation driven investor, I am continuously amazed at some of the equity valuations the public market bestows on growth companies, even in an age of near-zero interest rate borrowing conditions.

So for those valuation-driven readers, let me present the first of what I will simply call "guess the valuation." I present you with financial metrics and you tell me how much you think a growth investor, at most, should be willing to pay in total equity market capitalization terms.

Before the comments start coming, understand that I am fully aware that this exercise is overly simplistic and one would want to have more data before answering such a question. Humor me please to play along, and feel free to give the company below the benefit of the doubt (within reason).

Unidentified Company X

Financial results for the first 9 months of 2019

Revenue: $1 billion (+50% yoy)

Gross Profit: $600 million (+50% yoy)

R&D Expenses: $250 million (+50% yoy)

Marketing Expenses: $350 million (+35% yoy)

General/Admin Expenses: $125 million (+60% yoy)

Operating Loss: $125 million (-35% yoy)

Operating Cash Flow: $20 million (N/M)

Okay, guess the equity value assuming zero net debt on the balance sheet...

The IPO Market Has Taken The Baton From Large Cap Tech And Is Running Like Crazy

For several years until recently large cap technology companies were carrying the U.S. stock market on their backs. The nickname of FANG was even coined to describe the group, which included Facebook, Apple, Netflix, and Google. However, all of those companies saw their stock prices peak in 2018 and move in sideways fashion since, which has resulted in the S&P 500 doing the same over the last year:

With the tech sector comprising more than 30% of the S&P 500, as big tech stocks see their rapid ascents halted, so does the overall market...

However, with the economy doing well and stocks having rebounded from their Q4 2018 swoon, there are going to be pockets of strength in the market regardless. For a while it was cannabis stocks but now it appears to be the IPO market.

While the valuations are not as extreme as they were in 1998-2000 with the tech bubble, they nonetheless don't jive with the underlying financial profiles of the companies. Beyond Meat, which will wind up being among dozens of alt-meat competitors, should not be valued at $10 billion (for example). Unlike high margin tech companies like Facebook or Google, traditional businesses like food manufacturing or general merchandise retail have low margins and therefore will not result in large price-to-sales multiples over the long term.

I bring up the latter category because today's IPO winner du jour is online pet store Chewy.com (CHWY), which price its IPO at $22 per share and nearly doubled to more than $41 before 11:30am ET. At that price, CHWY's market value is $17 billion.

Chewy is growing very fast and could very well reach $5 billion in annual sales this year. That sounds great, and at a tad over 3 times annual sales, maybe the stock is not mispriced? Well, let's not forget that Chewy sells pet food online and ships it to their customers. This is not a revolutionary business model, and it certainly is not cheap to operate. Cost of goods for Chewy is above 75% and operating margins are negative. If the company decided to grow more slowly and cut marketing expenses from 10% of sales to 5% of sales, they could perhaps breakeven.

Even in a world where Chewy reaches $10 billion of sales and manages to turn a profit, the valuation should be relatively meager. General merchandise retailers like Costco, Target, Wal-Mart, and Best Buy all trade for less than 1x annual sales in the public market. This is because margins are relatively low (EBITDA less than 10% of sales) and retailers tend to trade at or below market multiples because they are simply middlemen/resellers of products that someone else makes.

Will the share of pet care continue to move in the direction of online e-commerce transactions? Almost certainly. Will Chewy be forced to price very competitively to win share from Target, Amazon, and Petco? Absolutely. Will they be able to ever make big profits by selling cat litter online and shipping it to your house? Of course not.

If Chewy trades at 1 times annual sales five years from now, it has to grow its business by28% annually during that time to be be worth today's price in 2024. For investors who buy it today and expect a 10% annual return over the next five years, Chewy would have to grow 40% per year through 2024.

So is Chewy the next big thing or just the most recent example of an overpriced new IPO? I would bet on the latter and will be paying close attention to see if high valuations persist when many recent IPO are available to short with minimal cost.

Full Disclosure: No position in Chewy at the time of writing

(Author's note added at 6/14/19 12:40p ET - Petsmart bought Chewy in 2017 for $3.35 billion, so they are sitting on a 5x return in 2 years, to give readers a sense of the valuation inflation going on here)

Not Enough U.S. Cash Burning IPOs for You? Here Comes China's Luckin Coffee

Just as U.S. investors are trying to make sense of the Uber (UBER) and Lyft (LYFT) IPOs, both disastrous for those buying at the offer prices, on Friday we will get a U.S. listing of Chinese-operated, Cayman Island-incorporated coffee upstart Luckin Coffee. How much should investors pay for this so-called Starbucks of China (even though its business model is not copying the Seattle-based giant)? Quite frankly, who the heck knows? If that is not a sign that one should pass for now, I don't know what is.

Below is a summary of Luckin's financials from the IPO prospectus, though keep in mind its operating history is short (having gone from zero to 2,370 stores between October 2017 and March 2019).

This income statement reads like a Silicon Valley cloud-computing start-up, not a Chinese bricks and mortar coffee chain

As you can see, Luckin's stores are run at a loss, with Q1 2019 sales of $71 million dwarfed by direct store operating costs of $83 million and another $25 million of marketing expense.

Investors should not exactly be enamored with Luckin's growth rate. After all, selling coffee at a loss is an easy way to rack up sales and there is no way that the company has a detailed, refined, and proven unit expansion plan in place given that they are opening these money-losing locations as fast as humanly possible (an average of more than 4 new stores a day since they launched 18 months ago!).

None of this says anything about the long-term odds of success for Luckin Coffee. They could very well become China's largest coffee seller and make money doing it. There is simply no way to know at this point, so investors are left deciding whether they want to take a gamble or not. Many will given that the company will list on a U.S. exchange this week, but with no sound financial model to back up the prices being paid for the shares, there is really no fundamental case to be made for buying the stock.

All one can do is estimate what they think margins could ultimately be based on the business model, assume long-term success, and calculate an imputed price-to-sales ratio worth paying today given certain growth assumptions. That is how Uber and Lyft are likely to be valued (assuming people care to value it at all), and the same idea applies to Luckin Coffee and whatever the next cash-burning IPO waiting in the wings happens to be.

Author's note: To give you an example, assume that Uber can ultimately earn 20% EBITDA margins over the long-term and one can justify paying 15x EV/EBITDA given their potential growth outlook. That valuation equates to an EV/sales ratio of 3x, which based on 2020 revenue projections could yield a per-share fair value in the $30 ballpark (vs today's quote of $40).And don't even ask me to guess what Luckin Coffee's margins could be.

What A Difference A Decade Makes!

There was a lot of talk on CNBC this week about the trailing 10-year returns of the S&P 500 index and what, if anything, they tell us about the duration of the current equity bull market. Interestingly, the U.S. stock market bottomed at 666 on March 6, 2009, and has since returned nearly 18% annually for a decade.

The consensus view is that periods of strong market returns are often bookended by low valuations on one side and high valuations on the other side. That is certainly the case in this instance, and I am not sure it tells us very much about the current bull market (in terms of when it loses steam). Using the intra-day bottom during the worst market environment in nearly 100 years, as a starting point, is almost assured to subsequently produce a decade of strong returns.

While we cannot use this data to predict the next bear market, it is noteworthy that the market does tend to go in cycles that last one or two decades. The last 10 years have been characterized by strong index returns, and the rise of the index fund as the go-to investment option for individual investors. But I would argue that recency bias is playing a large role in this trend.

Consider that from January 1, 2000 through December 31, 2009, the S&P 500 went from 1,469 to 1,115, a loss of 24%. Dividends made up for a lot of the decline, such that $1 invested in the index including dividends was worth 91 cents in the end, but still, that decade produced a cumulative loss of about 1% annually.

Perhaps that is why there were not nearly as many people piling into index funds 10 years ago. They work... until and unless they don't. Just as the economy and the equity market are cyclical, so to will be the popularity of index funds.

Interestingly, even Warren Buffett (arguably the greatest active portfolio manager in history) has been bitten by the index fund bug, having recommended them many times in recent years.

Side note: I think the saying "do as I do, not as I say" is fitting here. While Buffett now praises the index fund category, it is important to note how the 88 year old plans to transition his stock picking duties at Berkshire Hathaway when he is no longer around. Move all of his investments into index funds? Hardly. Instead, he has hired two hedge fund managers, Todd Combs and Ted Weschler, to take over management of Berkshire's stock portfolio. Fascinating.

So what can we expect over the coming decade for the stock market? Well, it is not exactly going out on a limb to say that returns will likely average less than +18% and more than -1%, but that is a start. After all, the coming decade is unlikely to be as good as the go-go 1990's, or as bad as the ten years immediately following them.

History would tell us that average returns will be somewhere in the single digits. I won't hazard a guess as to whether we get 3%, 5%, or 7% a year, but I think mid single digits is as good of a guess as any based on historical data. It will be interesting to see if, in such an environment, index funds remain the asset of choice, or if tastes shift to something else (and if that something else is already in the marketplace or if it has yet to be created).

U.S. Stock Market Seems Like An Obvious Buy For First Time In A Long Time

With the S&P 500 index now down roughly 18% from its peak reached about three month ago, for the first time in years it appears the U.S. stock market is severely oversold and pricing in worse than likely economic conditions. In the two weeks since my last post discussing valuation, the S&P trailing price-to-earnings ratio has dropped by more than a full point and now stands at just above 15x.

I have previously posted that we should expect P/E ratios of between 16x and 17x with the 10-year bond yielding in the 3-5% range (current yield: 2.75%). Given that 2018 corporate profits are pretty much in the books already, the current valuation of the S&P 500 assuming ~$157 of earnings is 15.3x (at 2,400 on the S&P 500).

Let's consider what this valuation implies. First, it presumes no further earnings gains, or put another way, 2018 is the peak of the cycle for profits. Could that be possible? Sure it could, but right now that is the base case. And even with that base case, stocks are 5-10% below the 16-17x P/E we would expect to see.

One could also make the argument that U.S. stocks are pricing in a mild, normal recession. Let's assume a typical 6-9 month recession occurs over the next 12-24 months, and as a result, S&P 500 profits drop 11% to $140. If a normalized P/E ratio would be 16-17x, I would guess stocks would fetch about 18x trough earnings during a recession (investors often pay higher multiples on depressed earnings). If we assign an 18x multiple on $140 of earnings, we get an S&P 500 target of 2,520, or 5% above current levels.

If we take a more bearish stance and assume a normalized P/E (16.5x at the midpoint, given low interest rates) on that $140 profit number, we would peg the S&P 500 at 2,310, or less than 4% below current levels.

I am not in the game of predicting short-term economic paths or stock market movements. All I can say now is that stock prices for the first time in many years are pricing in several of the most likely economic outcomes (normal recession or materially slowing GDP growth). Furthermore, it appears that the S&P 500 will close out 2018 at the lowest valuation since 2012.

Given those conditions, I am aggressively buying stocks with the majority of current cash balances in the accounts of those clients who are aiming for more aggressive, long-term, growth-oriented investment strategies. Put simply, I am seeing a ton of bargains right now and am not content waiting for further downside to pounce. For those who have excess cash on the sidelines, now could turn out to be a great time to add to your equity exposure, assuming that fits with your risk tolerance and investment goals.

With The Elevated Valuation Issue Solved, 2019 Earnings Growth Takes Center Stage

With S&P 500 profits set to come in around $157 for 2018, the trailing P/E ratio for the broad market index has fallen from 21.5x on January 1st of this year to 16.5x today. Surging earnings due to lower corporate tax rates have allowed for such a significant drop in valuations despite share prices only falling by single digits this year, which is a great result for investors. Normally, a 5 point drop in multiple requires a far greater price decline.

With sky high valuations now corrected, the intermediate term outlook for stocks generally should fall squarely into the lap of future earnings growth in 2019. On that front, there are plenty of headwinds. With no tariff relief in sight, the steady inching up of interest rates, a surging federal budget deficit, and no incremental tax related tailwinds next year, it is hard to see a predictable path to strong profit growth from here.

Even if 10-year bond rates go back into the 3's, market valuations should stabilize in the 15-18x range, so stocks today appear to be fully priced for a relatively stable economic environment. Although current profit estimates for 2019 are quite high (double digit growth into the $170+ area), I suspect those figures will come down meaningfully once companies issue 2019 guidance in late January and into February (analysts don't often go out on a limb so they will wait for companies to tell them what to expect).

Putting all of this together and we are unlikely to make new highs in the market anytime soon, in my view. We probably have 10% downside and 10% upside depending on various economic outcomes over the next few quarters. In the meantime, there are plenty of cheap stocks to accumulate and hold for the long term, until attractive exit points present themselves. Goldman Sachs (GS) is a perfect example, at it inexplicably trades for $176 today, below tangible book value of $186 per share.

Full Disclosure: Long GS at the time of writing, but positions may change at any time.