June Investment Comments
After a dizzying late February and March that saw the stock market fall into bear market territory (down 20% or more) at the fastest pace in history, the recovery from the S&P 500’s low of 2,237 on March 23rd has been almost as breathtaking, a roughly 30% advance. For 2020 the index is down about 10% for the year, substantially better than might be expected given the health and economic damage inflicted by the COVID-19 pandemic.
Recent statistics on the health impact of the virus are daunting. Johns Hopkins’s COVID-19 dashboard reports over 4.2 million cases worldwide and approximately 290,000 deaths. The U.S. alone now has over 1.35 million cases and approximately 81,000 deaths, 27,000 of which have occurred in New York State. The human toll COVID-19 has wrought is tragic.
However, the human spirit to face challenges and persevere is on display daily. Shelter in place orders put into effect in March are slowing the spread of COVID-19 and some areas, like New York City, are experiencing declines. Hospitals around the country have quickly organized to test and treat infected patients. The scientific community worldwide is working on both a cure and vaccine, and early results are promising. A treatment from Gilead Sciences, remdesivir has gotten approval in Japan and is now authorized by the Food and Drug Administration for emergency use in the U.S. Business has mobilized quickly to adjust the delivery of products and services that cater to the needs of individuals spending most of their time at home.
While the human toll should not be understated, the economic damage has been nothing short of severe. The press, by nature, tends to focus on the negative, and there are plenty of economic statistics available to paint a grim picture. If you don’t want to read yet another dose, please skip this next section. However, in the context of the stock market’s behavior over the past few months it can be instructive.
In hindsight, the market’s rapid fall was appropriately foreshadowing economic numbers that are, at best, on par with the Great Depression. The employment market began to show the first cracks as new weekly claims for unemployment quickly skyrocketed into the millions as employers, particularly in travel, retail, entertainment, and dining, laid-off or furloughed workers in response to shriveling demand. The April jobs report quantified the losses, as the unemployment rate surged to 14.7% and employment shrank by 20.5 million. While not as bad as the estimated 25% jobless rate during the Great Depression, April easily exceeded the previous joblessness record of 10.8% for data tracing back to 1948. Job losses by sector were widespread, with leisure and hospitality businesses leading the way at 7.65 million. Even white-collar jobs, such as consultants, accountants, and lawyers, saw layoffs.
A steep falloff in demand toward the end of the quarter contributed to a 4.8% decline in first quarter GDP, the largest quarterly drop since 2008. Consumer spending, which makes up 70% of the economy, fell faster, contributing 5.3% to the decline, joined by another 1.2% from less business investment and 0.5% from businesses selling down inventory. Offsetting these declines were trade (+1.3%), residential investment (+0.7%) and government (+0.1%).
While trade helped cushion some of the first quarter U.S. GDP weakness, the global economy won’t provide much ongoing support. The eurozone’s first quarter GDP was far worse than the U.S., dropping 14.4%. China, which endured the pandemic earlier, saw GDP fall 6.8%, the first decline since the country started reporting data in 1992. Other major countries, like Japan, have yet to report but will likely follow with declines of their own.
So now that all this bad news is out there and even more coming in the second quarter, why has the market turned so bullish? There are multiple reasons, but likely the most important one is the loosening of stay at home orders given the flattening curve of new COVID-19 cases. Getting people outside and back to work will lead to a rapid surge in demand for goods and services, restoring significant growth and setting the stage for a much better second half of 2020.
The market is also applauding the significant support provided by the U.S. government, both monetary and fiscal. Taking lessons learned from the 2008-2009 financial crisis, the Federal Reserve has significantly bolstered liquidity to credit markets and restored order to what had been panic in March. On the fiscal side, Congress and the Administration acted quickly by passing the CARES Act, providing direct support to the healthcare system to fight the pandemic, consumers with cash payments, the unemployed with expanded benefits, and small and medium businesses with forgivable loans to maintain payrolls. The small and medium business lending program was so popular that it ran out of money and has since been authorized with additional funds.
Has the market gone too far in anticipating recovery? That is a tough question to answer, but we can take some clues from businesses’ first quarter conference calls and examine revised earnings estimates to get a sense of valuation.
The first quarter calls that were the most bullish tended to come from firms that are well capitalized and participating in growth trends that were in evidence prior to the pandemic. An example is Amazon, which is hiring thousands of additional workers to fulfill surging eCommerce orders. Even though the cost of these extra workers will drag down short-term earnings, the investment is well worth it to add customers that had previously preferred to shop in a brick-and-mortar setting.
Unfortunately, most earnings calls did not go as well. Heavily indebted firms in industries immediately impacted by the loss of business, such as Neiman Marcus in retail or Hertz in travel, are either in, or approaching, bankruptcy. Most companies we follow have seen some impact on demand for their product or service and have responded appropriately by cutting costs to preserve their profitability and bolstering liquidity by drawing down lines of credit or suspending dividends and/or share repurchase programs. More worrisome are discussions around cutting costs in the second half of 2020, either through outright layoffs or slowing the pace of hiring. We worry that the market isn’t fully pricing in the reduction in earnings and economic activity from these post-pandemic belt tightening plans.
According to FactSet’s Earnings Insight newsletter dated May 8, 86% of companies in the S&P 500 have reported first quarter results. Unsurprisingly, they aren’t great, with earnings falling 13.6% and revenue advancing just 0.6%. The second quarter is going to be even worse, with analysts, often an optimistic lot, expecting earnings to fall 41% on an 11% drop in sales. For calendar year 2020 analysts expect earnings to drop 20% on a 4% sales decline.
Now more than ever, assessing a firm’s growth, valuation, and capitalization are critical ingredients to successfully building a profitable investment portfolio. Even during this recession there are quality companies that have durable business models available at reasonable prices.
Daniel J. Boyle, CFA