Curmi & Partners

Sharp macro recovery priced in equities

By Robert Ducker

2020 has been a year to remember for equity investors so far. First, the S&P 500 index (“SPX”) plunged 34% over 4 weeks into a bear market as investors feared COVID-19 will drive the global economy into a depression. All this changed over the next four weeks with the index rallying 29% up to 17/04. The decelerating rate of growth in confirmed new COVID-19 cases and the unprecedented support provided by central banks and governments were the main drivers of this rally.

Goldman Sachs (“GS”) have categorised bear markets into three types: (1) Structural (long term build-up of structural imbalances and financial bubbles) (2) Cyclical (economic cycle driven) (3) Event driven (exogenous shock). The average length of a bear market was calculated by GS at 27 months, with the average for structural bear markets the longest (42 months) and steepest (average decline of -57%), followed by cyclical (27 months with an average decline of 31%) and event driven (8 months with an average decline of 28%).

Last month’s bear market was an event driven bear market, the first event driven bear market since 1987 which was caused by computerised program trading strategies. The 1987 bear market lasted for around 3 months compared to just over one month for this bear market. The two are similar in terms of losses suffered (34% in both instances) and both bear markets followed a prolonged bull market. The swift recovery was surprising, as usually investors wait for confirmation that policy measures announced are working. Looking back to 2008, the SPX bottomed in March 2009 despite measures being announced four months earlier. During this period, the SPX rallied sharply on several occasions, with two distinct double-digit daily bounces.

Such elevated uncertainty on earnings (FY20 and FY21) makes an analysis of current valuations a tough task. Following the rebound in prices over the past four weeks the SPX is trading on a 12-month forward PE of 17.3x, above the five-year average (16.7x) and ten-year average (15.0x) according to data provided by Factset. Such valuations are not particularly expensive against the current risk-free rate backdrop; however, there is a lot of uncertainty over the current consensus earnings that underpin such valuations. Factset say that earnings in FY20 are expected to fall just 6%, followed by 16.5% earnings growth in FY21 according to consensus estimates. We think FY20 consensus earnings will be revised even lower over the coming months given the severity of the economic shock, but investors will likely look through such weakness. Notwithstanding, we could start to question FY21 consensus earnings forecast unless we see a significant improvement in economic data over the coming months.

At these valuation levels, it looks like investors are pricing in a strong recovery in the second half of the year, with the SPX circa 15% below its all-time high. Recent economic data published has been shockingly poor, and if this persists, the probability of a V-shaped recovery will diminish. The US economy has lost 26million jobs over the past weeks. To put this into some perspective, the jobs lost so far nearly cancel out the job gains recorded since the global financial crisis in 2008. We expect these numbers to improve as businesses reopen from the lockdown imposed by governments, but it remains doubtful whether aggregate demand can recover fast enough to mitigate these severe declines.

We expect 1Q20 earnings to be worse than consensus, but investors will likely look through such weakness. Additionally, we expect outlook statements provided by management to emphasise the challenges being faced by corporations due to the virus. It will be interesting to see if management will share some information on employment (more layoffs), capex plans and whether policy support will have any impact. Considering all of this, we continue to favour companies that have a strong balance sheet and generate high cash flows.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.