Wall Street is acting like this bear market is done. Perhaps so — but here’s a market approach that’ll cover you if it roars back
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***Yesterday, on one financial website, I saw the following headlines
Well, that’s not at all confusing, thanks.
The headlines are even more conflicting if we broaden our search to the economy:
Wonderful.
***It seems everyone has an opinion on how the global economic recovery will take shape, as well as how global investment markets will perform
The truth is no one knows.
So, today, I want to do something radical …
I want to refrain from burdening you with yet another prediction.
Instead, let’s simply evaluate what we know about the economy and stock market, ask a few questions about the future, then highlight a simple strategy that will work regardless of what the coming months hold.
Let’s jump in.
***Where we stand today
We know that from top-to-bottom, the stock market fell 34% in record time … about four weeks.
We also know the market didn’t linger at depressed levels. It shot off its low, surging 18% higher in three trading sessions.
Since then, stocks have continued to climb. With relatively few down-days, the S&P has added back nearly 30% since the late-March low.
As I write, the S&P is less than 14% below its all-time-high.
Now, before we make any comment/judgement on this, let’s make sure we’re on the same page …
As any longtime investor knows, Wall Street and the broad economy are not the same thing. They can (and often do) move in opposite directions at the same time. So, expecting Wall Street to reflect the economic pain felt by millions of Main Street Americans is a great way to grow horribly frustrated.
Two, remember that Wall Street is basically like a horse with blinders on. It only looks one direction — forward.
On one hand, it makes sense … If Company A had an earnings-collapse yesterday, but a new, groundbreaking product is expected to triple profits tomorrow, would the earnings collapse matter that much?
Not really. So, “looking forward” is Wall Street’s business-as-usual, and it continues to operate this way today.
Case in point, take that historic avalanche of job losses we just suffered (and are still currently suffering). According to Wall Street, that’s largely in the past since we’re now on the verge of re-opening the economy. Businesses will re-hire.
All those missed revenues for businesses large and small? That’s in the past. Shoppers will return to stores.
All those hampered earnings? They reflect a black-swan event that’s behind us, not business-as-usual. Ignore.
Everything looks forward.
“Fine, Jeff, Wall Street looks forward. But how far forward is it looking exactly? And should it be looking that far?”
Ah, well, those are interesting questions …
***What crystal ball is Wall Street looking at?
The “future” can be many things. Tomorrow … Next week … Next decade …
For our purposes today, let’s pick two broad time-frames: what’s immediately in front of us (the next quarter or two), and then what’s further out on the horizon (call it, 12 months and beyond).
In terms of what’s immediately in front of us, we have:
- Oil prices so low that they threaten to decimate the U.S. oil industry.
- A slew of companies on the brink of declaring bankruptcy (beyond the obvious companies in the oil industry, we have retailers including J.C. Penney and Neiman Marcus).
- A likely dramatic rise in consumer credit card defaults (in China, a proxy for what we might see here in the U.S., overdue credit-card debt swelled last month by about 50% from a year earlier).
- The private mortgage lending market facing 3.4 million borrowers who are unable to make their mortgage payments on time. That represents $754 billion in unpaid principal, plus unpaid interest on the loans. Though lenders have received some federal relief funds, many are still feeling a dangerous squeeze.
- Another month when a significant portion of the country will remain closed for business, increasing the risk of some smaller businesses closing doors forever without rehiring. And the parts of the country that are re-opening are doing so very slowly because the re-opening might have terrible consequences in the fight against COVID-19.
Wall Street’s 30% rally suggests it’s already lumping this into the “past” bucket. Or, we should just shift our gaze further out.
Okay, so “how far out is Wall Street looking?”
Well, let’s take a common Wall Street metric — the 12-month forward price-to-earnings ratio of the S&P 500.
For any readers less familiar, this ratio takes the estimate of the S&P’s earnings 12 months away and compares it to the S&P’s current price. It answers the question “how much are we paying today for what we believe to be next year’s earnings?”.
After the S&P’s vigorous rally over the last month, its forward P/E is 19.1.
For context, that puts it 14% higher than its 5-year average of 16.7. It’s also 27% higher than its 10-year average of 15.
Hold on to this for a moment. We’ll circle back …
***Below is a chart from data company, FactSet, that compares the S&P’s forward 12-month earnings per share estimate with the S&P’s price
It tracks those two metrics over the past 10 years. Give it a look before I provide any commentary.
Now, what you likely noticed was the far-right edge of the chart where there’s a massive divergence between earnings estimates and the market’s price.
Here it is, blown up. Remember, the light blue line is the S&P market value (its price) while the dark blue line is the 12-month earnings-per-share estimate.
***But isn’t Wall Street supposed to have blinders on, focused exclusively on the future?
Yes, which is why this divergence catches the eye.
Plus, keep in mind, these future earnings estimates are missing some key information — namely, guidance from the companies themselves.
As of last Friday, 122 S&P 500 companies had reported actual results for the first quarter.
From FactSet:
Of these 122 companies, 50 (41%) commented on EPS guidance for the current year.
Of these 50 companies, 30 (60%) stated that they were withdrawing or had already withdrawn previous EPS guidance for FY 2020.
All 30 of these companies cited the uncertainty of the future impacts of COVID-19 as the reason for withdrawing EPS guidance for the full year …
According to FactSet, we’re looking at:
Q1: -15.2%
Q2: -31.9%
Q3 -16.9%
Q4: -7.4%
For the calendar year, it’s -15.2%.
***Despite these projected earnings declines, FactSet notes that the price target for the S&P is 3169.65, which is about 9% higher than the S&P as I write … even after the blistering 30% rally so far
Is that a reasonable expectation?
Perhaps.
But if earnings are going down 15.2% for the calendar year while stock prices are heading up 9% over the next 12 months (after our 30% rally so far), what must change?
Well, you already know the answer because we talked about it a moment ago — the forward price-to-earnings ratio must rise.
In other words, investors like you and me must be willing to pay a more today (in relative terms) for fewer earnings tomorrow.
Do you want to do that?
You might. And it could pay off.
But it will require you to do what Wall Street is doing — basically brush off the next 12 months.
***One last way to look at it
If the S&P does climb back to 3169, that will put it about 6% below its all-time-high.
In the grand scheme, a 6% differential is nothing (we’ve recently seen 6% price swings in a single day), so let’s call it for what it is — Wall Street thinks that, as far as stocks are concerned, we’re back to normal in 12 months. COVID-19 will be done, swept under the rug.
Now, do you think there will be no more ripple effects from the Coronavirus in 12 months?
It’s possible. And with all due respect to those whose lives have been turned upside down by the virus, I hope it happens that way.
On the other hand, what if we re-open early and a resurgence of hot-spots causes states to lockdown again, further crushing Main Street businesses?
What if the oil industry does collapse and thousands more lose jobs?
What if too much damage has been done for a substantial number of companies and they don’t rehire the same number of employees?
Basically, what if Wall Street is staring so intently at what’s 12+ months out, that it misses any number of shorter-term issues that act as a trip-wire?
***What you can do as an investor given today’s complex market
Admittedly, today’s Digest has a bearish undercurrent. That’s because, while I won’t make any predictions about where the market is going, there seems a basic disconnect between today’s market price and the litany of economic unknowns still facing us.
Of course, that doesn’t mean the market is going to fall. Clearly, up to this point, Wall Street has been all-too-happy to simply write-off the economic destruction as a 1-time event that is repairable.
While I doubt that conclusion (or at least believe we’re years away from full repair), perhaps my concerns are unfounded and we’ll just ride off happily into the sunset.
If so, fantastic.
***But in case that doesn’t happen, let’s pivot to a simple action plan that will enable us to be okay regardless
First, as we’ve noted many times now in the Digest, you don’t have to invest all your capital at once. Dividing it into, say, 8-12 allocations and then investing them over a planned, fixed timeline will enable you to get a blended-average of what the market offers over the coming months.
Hopefully, you’ve already begun this process. If the market keeps soaring, great, you’ll find you have some “early” purchases that will have you sitting on hefty profits.
On the other hand, if the market heads lower, you’ll still have plenty of cash available to buy in at discounted prices.
Two, focus on top-quality stocks that are able to maintain solid earnings in our new “social distancing” world. While this is easier said than done, I’ll point you toward Louis Navellier’s free Portfolio Grader tool. It’s a fast, simple way to get a snapshot of a stock’s strength.
Three, focus on those trends that will survive any Coronavirus weakness. Matt McCall tracks many of these: artificial intelligence, driverless cars, 5G connectivity, robotics, and precision medicine just to name a few.
Third, review your portfolio for any remnants of “yesterday’s” economy. Eric Fry has written at length about the Technochasm — that’s his name for the growing divide between the “haves” and “have nots” that’s being fueled, in large part, by wealth generating from technology.
While the Technochasm applies to our culture, it also applies to stocks. Those companies that harness technological advancements have a better chance of thriving and growing your wealth, while older companies that don’t will likely underwhelm.
Finally, take any editorialized headline with a grain of salt (mine included). Barring a cure or a vaccine, no one knows what’s going to happen.
But by implementing the above guidelines in a way that’s relevant to your specific financial situation, goals, and time to retirement, you’ll likely come out the other end of this crisis in great shape … potentially better shape than you entered.
Have a good evening,
Jeff Remsburg
