Markets 2020: Three Negatives and a Silver Lining
By James Cakmak and Ryan Guttridge
The markets right now are scary. 1000-point swings were unthinkable until recently. What’s an investor to do?
Technology is great in that it makes the world more connected and promotes cooperation. But the negative is that we are all more connected. What goes up does so collectively, and unfortunately, also down.
As we discussed previously, disruptions in supply chains were inevitable. The market impacts are simply the result of a more connected society.
Virus scares are nothing new, but the additional connectivity makes them a bigger threat. The truth of the matter is we have no idea how bad COVID-19 can get in terms of its reach and mortality rates. If history is any guide, this will pass. But who knows when? We are left to deal with what we know now.
Currently, it seems the economic risks outweigh the health ones. There continues to be market risk despite the ~10% decline from record highs.
Here are three things to take seriously in evaluating the market as it stands today:
2020 earnings have 10%-20% risk
Current consensus for the S&P is about $175, which implies a market valuation of roughly 17x earnings. That’s not bad. However, our confidence in 2020 earnings is gone. And this doesn’t even include the supply chain concerns. As businesses, factories, and schools close in key markets around the world, demand will undoubtedly wane.
The middle quarters of 2020 are a throwaway at this point, with Q4 packing substantial uncertainty. James Bond isn’t even immune as No Time to Die was postponed to November.
A 10% reduction to 2020 S&P earnings is already in the cards, and potentially more. Expect disastrous guidance for the year as companies begin to report in the coming weeks.
Valuations still stretched
If S&P 2020 consensus earnings is cut to flat with last year, this suggests a market multiple of 18.5x. Not cheap, yet not expensive either. If we take 2019 as a baseline and assume a 10% cut from there, then earnings in the ballpark of $150 is not out of the question. The market is at about 20x based on that figure.
As we gauge where the effective bottom is, there’s a couple things to keep in mind. First, we have no idea how bad the earnings hit will be from supply chain pressures, elevated costs, and waning demand. Second, we’re in an election year with heightened uncertainty and room to further discount. Third, most S&P components (60%+) are still trading north of 20x.
If we assume a contraction in the market multiple to 17x, coupled with a potential 20% cut to 2020 consensus earnings, then the S&P can potentially fall to 2,600, a 15% decline from here.
Corporate bond markets don’t inspire confidence
High yield corporate bond spreads are not in recession territory, but they are getting close. The worst-case scenario is the breaking of debt covenants leading to bankruptcies and ultimately recession. While this isn’t an immediate threat, it is something to keep an eye on.
So, when do earnings no longer matter? We can’t look at things in a vacuum. The key thing to focus on is interest rates. With many companies paying close to a 3% dividend yield, stocks are relatively attractive provided companies can hold their footing through this uncertainty. With 10-year treasuries yielding less than 1%, it takes 100 years to get your money back. For context, Microsoft will pay you the same amount and offers the potential for growth.
With the VIX knocking on 40 amid a seemingly hopeless earnings picture, yields have effectively collapsed across treasuries. The silver lining is that the unfavorable earnings picture will likely matter less and less. As a result, the reality of the market’s potential lows lies somewhere in the middle between here and the levels we’ve described. Nonetheless, things will likely take more time to flesh out as companies begin to report and the information digested by investors.
Ultimately, expect further correction, but not a prolonged one.
Clockwise Capital is an asset management firm with a private equity approach to the public markets. We focus on the meaning of time and the role it plays in people’s lives. We believe the essence of a great investment resides in the ability of a company to either save their customers time, or improve its quality. We understand how technology evolves to drive these two factors, which we believe define human progress. As a result, we search for securities with cyclically depressed valuations whose companies save time, thus using secularly advantaged industries to build a concentrated portfolio. With each series of investments our goal is to optimize edge, maximize return, while also minimizing correlation. This allows our portfolio to maintain a liquid, low duration fixed income balance, ready to capitalize on market volatility, while still generating market beating performance.
