We are now in one of those times, like 52 years ago in 1968, that we and our children will always remember. Many of us have spent the weekend watching America burning in despair. As I write this missive, an extended portion of I-95 (in Palm Beach) has been closed to protesters on Sunday evening.
"Every time a riot develops, it helps George Wallace."
- Martin Luther King, Jr.
We all support peaceful protest and there is little denial that the George Floyd incident opened a wound for many who feel they are not full and equal participants in the social compact of America - providing a glimpse of how little progress we have made since the 1960s.
Somehow I wonder will this unrest begin something bigger this summer?
Meanwhile, the plight of 40 million unemployed will become another hot spot if the economy doesn't recover and employment pick up quickly.
We are now only five months away from what promises to be the most contentious election in history. Social unrest is certainly not going to be market friendly no matter how bad earnings are, and they will be bad, and how many companies fail - and many will - as nightly news showing the restlessness of Americans citizens is bound to lead to dislocations of asset prices.
Fifty Two Years Ago...
1968 was often considered to be one of the most turbulent and traumatic years of the twentieth century in the United States:
* The Vietnam War's Tet Offensive accelerated war in Southeast Asia. Protests against the war intensified.
* Fifteen years after the Korean War, in 1968, the relations between North Korea and the U.S. gave way to a crisis after North Korea captured the Navy intelligence vessel USS Pueblo and its crew. In 2020, we are still engaged with North Korea.
* The 1968 United States presidential election became a referendum on the Vietnam War. A peace candidate had previously emerged in the Democratic Party when Senator Eugene McCarthy challenged the Vietnam War policies of President Johnson, who had refused to seek or accept another nomination for president and had endorsed his vice president, Hubert Humphrey, for the Democratic Presidential nomination. Senator McCarthy's support came primarily from young people, most of whom were subject to the draft or were in deferred status. This divided the country by age as older citizens, a so-called silent majority, tended to support or not actively oppose government policies. Humphrey won the nomination and Nixon was elected president. In 2020, a progressive like McCarthy, Bernie Sanders nearly defeated Joe Biden.
* Martin Luther King was assassinated. The United States erupted in violent riots, the most severe of which occurred in Washington, DC, Chicago and Baltimore. Extensive urban areas of these and many other cities were looted, burned, and destroyed by the rioters and more than 40 people were killed during the month of protest, which led to greater racial tensions between Americans.
* Occurring at the dawn of the television age, the historic events of 1968 played out on TV screens across the country, bringing them home in a way that had never been possible before. In 2020, the events were played out on real time by FaceTime and YouTube.
* In popular culture, 2001: A Space Odyssey was the most profitable film of the year and Apollo 8 was the first manned spacecraft (Borman, Lovell and Anders) to leave the Earth's orbit and the first to reach the Moon, orbit it and return. In 2020, the U.S. launched two astronauts into outer space.
* The 1968 stock market marked the end of the Go-Go Years (with a two year gain of +50%), was speculative with casino stocks, computer leasing (remember Leasco?), nursing home stocks and conglomerates were the market leaders. Gerry Tsai's Manhattan Fund was hotter than a pistol (excuse the pun). From the 1968 peak the S&P Index declined by -36% by mid-1971. Unemployment, which was as low as 3.4% in 1968, reached 6.1% by the end of 1970. In 2020 we made an all-time high in the S&P Index on February 19, 2020 with a closing price of 3386. By mid-March the S&P traded under 2200, a decline of -35%. The unemployment rate in February, 2020 was 3.5%. By April the unemployment rate was 14.7%.
The music was epic in 1968!
Hey Jude (The Beatles), Sitting on the Dock of the Bay (Otis Redding), Sunshine of Your Love (Cream), Mrs. Robinson (Simon & Garfunkel), Tighten Up (Archie Bell and the Drells), Hello I Love You (The Doors), I Wish It Would Rain (The Temptations) and Dance to the Music (Sly and The Family Stone).
I can't name one popular song in 2020! I define anyone reading this to recite the words of Savage (Megan Thee Stallion featuring Beyoncé) - its the top selling song on The Hot 100 chart.
What The Last 2-3 Months Has Revealed to Me
So many questions, so little time.
The Covid-19 induced shutdown revealed:
* How poorly managed so many of our public companies are. With little in the way of a "cushion" or safety net, many companies and industries were exposed as ill equipped to weather the abrupt downturn - many sought governmental relief.
* How leveraged small, medium and even large businesses were. Reverse financial and operating leverage produced a remarkably quick drop in profits and margins.
* How dependent private businesses and publicly held U.S. corporations (of all size) are on federal support.
The markets have responded to a huge free lunch being heaped out by the Federal Reserve - but free lunches cannot be a permanent condition.
Unfortunately, as we begin the month of June I have an increased amount of economic, profit and market concerns.
Will a growing sense of social and financial disorder and chaos - delivered by income/wealth inequalities, the economic and health consequences of Covid-19, the accumulation of unprecedented debt loads (in the private and public sectors) and the open wound of institutional racism - lead to a change in political leadership in November?
What will it mean for society, our economy and our markets?
Consensus Profit and Economic Expectations Are Too High
* My "fair market value of the S&P moves from 2800 to 2700-2800
* I am moving my trading range from 2550-2950 to 2450-3010.
* Equities are about -10% overpriced
"Price has a way of changing sentiment."
- Divine Ms M (Helene Meisler)
As night follows day, S&P profit and price expectations have risen with the rip your face rally and mother of all squeezes.
I believe these expectations will prove wrong footed.
Indeed, reflecting the concerns expressed recently and in today's opening missive, I am reducing both my S&P 2020-22 EPS estimates and my calculation of "fair market value."
It is important to note that my 2020-22 S&P EPS estimates are substantially below consensus. As an example, my pal Thomas Lee expects 2021 S&P EPS of close to $190/share (or +50% above my forecasts) based on historically strong productivity and margin gains (I am looking for the exact opposite). One of us will be very right and the other will be very wrong.
I now believe that it will not be until 2023, at the earliest, that S&P EPS exceeds 2019 actual results (which were $165/share and $155/share - before buybacks).
The lynx-eyed Jim Bianco is calling for a 90% economic recovery - he might be too optimistic (as I am thinking 80% to 85%)!
Here are my new estimates:
S&P EPS Old (per share) New (per share):
- 2020E $110 Sub $100
- 2021E $135 $125-$130
- 2022E $155 $145-$155
My new "fair market value" goes from 2800 to a range of 2700-2800 (the mid range is 18.25x estimated 2022 S&P EPS of approximately $150/share).
Based on the above, stocks are approximately -10% overvalued.
To reflect the recent action of the markets and my new EPS projections I am changing my forecast for the S&P trading range over the balance of the year from 2550-2950 to 2450-3010.
Timing Economic "Normalization"
I am shifting my base case back to our "normal lives" to the second half of 2021 (from late summer, 2021). This means that the rate of growth in S&P EPS will not likely normalize (back towards 2019 levels) until about one year from then, or by year-end 2022.
Naturally, the possibility of multiple Covid-19 outbreaks this fall would put a halt of the aforementioned improvement in profit and economic growth - rendering the new normal as very abnormal (leading to big economic and EPS disappointments - even from my non consensus and low projections).
So, we must stay on alert to changing conditions.
Overarching Level of Uncertainty Combines With Shifting and Worrisome Paradigm Shifts
In the Jewish religion at Passover there are asked four questions. as indicated over the last two years, I have three questions that I wake up every morning before trading starts and I ask of myself: I still don't like the answers - today more than ever:
- In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are?
- In a flat, networked and interconnected world, is it even possible for America to be an "oasis of prosperity" and a driver or engine of global economic growth?
- With the G-8's geopolitical coordination at an all-time low, how slow and inept will the reaction be if the wheels do come off? Some of the important paradigm shifts witnessed over the last few decades are healthy, like the disruption brought on by technology.
Some of the important paradigm shifts witnessed over the last few decades are healthy, like the disruption brought on by technology. But even that shift holds some negative ramifications - for example, privacy is sacrificed, and industries and employment are displaced.
As described recently, the paradigm shifts are deafening (and most are market unfriendly):
* Covid - Induced Shifts In Behavior - As a society will be travelling less and working from and eating at home more:
1. Safety - Consumers will spend more time at home - working at an office and travelling will be more limited. This means more eating at home and less eating in restaurants.
2. Recession - Consumers will probably become more frugal and risk averse after their experience in early 2020. With unemployment abruptly rising by record amounts and the economic outlook still uncertain, the consumer will spend less, save more and reduce the frequency of restaurant visits after their experience in early 2020.
3. Less Competition - More difficult access to capital, much more expensive cost of capital and higher costs of doing business (the $4 billion pandemic cost in Amazon's (AMZN) past quarterly report should be a wake up call) - particularly in a recessionary setting - will result and morph into a slower growth backdrop. This means that less sizable, upstart competition will be reduced (the death knell for small businesses) and Tom Lee's expectation for margin expansion may not be realized.
These three factors will contribute to a fundamental change and demand destruction in the travel, leisure, restaurant, hotel and non residential real estate industries (which represent a large swatch of U.S. employment).
All these industries will be operating less profitably at lower capacity.
Yes, as Tom Lee suggests, businesses will be using less labor than before Covid-19, but consider the impact on consumer demand as the many previously employed reinvent themselves in their search for new job opportunities reflecting a secular downshift in utliization rates in the aofrementioned industries.
As Danielle DiMartino Booth writes this morning:
* As the whole-economy Chicago PMI New Orders-Inventories spread hit a record low in May and backlogs' contraction accelerated, significant supply-demand imbalances persist in the supply chain; supply disruption via longer delivery times adds the risk of higher freight costs.
* While May auto sales will necessarily rebound off April's shutdown-forced lows, a sustainable recovery requires rising income expectations; with lending standards tightening, greater auto manufacturer incentives could spur sales growth but would pinch profit margins further.
* Major discretionary purchases will be dictated by consumers' ability to access financing and shoulder additional monthly payments as layoffs move up the income ladder; the added uncertainty brought on by the rioting will act as a further depressant on spending's revival."
Given these factors, the personal savings rate will likely be ratcheted higher for some time to come - at the expense of consumption. That is not the recipe for domestic economic growth.
* Modern Monetary Theory - In contrast to 1968, MMT proposes dealing with the rising deficit and national debt load by printing more and more money. In turn, it is argued (by Ray Dalio and others) that the implementation of MMT would help equalize the rising income and wealth disparities. MMT has now been an implicit policy in defense of Covid-19 and in an attempt to bring back our domestic economy.
While no one knows for sure what the negative ramifications of MMT may be (but some are quite obvious like pension plan woes), the ready adoption of the theory is worrisome to this observer (and others). Stated simply, the paradigm shift to MMT is ultimately a terrible error of policy and intellect.
* Unbridled Fiscal Spending - Last year (and before Covid-19) the U.S. Treasury posted ever increasing deficits as government spending consistently climbed. Remember, deficits are supposed to decline as an economic recovery matures; now just the opposite is happening, with deficits now approaching 5% of U.S. GDP. There is a growing feeling that, like excessive monetary easing, there is no tipping point nor negative investment ramifications to unlimited fiscal non-restraint. The deficit and our debt load has been placed on its head since the government has come to the aid of our economy and our businesses. There is no need to document the unprecedented spend - it is well known. I remain skeptical of the ability to continue the current pace of fiscal spending and monetary growth without raising inflation and inflationary expectations, and the wrath of the bond vigilantes.
* The Emergence and Dominance of Machines/Algorithms That Worship at the Altar of Price Momentum - Market structure changes represent a fundamental risk. The paradigm shift from active investing (mutual funds and hedge funds) to passive investing (ETFs, quant products and strategies) holds risks that are reminiscent of October, 1987, when the growing acceptance of "portfolio insurance" ended badly in a convulsive move lower in the U.S. stock market.
* "Worsening" Demographic Trends - Reduced birth rates are a contributing factor to the subpar economic trajectory of growth and the diminished global secular growth prospects. Real economic growth is the addition of population/labor force growth plus productivity gains.
* Fading Globalization and Growing Nationalism - The abandonment of the post-World War II political/economic order and the lack of coordination and cooperation among countries in an increasingly flat, networked and interconnected world raise the issue of how slow and inept the reaction will be if the trade wheels do come off. Again, like lower birth rates, this will likely result in diminished secular global economic activity.
* Movement to the Political Right and to the Political Left - A toxic worldwide political setting seems to be a near-permanent shift and has created a bear market in political decency. The death of traditional conservatism (Republicans) and the move toward socialism (Democrats) has created a schism of beliefs that expand political animus and argue in favor of reduced compromise and less likely implementation of much-needed legislation (infrastructure comes to mind). Worrisome to many, including myself, are the social and economic ramifications of the paradigm shift of a widening gap in political beliefs.
* A Widening Income and Wealth Gap - I broached this subject initially in a Barron's "Other Voices" editorial, "The Threat of Screwflation", in 2011. Little has been done policy-wise to address this paradigm shift, which has resulted in political divisiveness and angry rhetoric. Moreover, the promise of financial repression not only results in mischief, incites investment speculation and the misallocation of resources, but also holds the risk that the income/wealth disparity will widen as it benefits borrowers over savers and favors those with bigger balance sheets (real estate and stocks). The threat of this disparity and these expanding gaps between economic classes hold social and political concerns as well - as seen in the past few weeks.
* The Emergence and Dominance of Machines/Algorithms That Worship at the Altar of Price Momentum - Market structure changes represent a fundamental risk. The paradigm shift from active investing (mutual funds and hedge funds) to passive investing (ETFs, quant products and strategies) holds risks that are reminiscent of October, 1987, when the growing acceptance of "portfolio insurance" ended badly in a convulsive move lower in the U.S. stock market.
My Strategy
The rip your face off rally and mother of all short squeezes that I envisioned in early April is likely over and I have capitalized on it as my net exposure was large (long). In the last few days (and weeks) I have profitably eliminated a number of long investment positions including (BA) , (FDX) , (DIS) , (MS) , (HLT) , (H) , (VNO) , (GS) , (VIAC) (a profit in some accounts but not in the aggregate), (CMCSA) , (GLD) , (PZZA) , (TWTR) and (PENN) (ugh!). (I previously liquidated most of my Alphabet (GOOGL) , all of my Facebook (FB) and Amazon - for large gains).
I am left with no growth names (as I see a pivot to value), a large exposure to financials (even though I have sold my (GS) and (MS) for nice gains), several packaged foods names ( (PG) , (KHC) , (SJM) and (THS) ) and a few speculative stocks (e.g., (GE) ).
I am short the indices (large sized) and bonds. Late last week I reshorted (AAPL) and (CAT) .
Bottom Line
* Getting back to normal will take more time than the consensus expects
* Big picture changes loom on the investment horizon, so do fundamental disappointments
* Many of these paradigm shifts are disruptive and market unfriendly
* There will be some industry winners (healthcare/biotech, internet, packaged foods) but far more industry losers (hotels, airlines, non-residential real estate)
* But, in an increasingly debt laden society where access to the capital markets may be limited, there will be less obvious winners (commercial banks and investment bankers)
* Large companies' moats are deepening (thanks to policy decisions and structural issues) and the Russell (Index) won't likely be crowing
While uncertainty is typically the refuge of hope, we face unprecedented inconclusiveness in the time ahead - in America's social contract, in our health, in the trajectory of economic and profit growth and, of course, in market prices and valuations. The change has been abrupt and, for most, disruptive - incomparable to any experience we have had in the past. When, many now ask, will we "get back to normal", when will we return to our old lives and how will our behavior change? In support, the government has countered with the accumulation of more debt.
However, growth suffers under a pile of debt - which acts as a governor to economic growth.
Zero interest policy has unintended consequences. As an example, low interest rates have led to a massive underfunding of pension and endowment programs including those benefiting the less well off like social security and medical and retirement plans.
If one was concerned about the growing inequality in the U.S., this contrast is a prescription for civil unrest in the near future. We are seeing a whiff of that in the last few days around the country.
The stock market has been celebrating almost daily while small businesses and the average American are suffering. Why not buy stocks if the Fed promises that yields will stay near zero for the foreseeable future and alternative fixed income yields are almost nonexistent? (In other words, TINA - "there is no alternative".) Though most think lunch will continue to be delivered because of low interest rates there is never a free lunch. There are numerous problems in the accumulation of record amounts of debt even when coupled with low rates.
If stocks are supposed to reflect future earnings discounted to the present, the market's price seems extreme because President Trump's policies (and behavior) are likely leading to a greater likelihood of a Democratic victory in November. Corporate taxes will almost certainly be raised to help address the yawning deficit.
The argument that the market is not high relative to interest rates fails to recognize that present interest rates are totally artificial and much lower than they would be without massive Fed support. Such support reflects economic weakness, not strength.
The S&P has overshot the high end of my projected trading range by about 3-4% - and I have moved back to a large net short exposure.
(Amazon, Disney, Goldman Sachs, Alphabet, Facebook, and Apple are holdings in Jim Cramer's Action Alerts PLUS member club. Want to be alerted before Jim Cramer buys or sells these stocks? Learn more now.)
(This commentary originally appeared on Real Money Pro on June 1st. Click here to learn about this dynamic market information service for active traders and to receive Doug Kass's Daily Diary and columns from Paul Price, Bret Jensen and others.)
