The Big Picture

“No price is too low for a bear or too high for a bull” 

The simple definition of a bear market is a decline of 20% in stock prices. The simple definition of a bull market is a 20% increase in stock prices. Utilizing this definition the bear began in mid-March and the bull began in early April. These definitions may be a bit too simple and not portray the whole story. A Real Bear is a market that may witness a longer period of declining prices, with several rallies along the way. A Real Bear may also coincide with a recession and a significant decline in company earnings. Essentially, A Real Bear is a different animal altogether. More dangerous, more vicious.

Not this guy…

This guy…

A child could deal with the baby bear. Not even Martins Licis (current World Strongman) could handle the Real Bear! So the only question is, are we dealing with the baby bear or the Real Bear? This has been the question on the minds of many. What does the data say on determining just what kind of bear we are dealing with?

Have a Plan and a Process!

From the Trenches

“In a bear market, you have to use sharp counter trend rallies to sell” 

-Bruce Kovner

Kovner is referring to the opportunity to reduce risk when the overall trend of the market is bearish but a shorter-term rally is experienced. Regarding the rally witnessed since the end of March: Is this an opportunity to sell, or reposition allocations-or- is the worst already behind us?

Process & Data

Our research process covers 3 categories. Macro, or the big picture; Fundamentals, or how companies are faring; and the Market itself, the indications we gain from the day to day operations of the market.

Macro. Big picture economic factors generally revolve around policy actions, such as the recent CARES Act. We also should not ignore the Federal Reserve (Fed) which has been a leading factor in the markets since the financial crisis over a decade ago. No surprise, the Fed continues to be a primary bullish factor in the markets. For many, as long as the Fed is active a bullish outlook is warranted. Will the Fed be successful at “bridging” the economy and buoying the markets? Over the past several weeks, this has been the narrative.

Fundamentals. Highlighting the earnings picture: The current Standard & Poor’s estimate on earnings in the S&P 500 for the next 12 months is approximately $130 per share. Currently, the market is trading at 23 times earnings. This multiple would be on the high side of the valuation scale. Essentially, the market is pricing in nearly no effect from the economic damage that has been caused from COVID-19. In other words, earnings estimates have fallen by 30% and the market is valued as if earnings will not decline at all. At present, this is the third highest valued market of all time.

The below chart covers 3 potential scenarios based on potential market multiples witnessed over time. A multiple north of 18 would indicate a higher valued market. The average multiple is roughly 15 which would imply the price of the S&P 500 at 1950, or a 35% decline! A low double-digit multiple, in a severe recession, may take the market down to 1560!

I have had conversations covering all sides of the spectrum here, from the best-case to the worst-case. Fundamentals are overall bearish, however the market is currently ignoring this fact.

The MarketI do believe the market has gotten ahead of itself at present. However this is not uncommon during bear markets. If we assume we are in a Real Bear, it is possible to have several “bear market rallies” throughout the bear process. That said, given the Macro assistance we are receiving, the worst-case scenario is not very likely. We have witnessed higher multiples since the financial crisis. Low interest rates may be a potential reason for higher multiples. As well as Fed intervention. This still leaves a fairly significant range of outcomes.

The Bull Case: The bull case is straightforward. It revolves around the belief that the government through fiscal stimulus, as well as the Fed through asset purchases, or “money-printing”, may bridge the economy through this period with an expected economic recovery to begin later in the year. 

The Bear Case: Regardless of government and Fed intervention, the economic damage is material. There is a disconnect between the current prices of financial assets and the underlying economy. Stock prices are too high given the full picture and the recovery may not be as swift.

Our take is likely a bit of both, or a Base Case: The government intervention is buoying asset prices but there is a strong probability that we may see lower prices over the short term. The worst of the economic data should appear in the second and third quarters. This would imply a price level somewhere between the average recessionary multiple plus a premium due to government and Fed intervention. Currently, the market is priced as if there is little damage at all to the economy.

Bottom Line: The stock market is not the economy. We do witness disconnects between asset prices and economic data from time to time. Don’t allow price alone to blind you from economic realities. At minimum, utilize a process for mitigating downside risk!


The Weeds

“In a bull market, everyone becomes an expert. In a bear market, everyone becomes wise.”

For those curious what a Real Bear looks like…

We do witness counter-trend rallies in a bear market. They are quite common. Looking at some prior bears, we witness periods lasting several weeks to months where stocks prices rally. Generally, prices will not reattain highs, and the overall trend is lower over time.

Below is a comparison of the initial 50 trading days of the start of a bear market. The Coronavirus Bear (assuming it is a Real Bear) was the fastest decline to a bear market with an equally impressive rally. However, is this bear over?

Chart from IQ

Below is a comparison of bear markets over a longer time frame. Notice that all bear markets experience counter-trend rallies. Some are very impressive and convincing that the worst may have passed. 

Chart from IQ

Bottom Line: While there remains some questions on whether we have entered a Real Bear, some caution is warranted. Time will tell whether the current rally is the beginning of the next bull phase or a more dangerous bear market rally.

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The S&P 500 is an unmanaged index which cannot be invested into directly. This index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. 

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