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BMT Monday Market Insights – March 16, 2020

Market Insights

Top Weekly Themes

  1. Falling oil prices add to market anxiety. OPEC’s (The Organization of the Petroleum Exporting Countries) inability to come to terms on the extension of output cuts led to additional market stress last week. Russia said it will no longer be adhering to production cuts, and Saudi Arabia will not bear the brunt of additional supply reductions. The oil market is now pricing in a significant increase in oil supply, and oil prices are down 50% since the start of the year. The concern for investors is that dramatically lower oil prices will have knock-on effects within credit markets, with some lenders particularly exposed to the oil patch, and U.S. economic growth could suffer given how important the energy sector has become for capital investment and employment. This could all change rapidly if Saudi Arabia and Russia reach an agreement. Both countries rely heavily on oil, and Saudi Arabia uses oil to fund much of its fiscal budget. That fiscal breakeven price is at $85 a barrel, so there is an incentive to support prices if both countries can politically save face. In the interim, we have–and will remain careful with our energy exposure. Last year, we sold our more volatile energy exposure (exploration and production companies) in favor of integrated oil companies with somewhat less direct commodity price exposure.
  2. Stimulus to the Rescue? To date, there has been discussion of fiscal stimulus, but nothing concrete. For this reason, the market has not seen any relief in anticipation of such efforts. In part, we believe this is because the stimulus calculus is complex. For one, it is hard to introduce targeted stimulus to areas most impacted by COVID-19 because it is not clear who the beneficiaries should be – if airlines get support, do restaurants get it too? What about other small businesses? Therefore, a more general fiscal stimulus package is likely, but this is also politically complicated, and the timing is unclear. The market is looking for something akin to “shock and awe” and has thus far been disappointed. Our view is a package needs to come together that will support the slowdown in economic activity, while also creating a more robust economic rebound once the dust settles. But until we see more evidence of what that package includes, markets will trade as if it doesn’t exist.
  3. Get out and get back in? “Eleven years ago, in 2009, the stock market stopped going down. There was no reason. The dust had settled, without fanfare or any sort of official announcement. If you had polled people that day, or week or even month, most would not have agreed that we had seen the worst. The economic headlines were not improving. But there it was. And by June 1st, less than 3 months later, the stock market had climbed 41% from that March low. And even with that having happened, the majority of participants still weren’t clear that…we had, in fact, seen the worst. There were still people 3, 5 and 7 years later who had gone to cash and still hadn’t gotten back into stocks. They missed a new record-high a few years later and hundreds of percentage points in compounding on their assets.”[1]Let’s do the math: for simplicity sake, assume a $1,000 investment made up of 10 shares of a $100 stock. Assume that stock drops another 25% from here. Even if one could time that next 25% drop perfectly, selling now and getting back in precisely at the low (which you won’t), it hardly seems worth it. Taxes would relegate your cash holdings to about $900[2], allowing you to purchase 12 shares of that stock at $75 per share. When the share price eventually recovers to $100, that equates to a profit of 20%. Assume you get the timing close and capture half of that, or 10%. Not as compelling as you might think. Assuming a 70/30 stock/bond portfolio, the impact on the total investment pie is even smaller – that 10% benefit turns into 7%.
  4. [1] Brown, Josh. “The Reformed Broker”. March 9, 2020 https://thereformedbroker.com/2020/03/09/im-here-to-remind-you[2] Assumes a long-term capital gains tax rate of 20% and a long-term capital gain of $500 on the $1,000 investment.

Returns Table

Week (%) YTD (%) 1-Year (%) 3-Year (%) 5-Year (%) Div Yield (%)
Equities
S&P 500 (17.9) (22.9) (9.4) 11.0 33.0 2.09
Russell 1000 Value (20.5) (28.4) (18.4) 7.6 7.6 3.07
Russell 1000 Growth (16.4) (18.4) (1.9) 31.6 56.2 1.22
Russell 2000 (24.0) (32.5) (26.5) (14.3) (2.6) 1.78
MSCI EAFE (19.6) (26.4) (17.1) (6.6) (3.7) 3.19*
MSCI Emerging (15.0) (20.6) (13.5) 3.6 6.9 2.64*
Week YTD 1-Year 3-Year 5-Year Yield 
Fixed Income
Bloomberg/Barc US Aggregate (1.6) 3.0 10.1 16.4 18.8 1.80
Bloomberg/Barc US High Yield (8.3) (8.8) (1.8) 7.9 20.0 8.22
Bloomberg/Barc Muni Bond (3.8) (0.9) 4.7 13.2 17.4 2.05
Bloomberg/Barc Global Agg. Ex U.S. (1.9) 0.6 5.5 14.5 16.4 0.81
Week YTD 1-Year 3-Year 5-Year Current Level
Commodities
Crude Oil (WTI) ($/bbl) (31.1) (48.4) (44.6) (35.0) (33.0) 31.5
Natural Gas ($/mmbtu) 3.9 (15.9) (33.9) (38.8) (32.7) 1.8
Gold ($/ozt) (4.6) 4.6 22.8 32.4 37.9 1,589.3
Copper ($/mt) (5.0) (12.5) (17.3) (5.7) (8.2) 5,386.5
1 Week Ago YTD 1-Year Ago 3-Years Ago 5-Years Ago Current Level
Currencies
Euro/USD 1.12 1.12 1.13 1.07 1.06 1.11
USD/YEN 106.67 108.68 111.38 114.96 121.28 105.68
Pound/USD 1.29 1.32 1.31 1.22 1.49 1.25

As of March 12, 2020 (close)
*Dividend Yield For MSCI EAFE and MSCI EM are from 12/31/2019

Chart of the Week

Click the chart to enlarge it.

Chart of the Week
Sources: FactSet, Inc.; BMT

Key Takeaways

  • The chart is a simple investor survey, measuring the percent of bullish and bearish respondents. At each significant market low since the Financial Crisis (2018, 2015/16, 2011), the percent of bears exceeded the percent of bulls. We have made more progress in closing that gap, but we are not there yet. This would signal additional downside is needed to further wash out sentiment.
  • Extreme investor pessimism is usually a good sign that markets are close to finding a bottom. According to this measure, things may need to get a bit worse before they get better.

Commentary

We will often look to the bond market for clues about how the equity market may behave. In many cases, the bond market is quick to price in the fundamental reality, whereas equity markets can take time to reflect the same likely outcome.

Currently, stocks appear “expensive” relative to what the corporate bond market is reflecting. Historically, there is a relationship between credit spreads (or the additional yield investors demand over treasury bonds for taking on the credit risk of a company) and the price-to-earnings ratio (P/E) of the S&P 500 (or the price investors are willing to pay for every dollar of company earnings). Usually, as credit spreads increase during times of market stress, investors are willing to pay less for stocks and valuation measures like P/E fall. Recently, we have seen a gap develop between credit spreads and the P/E ratio of the S&P 500.

2020-03-16 Commentary Chart
Source: Cornerstone Macro Research

Of course, this gap can close three ways – credit spreads can tighten if perceived risks diminish, stock prices can fall more in line with credit markets, or some combination of the two. This is by no means a precise science; however, the current level of corporate credit spreads would be consistent with a P/E on the S&P 500 of about 13.5. If we use current estimates for 2020 corporate earnings[3] that would suggest a level of about 2,335 on the S&P 500. During times of acute market stress, BAA corporate credit spreads have, on average, peaked around 3.50%. Given the nature of the issues currently facing the global economy, this is certainly feasible today. This level of credit spread would be consistent with an 11.5 P/E ratio. In this more dire scenario, that would be consistent with a level of about 1,955 in the S&P 500. Again, we want to stress that this is only one calculation, and the range of possible outcomes is wide. Still, it is an interesting relationship when trying to gather signals about the likely near-term trajectory of the market.

[3] For this analysis we are assuming $170 per share. Given the situation, this number is highly uncertain, and earnings expectations may fluctuate significantly in the coming weeks and months.

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