Just as balance sheets are a snapshot of a company’s financial position, so the letters written by fund managers to their investors act as windows to a moment’s sentiment. It’s fair to say, times have never been so dramatic.
Personal written communications enable chief investment officers (CIOs) to frame strategies and reassure clients that they’re with the smart money. The various authors don’t try to predict when the coronavirus will be beaten, but there is a palpable sense that this crisis is a turning point for investors.
Many of the letters were composed in early April or before, since when we’ve seen the biggest one-month rally for US stocks since 1987. Yet the observations remain valid – that this is a relief rally on the back of the open-ended stimulus promised to credit markets by the Federal Reserve, and that the fundamental facts of corporate profits are shakier than ever.
Paul Singer, who heads $35bn hedge fund Elliott Management, wrote on 16 April that his gut feeling was that the S&P 500 should fall 50 per cent from its February high. This hasn’t happened and in fairness Mr Singer made the caveat that “public policy has been marshalled with all its strength to do battle with a resumption of the market decline”.
Thus far, it seems to be working, with investors happy to make blind bets on the recovery of the US economy and company earnings, so long as the Fed pumps liquidity into credit markets to give corporate America a funding lifeline.
Summarising his approach to stock markets that defy conventional logic, Mr Singer is philosophical: “[Our job is] to have a portfolio that can make some money in normal times and keep it when the music stops for any reason, the timing of which is always a surprise even if you keep a sharp eye on the disc jockey.”
Valuation risk greater than ever
Extending the DJ metaphor to records spinning on the turntable, it could be said investors are dancing to Milli Vanilli (the manufactured ‘80s pop-synth group where the front-men famously mimed all the vocals). Rebounding markets are comforting but the lack of substance is alarming.
Drawing comparison with the global financial crisis 12 years ago, Mr Singer highlights the aggregated share price/sales ratio of S&P 500 companies was still 1.86 at the end of March 2020. In the financial crisis, the ratio was 1.64 at the outset in September 2007, before falling to 0.82 by the March 2009 nadir.
Mr Singer acknowledges the risk of expectations being too influenced by how the last crisis played out, but is concerned by the lack of serious undervaluation. Although the previous recession remains a benchmark: “…we recall (vividly) that after prices in 2008 got to ridiculous levels, they proceeded to further collapse to insanely low levels (and that is before taking into account the probability that the current recession significantly exceeds, in severity and possibly in length and impact, the 2008-2009 episode).”
Others are more bearish – and were so heading into the crisis for a plethora of reasons. Colorado hedge fund group Crescat Capital listed sliding corporate earnings, historic high equity valuations, record corporate leverage, shrinking global trade, a repo liquidity crisis and breach of the critical 70 per cent level for US Treasury yield curve inversions.
These factors, which they describe as “gene sequencing of the illness at the peak of the economy”, have been compounded spectacularly. The snapback rally in April, after the S&P 500 suffered the fastest 30 per cent-(plus) decline in US stock market history, was natural, but Crescat believes investors must be wary of getting sucked in.
Their CIO, Kevin C Smith, and portfolio manager, Tavi Costa, wrote on 14 April that the initial blow from the coronavirus shock could have been twice the $30 trillion stock market writedown that occurred. Crescat’s prognosis was for the bear market to resume with the first quarter (Q1) earnings season: “Plunging corporate earnings are not likely to be shrugged off this time.”
Recent announcements, such as Apple’s (US:AAPL) decision to withhold guidance for the current quarter and mixed messages from Amazon (US:AMZN), are ominous. Rebuking late-cycle bulls who had clung to reasonable price/earnings (PE) ratios, even after declining Q4 earnings, Crescat argued that PEs are a value trap at the peak of a business cycle.
“Now,” they say, “we expect the E in the PE ratio to be plummeting all year, dragging the P down with it.”
More optimistic analysis was proffered by Matthew Sweeney, principal of Laughing Water Capital. Adapting an often-repeated quote his April note opined: “After all, ‘The time to buy stocks is when there is blood in the streets’ [and] other people are buying toilet paper.”
Since this was written, some interpretations of Amazon’s results loosely fit the narrative, such as comments by Lewis Grant, senior global equities manager at Federated Hermes. Although Amazon cautioned that efforts to protect staff and customers from coronavirus will hamper operating income in Q2, Mr Grant applauds the company for having taken “a socially responsible stance at an important moment”.
Focusing beyond the next three months’ profits, Mr Grant says: “Amazon is improving its ability to deliver in the long term,” and adds: “For the cynics, it is also a smart PR move.” The company once again delivered stunning revenue growth, with the high-margin Amazon Web Services business reaching $10bn in quarterly revenue, but overall profitability left investors underwhelmed.
Still, companies like Amazon remain front and centre of the argument to buy quality names on sale. However, the bears at Crescat would refute that we have seen true bargain sale prices, even for stock of outstanding companies such as Amazon, Apple, Nike (US:NIKE), Alphabet (US:GOOGL), Disney (US:DIS), Clorox (US:CLX) and Procter & Gamble (US:PG).
Other investors, whose strategies imply confidence in a faster recovery, feel such bastions of quality offer less upside than value stocks. Unsurprisingly, Bill Miller of Miller Value Partners is beating the value drum. He argues that, although the companies mentioned above are excellent (and his firm owns stock in several of them), a quality-only portfolio will underperform.
Oil misery a lesson or an opportunity for value strategies?
For a stark warning that hedge funds can be spectacularly wrong at times, look no further than the contrite letter from California’s Open Square Capital on 20 April. Its discounting of coronavirus as being “contained in Asia”, and a heavy exposure to energy stocks, left it with the difficult task of convincing investors to keep faith.
Its decision to stick with energy investments seems absurd, but there is more to it than stubborn refusal to face facts. An ultra-optimistic view that the “holy trinity of unprecedented monetary easing, trillions in financial stimulus, and frankly pent-up demand” will spark a recovery that “surprises in its speed and intensity” comes across as wishful thinking. But they make an interesting point about the mid-term future of oil.
“Maintaining our energy investments is a continuing bet on the very idea that society will return to normal, but not supplies.” Storage capacity may be overflowing and at the time of Open Square’s note, West Texas Intermediate futures were trading at negative $37 per barrel, but the effect of the plunging oil price could be to knock out so much production that the flood will eventually be followed by drought.
“What’s obvious is that despite the inventory builds currently happening (the scale of which is debatable [due to spare capacity needed for transportation]), demand will recover, but supplies will lag. By Q2 2021, the historical build we are experiencing will be eliminated and thereafter a similar unprecedented shortage will begin.”
In the longer term, there is a compelling argument that the rise of sustainability concerns and new technology will lessen the world’s reliance on oil. In the interim, the impact of environmental, social and governance (ESG) investing mandates on companies’ cost of capital also affects their profile as investments.
Open Square may not be entirely right, and if the recession is deeper and longer than its upbeat recovery assessment allows for, it will lose more money. If this is the case, however, then oil supply destruction will be harder to reverse. That represents a serious inflationary risk further down the line, especially given the likelihood of unintended consequences of government and central bank policies.
Massive stimulus is needed to stave off depression, but its normalisation is wrong
Managers are unanimous in their acceptance of the need for colossal fiscal (government spending and tax cuts) and monetary (low interest rates and measures to boost money supply) policy to support businesses and households. Scathing analysis is made of the profligate use of these tools before the coronavirus paralysed economies around the world.
On US fiscal policy, Crescat points out “the largest economy in the world, the keeper of the global reserve currency, has already had increasing deficit spending for the last four years. US deficit spending was already close to 5 per cent of GDP at the peak of the expansion. That is a level only seen in the middle of recessions historically. It’s about to skyrocket adding a dimension of ultimate inflationary risk, but not necessarily an imminent one”.
Combined with more money printing by central banks such as the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BoJ), it is possible that government debt levels finally reach the tipping point where they precipitate a collapse of confidence in fiat currencies. Throw in an oil price spike in a couple of years and the next leg of economic misery could be inflationary.
For now, with many of the world’s governments scratching their heads over the conundrum of easing lockdowns, deflation is the order of the day. Even before the announcement that US gross domestic product (GDP) had fallen by 4.8 per cent – its worst quarterly contraction since 2008 – Crescat was cautioning the world’s economic output could plunge at its fastest rate ever.