We're Back at the Top of the Stocks Helter-Skelter

Points of Return
Bloomberg

A Remarkable Round Trip

When you get to the bottom you go back to the top of the slide and you stop and you turn and you go for a ride then you get to the bottom and you see me again.

If ever there was a Helter Skelter market, as Paul McCartney might have put it, this year has seen it. After an epoch-making surprise from the monthly U.S. unemployment report, both the dollar and the U.S. stock market (as measured by the S&P 500), are essentially where they started the year, after a remarkable round trip. 

There is dispersion. The FAANG stocks are up 27% , and government bonds and gold are holding on to gains; equities outside the U.S., particularly in the emerging world, are still sitting on significant losses, despite a near-universal rebound. But the rally has widened in the last week or so, with previously overlooked investments beginning to catch up. This is exactly what we should expect if it's a "real" recovery with durability, rather than a bear-market bounce.

It could yet turn out to be a "false" rally. But even if we have another big dive, it would have been great to buy in late March. How could we have spotted this in real time? And should we trust this rally to continue?

On the first question, full disclosure: This is the Points of Return that went out at the beginning of March 23,  the day the S&P 500 bottomed, while this is the one that came at the end. The key passage from the morning:

At this point, it looks to me like the moment of maximum panic is close at hand. If a Fed governor says U.S. unemployment could rise to 30%, and we discover that Angela Merkel has put herself in quarantine while the mayor of New York begs for help from the army to stop people leaving the house, that sounds like a traumatic low in confidence is close, if it is not here already. 

It is reasonable to expect that some kind of relief rally will get underway in the next few days. It is also reasonable to expect that the final low is still a ways off. The bottom comes when all hope has been lost, and resignation sinks in.

Three months ago, it was plain that a relief rally was near. But I still assumed that the ultimate low was further off. Generally, sudden crashes are like a bereavement, with panic, followed by relief, followed by demoralization or resignation. We seem to have avoided the last two. That leads to a new question:
 

How to Spot That This Rally Would Be So Strong?

The answer, very simply, was from watching liquidity. To use the phrase of Michael Howell of CrossBorder Capital, who turned bullish in March, "if there's money anywhere, there has to be money somewhere" — and when rates on low-risk securities are as low as they are now, that means stocks. 

A long-time reader, recently retired asset manager Stephen Mitchell, sent me this graphic, which formed part of his reasoning for buying stocks starting March 23:

Photographer: Jenny Wang

Photographer: Jenny Wang

It's a crude but effective indicator that adds all rate cuts across the world. The central banks of Bangladesh or Ecuador count as much as the Fed. The sheer amount of monetary easing was evident. As Mitchell put it, "there have been 144 rate cuts this year and I have lost track of how many QE announcements. Aggregate rate cuts total over 50% which is bigger than the 31.5% of rate cuts in 2019 — itself a big year of monetary policy easing. After many years of investing I think this and watching the inflation numbers that help drive it are about the most important thing I can watch."

He put most of his money into quality and value stocks, and is now sitting on two-month gains of more than 30%. Well done him.

Related was a willingness to make moves that might make you morally queasy. Mohamed El-Erian, a Bloomberg Opinion columnist, commented last week that he didn't want to invest in moral hazard, or the kind of risk-taking that comes with central bank support on the scale we have just seen. Veteran equity strategist Ed Yardeni in his regular note to investors suggested, however, that the conditions for "crony capitalism" looked excellent:

I'm not a preacher, so I am not going to dwell on whether this is a good or bad development. As an investment strategist, I focus on assessing whether the government's policies are bullish or bearish. The latest developments are bullish for stocks, especially of companies that are likely to benefit from the triumph of crony capitalism… Companies that have strong balance sheets with lots of cash will be like kids in a candy store, buying up distressed assets and companies with little resistance from anti-trust regulators, in my opinion. That's because many of them also have lots of lobbyists in Washington who are vital intermediaries between big business and big government. They grease the wheels of crony capitalism.

To be clear, Yardeni dislikes crony capitalism. He views it as his job to help clients make money; they can then decide whether to put it to a moral purpose. We can leave the (fascinating) ethical conversation for another day; he is right so far that this was a good way to make money. 

 

Where Now?

Even after this rally, several bears aren't for turning. Albert Edwards of Societe Generale SA, one of the most famous perma-bears, was wrestling with when to turn the week before the bottom. He put out a new note last week, looking at the reasons for switching to bullishness. This chart compares the S&P to M2, a broad definition of money:

Stock prices grew far in excess of liquidity during the dotcom bubble. Nothing similar is afoot this time. M2 shows that the Fed's reaction was on a different scale from previous interventions:

Edwards is looking for the moment when the Fed's attempt to keep all the balls in the air at once at last tips over into inflation — or to use his own analogy, causes the ice of the Ice Age to melt. While that moment may well be getting closer, this hasn't happened yet. 

Edwards isn't giving up on his bearishness, showing that share prices are more out of whack with fundamentals than ever. This chart from Lance Roberts of Real Investment Advisors highlights the extraordinary gap between the S&P and corporate profits after tax for the nation as a whole:

Edwards also shows a ratio popularized by John Hussman, another analyst who has been strongly bearish for many years, which compares price to the maximum profits of the last 10 years. This averts any risk of indicators being distorted by a freak and temporary fall in profits, such as may be happening now. This chart is from Cypress Capital using data from Standard & Poor's:

Edwards summarizes this exercise: "After the bull market peaked in February with the second highest Price/Peak eps multiple in history (23.1x), the shortest bear market in history ended with its highest ever ending multiple (18.5x)! Give me a break."

Jeremy Grantham, founder of Boston-based asset manager GMO LLC, goes further. In his latest letter to investors, he says GMO added to equities and credit for a few weeks around the low, but is now cutting the equity allocation in its main benchmark portfolios to 25% from 55%, and making a heavy bet on value stocks to outperform, particularly in emerging markets. Why?

The following two charts show GMO's projected average returns over the next seven years for a range of asset classes at the bottom of the market:

And this is what they were forecasting by the end of April:

Many complain that GMO has been bearish for years, and bullish about emerging markets. It could be said to be flogging a dead horse. Then again, this is Grantham's explanation:

The current P/E on the U.S. market is in the top 10% of its history. The U.S. economy in contrast is in its worst 10%, perhaps even the worst 1%. In addition, everything is uncertain, perhaps to a unique degree. The market's P/E level typically reflects current conditions. Markets have historically loved fat margins, low inflation, stability and, by inference, low levels of uncertainty. This is apparently one of the most impressive mismatches in history. That being said, this is a new type of crisis and much will be different. There are no certainties but there are probably still some better and safer themes. Caution and patience are likely to be two of them.

Put like that… 

 

Avoiding the Issue of Timing

Should we simply not try to spot the bottom, even at exciting times like these? For anyone who isn't a professional investor, and doesn't have time to monitor the markets daily, the standard advice is to eschew timing, and avoid the temptation to act for the sake of acting. Here's how the most popular ideas have worked this year:

Buy and Hold/ Stocks for the Long Run

Just loading up on equities and staying with them, on the philosophy that the long term is your friend, does have a lot to recommend it. So far this year, it would have lost 1.5%.

Dollar-Cost Averaging

You can try to reduce the risk of timing further, at the expense of reducing your exposure to the very long term, by putting in a regular amount each quarter or month. If saving out of income, most of us have to do this out of necessity. A policy of putting equal amounts into the S&P 500 each quarter would so far this year have turned $100 into $111.04.

Asset Allocation: 60/40

For most of us, being long equities without anything to balance them is too risky. You might have to retire, or lose your job, just as the stock market is low. So the most popular traditional alternative is 60/40, with 40% in bonds. Professionally branded "60/40" funds have gained a little over 1% for the year. Making the aggressive assumption that you put all of that bond allocation into long Treasuries, $100 would now be $105.94.

60/40 With Rebalancing

The most popular form of market timing is to rebalance a portfolio at regular intervals to revert to the asset allocation with which it started. This means selling some of what has risen and buying some of what has fallen. A 60/40 S&P/Long Treasuries approach that rebalanced at the beginning of the second quarter would have turned $100 into $108.30 — a fine return over five months. 

Timing to Perfection

Selling short the S&P 500 to start the year, and then switching and going long at the low would have turned $100 into $198.17. This is why so many people try to time the market. 

So, a mechanized asset allocation program with regular rebalancing would have fared well. As a growing proportion of savers are deploying their money through some version of this approach, as part of the default option for defined contribution pension plans, this is good news. Boring asset allocation would have handled this bizarre year quite well. And for those prepared to be more active, you don't have to move all your money at once; you could have fed just some of your savings into stocks on the morning of March 24.  

If you want to try timing, a clear moral of 2020 is never to ignore liquidity. Time will tell whether it is safe to ignore fundamentals.

 

Survival Tips

Really, The Guardian? West End Girls by the Pet Shop Boys? According to the Guardian's music writers, this 1986 chart-topper is the greatest U.K. number one single of all time. It isn't. What should be? It strikes me as silly to pick anything not by the Beatles. With a gun to my head, I would choose Eleanor Rigby/Yellow Submarine, a double A-side that hit number one in August 1966 and was top on the day I was born. Their next single, also a double A-side, was even better: Strawberry Fields/Penny Lane. But it didn't get to number one. If you want to survive the lockdown with your sanity intact, make your own list.

 

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