It seems that virtually every pundit and economist who missed the stock market rally is claiming it was not based on fundamentals. They ‘blame’ the rally on the Fed buying assets, on allegedly naive Robinhood investors, or any other number of reasons, other than that stock markets have behaved rationally. Some have argued that the stock and bond market are telling different stories, when in fact they have been telling the same story. They won’t admit that they have been misinterpreting data.
I think that is is extremely important to point out that the fundamentals have played a large role in the rebound, so investors don’t keep making the same mistakes. For clarity I was bearish in February, I got bullish in March, though I started recommending to buy too early (i.e. I did not time my reversal from bear to bull perfectly – I’m not making that claim). Since then I was bullish, with several variations on what I was bullish on, all based on fundamentals. On Thursday last week, I switched to neutral and am officially moderately bearish as I write this piece defending fundamentals.
Let’s start with a few questions.
What were the all-time highs in stocks? There are many angry rants about being back at all-time highs despite all the uncertainty. It is a question that has some merit. The S&P 500 was just below 3,400 on February 19. It is still 5.5% below that. But, and I think this is something every bear needs to think about, is what level would stocks have reached if the coronavirus wasn’t an issue back in February? COVID-19 was still known as the coronavirus back in February and was impacting markets. There was still fear about what was occurring in China and Asia. Investors were looking to the WHO for guidance and information. I think stocks would have been much higher in February without the virus, which is important when thinking about where we came from and where we might get to.
Were the lows based on fundamentals? The S&P 500 got as low as 2,200 in the middle of March. Day after day markets were halted as daily change limits were breached. ETFs (especially in the fixed income space) were trading at extreme discounts to NAV, creating chaos in the bond market and impacting mutual funds in unprecedented ways. Many watched in horror as a small number of oil futures contracts traded at negative prices in April. I would argue that extremely violent moves have more to do with technicals and positioning rather than fundamentals, which may have overstated how bad things were (and might be overstating how good things are now after the past few days of intense buying).
Now let’s look at the fundamentals that drove the market
- The Treasury Department and the Fed. The Fed was supplying the repo market with liquidity (it had been doing so since September). It was also buying treasuries and supporting markets directly where it could. Then, with ‘equity’ infusions from the Treasury, the Fed was able to announce a series of new supports for markets – including mortgages, structured debt, commercial paper, money market, municipal bonds and corporate debt. The Fed and Treasury department got ahead of the curve. I was impressed as during the financial crisis they always seemed to solve last week’s problem. They were aggressive and preempted many problems – something that I’d never seen, but had to incorporate into analysis. If you think that the Treasury and Fed signaling that they would support safe bond markets and keep yields low isn’t fundamental, then you are making a big mistake. You may disagree with the policy, but knowing that the front end of credit markets were supported and that yields would be kept low, was an important shift to relative value analysis and markets that had not been present (to this extent before). At some level, low interest rates in the treasury market translate into increased risk taking across the board.
- The Cares Act. I am not sure why so many people seemed to miss the importance of the Cares Act in terms of altering the fundamentals. Yes, job losses are scary and concerning, but an extra $600 per week flat rate from the U.S. government goes a long way to reducing that concern. If a person loses their job, but is receiving close to 100% of their prior income and has a high degree of confidence that their job will return, then we cannot treat that job loss the same as what we are used to. Not everyone benefits from this program, but it is not trivial either and too many pundits seem to lament job losses in their bearish analysis without refining their view to account for the Cares Act. Direct checks were another big factor in why we can’t look at the economic data the same way as we did before the Cares Act. Credit card balances are actually declining, because people are taking the government money and reducing high cost debt. That is smart and will leave those people better positioned economically going forward. Credit card delinquencies did not spike higher, yet another example of how the Cares Act broke the traditional correlation between job losses and debt payment. PPP, the program to support small businesses is a story in itself. This is far more complex to analyze but has also played a major role in mitigating the damage and making the actual fundamentals for most Americans far less dire than the headline data might have indicated.
- The reason for job losses is important. In a normal recession, companies that made bad business decisions get in trouble. That leads to layoffs and impacts other businesses. Those businesses in turn struggle, leading to more failures. In this case business were forced to shut down. People who ran viable businesses or had seemingly safe jobs one day, didn’t the next because the government forced them to shut down. That is important when you think about how successful the reopening can be and is why the government owed the people the Cares Act (and why another stimulus bill is winding its way through D.C.). Similarly, on consumer spending, too many very smart people didn’t seem to be able to incorporate the fact that people couldn’t spend money into their analysis. Too many people tried to force unprecedented data into their old models – big mistake. If the data is unprecedented (and it was), then you need to make new models to account for it.
- Getting what you wish for. Invariably people complain about the short term nature of investors. Senior management at companies chafe at the quarterly reporting and constant pressure to deliver quarter after quarter when long term growth is ultimately more important. That has been the case for decades and suddenly, when investors start ignoring P/E ratios which are volatile and not particularly forward looking, everyone is angry? Even forward looking P/E ratios are not that forward looking and are subject to analysts being too embarrassed to say they don’t expect COVID-19 to impact much beyond a year or more.
- Improved Information on COVID-19. As data starting coming in, the biggest lesson we learned was that COVID-19 was not as risky for everyone. There were incredibly high-risk groups. Clearly age and pre-existing serious conditions impacted the severity of getting the virus. It also seemed that viral load was playing an important role in the spread. When around 50% of all deaths in the country are occurring in long term care facilities we have a serious problem that needs to be corrected, but also a path to a safer and stronger reopening. People digging into the data were seeing this in early May. We also went from concerns about a horrifying lack of PPE, ventilators and hospital beds to evidence that those situations might not get out of control as we thought. Lockdown helped. Wearing masks helped – especially as they started to become more readily available. A lot of things on the COVID front were working well, but not getting the attention they deserved. My experience on COVID data was that people responsible for business decisions or big investment decisions were seeing the data for what it was, while those with less responsibility were still fixated on the messaging from mainstream media – which went out of its way to obscure facts. Those that saw this obvious trend in the data were able to bet on an improving economy which is as fundamental as it gets.
Just look at how the rally played out.
Work from home stocks rallied first. Once it became clear that many companies would continue to operate, but largely from home, investors bought stocks that benefited from that. Shop from home? Amazon hit all-time highs, by far, and why isn’t that “fundamental”? The company probably best prepared to sell on-line did well and that isn’t fundamental? Give me a break! Maybe those people receiving significant amounts of government money were left scratching their heads at why wall street was missing out on that factor and were opening accounts to trade?
Then we started transitioning to reopen stocks. Maybe Millennials who were taking advantage of cheap flights on one screen were buying stocks on another screen? Maybe all those who looked at the COVID data and remembered that it was only supposed to be a couple of weeks and that we were just supposed to flatten the curve and realized that hospitalizations and fatalities were not equally distributed started to buy more stocks. Maybe business owners who planned to reopen and knew they had demand for the reopening bought stocks.
The pattern I have seen in stocks is rational and fundamental.
I think anticipating fundamentals has played a major role in making good investment decisions and will continue to do so. I am currently bearish, as of Friday, because I think the fundamentals (and technicals) are now aligned to create a small pullback in stock prices. I am mostly focused on whether D.C. can maintain their focus on the economy and what we do with China.