Keeping Score for January 2020

I’ve just updated myKeeping Score page for January.   weaker world economy = interest rates lower for longer = more buoyancy in stock markets

more on the new coronavirus

SARS

SARS emerged in China in November 2002.  Local authorities, later removed from office in disgrace, initially failed to sound an alarm about the new disease, apparently thinking reporting it would reflect badly on them and hoping it would just go away if ignored.

The world first became aware of SARS as a public health threat in February 2003.  The disease was declared under control in July 2003.  By that time there had been 8000+ reported cases and about 800 deaths.  The overwhelming majority of the fatalities were in China.  The elderly and the very young were the age groups hardest hit.

the new virus

As of yesterday, there had been 2700+ cases of the new coronavirus reported and 80+ deaths.

There are four differences I see between the SARS epidemic and this year’s outbreak:

–faster reporting and more aggressive quarantining today (the disease is passed through contact with an infected person’s bodily fluids.  There’s no medicine that works against it, so isolating victims is the only “cure”)

–symptoms emerge on average about ten days after infection, pretty much the same as with SARS.   But unlike the case with SARS, where carriers only became infectious after they showed symptoms, carriers of the new virus appear to be infectious from day one, long before they become visibly itt

–China is a much larger part of the world economy today than it was back then.  While the US has grown by 80% (using conventional GDP) since 2003, China is 12x the size it was then.  So the slowdown in global economic activity that will result from quarantine measures in China today will be greater than it was for SARS.  If SARS is a good indicator–and it’s the only one we have, so it is in a sense our best guide–the current outbreak will be well past the worst by mid-year

–SARS happened just as the world was beginning to recover from the recession caused by the internet bubble collapse of early 2000.  The new virus comes during year 11 of recovery from the downturn caused by the near-collapse of the US banking system from losses that piled up during years of wildly speculative lending and securities trading.  In other words, SARS happened when profits were beginning to boom and stocks really wanted to go up; in contrast, this virus is happening when profits are plateauing and stocks want to go sideways mostly because interest rates are crazy low.

investment thoughts

During the SARS outbreak business travel came to a screeching halt because people feared becoming sick/being quarantined in a foreign country. If it’s correct that the new virus can be passed on even before the carrier shows symptoms, the risk in using public transport is substantially greater.  So too the possibility that one’s home country will temporarily bar returnees from virus-infected areas.

Securities markets in China are currently closed for the New Year holiday.  It isn’t clear that they will reopen on schedule.  In the meantime, China-related selling pressure will likely be redirected to markets like New York.  Alibaba (BABA) shares (which I hold), for example, are down about 6% in pre-market trading.  At some point, assuming as I do that the SARS analogy will be a good indicator, there’ll be a buying opportunity.  For me, it’s not today, although if I weren’t a BABA holder I’d probably buy a little.

It will be interesting to see how AI handles trading today.

 

 

the new coronavirus

A little more than 17 years ago, the coronavirus SARS (Severe Acute Respiratory Syndrome) surfaced in China.  Despite occurring at what proved to be the onset of a new bull stock market, SARS cast a months-long pall over world stock exchanges, particularly those in Asia and notably Hong Kong.

Two key reasons:  this was the first coronavirus many investors (myself included) had seen, so it was especially scary;  rather than quarantine infected individuals, local authorities in China decided to cover up the presence of the disease, so SARS had a chance to spread unchecked for several months.

 

The coronavirus MERS (Middle East Respiratory Syndrome) only captured world attention for a few days then it emerged in 2012.  Overall economic/stock market conditions were favorable.  Authorities moved quickly to contain its spread.  And investors had already seen how SARS played out.

 

The new coronavirus, which doesn’t have a snappy acronym yet, comes from China and is a relative of SARS.  One might expect that its impact on stock markets will be more like that of MERS than SARS.  Two caveats:  it is hitting China just as the annual New Year travel/spending/celebrating holiday is beginning; and markets have been rising for years.  Economic activity is healthy but not awesome, and is beginning to slow in the US.  Ex Hong Kong and mainland Chinese bourses and travel-related stocks, however, the new virus will be the possible trigger for a selloff, in my view, rather than a cause.

 

a PS to today’s post

The Russell 2000, which is composed of medium-sized US-based firms serving mostly US customers is up by 4.5% over the past two years.  This compares with +16.5% for the S&P 500 and +25.5% for the NASDAQ, which are far more globally oriented.  (These are capital changes figures, which I plucked off Yahoo Finance.)

The latter two are 3.7x and 5.7x the return on the Russell 2000.  Attention grabbing, yes, but not the right way to sum up the situation.  More important is that these ratios happen because ex dividends the Russell has returned pretty close to zero.

starting out in 2020

The S&P 500 is trading at about 25x current earnings, with 10% eps growth in prospect, implying the market is trading at around 22.7x forward earnings.  During my working career, which covers 40+ years, high multiple/lower growth has virtually always been an unfavorable combination for market bulls.

Could the growth figure be too low, on the idea that forecasters give themselves some wiggle room at the beginning of the year?

For the 50% or so of earnings that come from the US, probably not.  This is partly due to the sheer length of the expansion since the recession of 2008-09 (pent up demand from the bad years has been satisfied, even in left-behind areas of the country–look at Walmart and dollar store sales).  It’s also a function of shoot-yourself-in-the-foot Washington policies the have ended up retarding growth–tariff wars, suppression of labor force expansion, tax cuts for those least likely to consume, no infrastructure spending, no concern about education…  So I find it hard to imagine positive surprises for most US-focused firms.

Prospects are probably better for the non-US half.  How so?  In the EU early signs are emerging that structural change is occurring, forced by a long period of stagnation.  The region is also several years behind the US in recovering from the recession, so one would expect that the same uptick for ordinary citizens we’ve recently seen in the US.  Firms seeking to relocate from the US and the UK are another possible plus.  In addition, Mr. Trump’s life-long addiction to risky, superficially attractive but ultimately destructive, ventures (think:  Atlantic City casinos) may finally achieve the weaker dollar he desires–implying the domestic currency value of foreign earnings may turn out to be higher than the consensus expects.

 

The biggest saving grace for stocks may be the relative unattractiveness of fixed income, the main investment alternative.  The 10-year Treasury is yielding 1.81% as I’m writing this  That’s 10 basis points below the dividend yield on the S&P 500, which sports an earnings yield (1/PE) of 4.  I say “may” because, other than Japan, the world has little practical experience with the behavior of stocks while interest rates are ultra-low.  In Japan, where rates have flirted with zero for several decades, PE ratios have declined from an initial 50 or so into the low 20s. Yes, Japan is also the prime example of the economic destructiveness of anti-immigration, anti-trade, defend-the-status-quo policies Washington is now espousing. On the other hand, it’s still a samurai-mentality (yearning for the pre-Black Ship past) culture, the population is much older than in the US and the national government is a voracious buyer of equities.   So there are big differences.  Still, ithe analogy with Japan holds–that is, if the differences don’t matter so much in the short term–then PEs here would be bouncing along the bottom and should be stable unless the Fed Funds rate begins to rise.

That’s my best guess.

 

The consensus was of viewing last year for the S&P is that all the running was in American tech industries.   Another way of looking at the results is that the big winners were multinational firms traded in the US but with worldwide markets and very small domestic manufacturing and distribution footprints.   They are secular change beneficiaries located in a country whose national government is now adamantly opposing that change.  In other words, the winners were bets on the company but against the country.  Look at, for example,  AMZN (+15%) vs. MSFT (+60%) over the past year.

The biggest issue I see with the 2019 winners is that on a PE to growth basis they seem expensive to me.  Some, especially newer, smaller firms seem wildly so.  But I don’t see the situation changing until rates begin to rise.

 

Having said that, low rates are an antidote to government dysfunction, so I don’t see them going up any time soon.  So my practical bottom line ends up being one of the gallows humor conclusions that Wall Streeters seem to love:  the more unhinged Mr. Trump talks and acts–the threat of bombing Iranian cultural sites, which other governments have politely pointed out would be a war crime, is a good example–the better the tech sector will do.  As a citizen, I hope for a (new testament) road-to-Damascus event for him; as an investor, I know that would be a sell signal.

 

 

 

 

 

 

 

 

thinking about 2020

where we are

The S&P 500 is trading at around 25x current earnings, up from a PE of 20x a year ago.  Multiple expansion, not earnings growth, is the key factor behind the S&P rise last year.In fact, earnings per share growth, now at about +10%/year, has been decelerating since the one-time boost from the domestic corporate income tax cut cycled through income statements in 2018.  Typically earnings deceleration is a red flag.  Not so in 2019.

EPS growth in 2020 will probably be around +10% again.

About half the earnings of the S&P come from the US, a quarter from Europe and the rest from emerging economies.  The US will likely be the weakest of the three areas this year, as ongoing tariff wars take a further toll on agriculture and manufacturing, as population growth continues to wane given the administration’s hostility toward foreigners, and as multinationals continue to shift operations elsewhere to escape these policies.  On the other hand, Europe ex the UK should perk up a bit, emerging markets arguably can’t get much worse, and multinationals will likely invest more abroad.

 

interest rates:  the biggest question 

What motivated investors to bid up the S&P by 30% last year despite pedestrian eps growth and Washington dysfunction?

Investors don’t buy stocks in a vacuum.  We’re constantly comparing stocks with bonds and cash as alternative liquid investments.  And in 2019 bonds and cash were distinctly unattractive.   The yield on cash is close to zero here (elsewhere in the world bank depositors have been charged for holding cash).  The 10-year Treasury started 2019 yielding 2.66%.  The yield dipped to 1.52% during the summer and has risen to 1.92% now.  In contrast, the earnings yield (1/PE, the academic point of comparison of stocks vs. bonds)) on the S&P was 5% last January and is 4% now.

The dividend yield on the S&P is now about 1.9%.  That’s higher than the 10-year yield, a situation that has occurred in our lifetimes only after a bear market has crushed stock valuations.  In my working career, this has happened mostly outside the US and has always been a clear buy signal for stocks.  Not now, though–in my view–unless we’re willing to believe that the current situation is permanent.

The situation is even stranger outside the US, where the yield on many government bonds is actually negative.

In short, wild distortions in sovereign bond markets, a product of unconventional central bank measures aimed at rescuing the world economy after the 2008-09 collapse, have migrated into stocks.

How long will this situation last and how will it unwind?

 

more on Monday