COVID Cases Rising => Greater Uncertainty

• US COVID-19 infections are rising – how will this impact the economy? 
• Q3 earnings are beating expectations – but down almost 20% YoY
• Expecting more volatility heading into the election

We’re in the middle of the Q3 2020 earnings season and so far results are handily beating what is a low bar.

In fact, 86% of the companies who have reported so far are showing a positive earnings surprise; and 82% beating revenue expectations.  

That said, the earnings average decline is almost down 20% YoY.

And if that holds for the balance of 90% of companies still to report – it will be the worst result since the great recession of 2009 (where earnings dropped 27% YoY)

For example, if you look at the latest earnings insight from Factset (Oct 16) we find (with 10% of all companies reporting so far):  

• Earnings Scorecard: 86% of S&P 500 companies have reported a positive EPS surprise and 82% have reported a positive revenue surprise. 
• Earnings Growth: blended earnings decline for the S&P 500 is –18.4%. If -18.4% is the actual decline for the quarter, it will mark the second largest year-over-year decline in earnings reported by the index since Q2 2009 (-26.9%). 
• Earnings Revisions: On September 30, the estimated earnings decline for Q3 2020 was -21.0%. Eight sectors have smaller earnings declines or higher earnings growth rates today (compared to September 30) due to positive EPS surprises. 
• Earnings Guidance: For Q4 2020 – 2 S&P 500 companies have issued negative EPS guidance and 6 have issued positive guidance. 
• Valuation: The forward 12-month P/E ratio for the S&P 500 is 22.0. This P/E ratio is above the 5-year average (17.3) and above the 10-year average (15.5).

Here’s Factset’s forward 12-month earnings (i.e. ~$160 per share or a forward PE of 22x) versus what we see with the S&P 500 over the past 10 years: 

Factset – Oct 16 2020 – Forward EPS vs S&P 500

A couple of things which standout to me:  

• Over the long-run – earnings per share will largely track the S&P 500. However, in the short-run we can see large divergence either way 
• Today that divergence is as large as we have seen since 2010. When the light-blue line (S&P 500) gets too far ahead of the dark-blue line (earnings per share) – typically we will see convergence in the months ahead.  
• Today’s forward PE of 22x is high – however we need to be mindful of a negative real interest rate environment.  
• Today stocks are almost priced to perfection – assuming we will see a big rebound in earnings over the coming year – either as a result of things such as (a) massive central bank and fiscal stimulus; (b) greater costs savings and operating efficiencies; and/or (b) a rapidly recovering economy. 

With that, let’s talk to that last point – as the economic recovery will most likely be a function of what we see with COVID; and government policy (which will include things like (not limited to) fiscal relief, regulations on businesses re-opening, taxes and so on)

US COVID-19 Cases Rising (Again)

Up until recently (early Sept) – the US was experiencing a gradual downtrend when it came to COVID infections. 

Unfortunately the trend bottomed Sept 7th... where US daily reported cases were just 25,000. Today that number is ~70,500 and rising. 

The “good” news is that trend isn’t echoed with COVID deaths – averaging between 300 per day (at the low point) and 900 per day at the high point (as we see below)

The market’s concern with COVID infections rising will be renewed pressure from governments to enforce further business restrictions. 

As I said on Thursday – we are seeing some governments in Europe reinstate pandemic restrictions to curb a second wave.

France has declared a public health state of emergency and the U.K. is nearing a second national lock-down.

Will we see the same thing from the US over the coming months if this curve continues to rise? 

Now if the answer is yes – then obviously this is going to impact the economy’s recovery (and in turn – corporate earnings, employment and so on)

From mine, this will only increase the pressure on governments to inject even more fiscal stimulus – as more people struggle to find work (and small business fight to remain solvent)

Unemployment Doggedly High

Last week I also touched on the trend with first-time (U.S) weekly unemployment claims 

It remains doggedly high – just under 1M weekly claims  (vs the 200K average we saw prior to COVID)

What’s concerning is there are still a total of more than 25 Million people claiming benefits for unemployment… and it’s barely moving.

Note the far right column – that number was just 1.4M a year ago vs 25.2M today.

If we put 25M into perspective – that’s almost 17% of the Feb 2020 workforce. Put another way – 1 in 6 US workers are now potential lining up for food stamps. 

1 in 6!

(For the purpose of this post – I’ll refrain on sharing my personal views on what Congress should do – enough said on that point)

The point of these charts (COVID infections and unemployment) is to illustrate what this could mean for any potential “robust” economic recovery. 

I’ve always maintained that is recovery (from March) is more likely to be either “U” or “L” shaped (never “V”)

The only “V” we were likely to see (which would be a function of Fed money printing) would be for some sectors of the stock market (i.e. those who do not depend on a physical premise for income generation)

And it didn’t matter how much money the Fed print or how many “trillions” in debt the government chose to inflict on future generations to pay back – neither will be useful in containing COVID. 

Note – below is the US Federal Debt as a function of GDP – now almost 140% – and in my view – likely to exceed 200% by Q2 2021 (subject for another post!)

US Federal Debt now ~140% for GDP

So What Does This Mean for Stocks?

In a single word – extremely uncertain!

If there’s one thing that the market hates – it’s uncertainty. 

It would always rather know bad news versus not know what might (or might not) happen. 

Bad news you can plan for. 

Today I think stocks are extremely optimistic on the relative speed of the recovery.  Again, a forward PE ratio of 22x is largely a function of three things: 

• Real interest rates being negative (combined with Fed assistance); 
• Several trillion of government fiscal spending (i.e. relief bill); and
• The economic recovery looking more V-shaped vs L-shaped

Let’s look at the all-important weekly trend for the S&P 500:

S&P 500 – Oct 17 2020

Here’s what I see (from a technical perspective):
 

• The weekly trend remains bullish – with the 10-week EMA (red) trading well above the 35-week EMA (blue). Therefore, our first disposition should be bullish 
• The VIX remains very elevated (27.4) despite the market trading very close to all-time highs. This tells me investors are pricing in a lot of uncertainty – and are willing to pay a high price for “put protection” in the event of downside.  
• Our weekly-MACD has been declining since the first week of June… despite the S&P 500 rallying from a level of 3200 to ~3600 (an increase of around 12.5%). This is what is called “negative divergence” and is often a warning of selling pressure ahead.  
• I have penciled in a small Fibonacci retracement we saw very early in the year (before the sell-off). The top of this structure was the market high in Feb of 3394. 61.8% outside this structure (on the high-side) is 3522 – where we are seeing resistance. And 61.8% on the downside is around 3100 – and where we might find support (and my preferred “buy zone“).  

In summary – I am very wary of near-term selling pressure. However, it’s important not to confuse that with being bearish. 

I think there’s a high probability we will see another test of the 3100 to 3200 zone over the coming weeks.  And if we do – that would be a buying opportunity with strict levels of capital (risk) management. 

Before I close – regular readers will know that given this disposition – my strategy over the past 3-4 months has been to (a) sell out-of-the-money put options on quality stocks; and (b) at a price I would be comfortable paying. 

My strike rate on this strategy has been 100% to-date – sharing about 70% of these trades on the blog.

For example, on Friday (Oct 16) I was able to bank terrific income from (bullish) positions on BABA, APPL and INTC (and others) for between 9% and 16% annualized.

I also banked income from selling call options on Hilton (HLT) for 16% – which I thought would struggle given what we see with COVID. 

And recently – I placed new trades on XOM and BAC (also shared on the blog) 

Whilst this strategy works well for in the near-term – ideally I want to buy quality stocks. That’s how I prefer to make bigger returns (as I did with Amazon and Apple over the past couple of years). 

But to do that – I need to be comfortable at the risk/reward which is on offer.

And as it stands now – my view is that’s not overly compelling. 

As I said recently – trading this market isn’t simple. 

For me, the past few months I’ve been “grinding” my returns higher… month after month with what I like to call “income plays”. 

I’m constantly trying to balance the risk/reward in terms of capital exposure – versus what I can read from the economic (and political) tea-leaves. 

For example, I think the economic outlook is extremely uncertain – very much a function of what we see politically.

And I know reader’s bias will vastly differ to mine in terms of: 

• how the political environment will impact markets (and the economy); and secondly
• what they would prefer to see with the coming US election

The latter point is extremely contentious (politics always is). Trust me, I receive no shortage of emotionally charged emails from readers if I dare talk politics (which is expected). Politics is sensitive. 

But rarely has there been a time where so much weighs on the outcome.

My own ideology (which will almost certainly differ to yours) is anchored in four broad (policy) principles:  

• free markets and the role of free-market forces;
• greater individual freedoms (freedom of speech and civil liberties); 
• policies which incentivize private investment (and employment); and
• smaller government (i.e., less intervention and manipulation). 

And yes – unfortunately it’s not always so “black and white“.

Far from it!

For example, how do we effectively find the right balance between  

• short-term priorities (and incentives); with
• potentially negative longer-term impacts and consequences?

What works “well” for the next say “1-5 years” may not equate to the same benefits over the next “10-20 years”?

Unlimited fiscal spending (and public debt) is one example. 

I’m sure the current generation will benefit from unlimited government spending (and debt) – but what about future generations?

Will they realize the same benefit?

Future generations will be the ones who must pay it back (and a higher rate of interest) who (a) didn’t get a say in it; and (b) will not enjoy the benefit?

Tough one right?

I often call this the difference between what’s seen versus what’s unseen. 

How about climate change – this is another good example. 

For example, there is a clear short-term benefit (e.g. maybe 10 years) to accelerate high level of investment in fossil-fuels without restriction (i.e., generating thousands of jobs, greater income and stronger market returns etc). 

That’s what’s “seen”.

But does this strategy serve us well for generations to come (i.e. what’s unseen)?

Put another way, would the private sector alone (without any form of government legislation) decide we should prioritize climate change (and clean air) over increased carbon emissions?

Maybe it would?

Or maybe the private sector is incapable because of the short-term profit (and job) incentives (which is a widely held view).

I don’t pretend to know.

I would l like to think the private sector is capable – as incredible companies like Tesla meet the private sector’s insatiable demand for all-electric vehicles. 

That’s the market voting or deciding on what they feel is important (and there are many other similar examples). 

And from there, if more people choose all-electric cars, this will naturally curb the demand for fossil fuels. 

That’s free market forces in play. 

Again, I am sure you will have your own (strong) view on these questions. 

My intent here is not to answer (or debate) these complex (and sensitive issues). 

I raise them to simply provide an example of the complexities we must deal with (and there are many others such as government bailouts and subsidies)

For example, the points I provide above on things like greater individual freedoms and free(er) markets is my own (high-level) framework for thinking through policy decisions.

But I equally recognize the answers are rarely binary. 

Above all else, all we can do is continue to think critically and challenge everything we read or hear (and that includes anything that I write or share).

There’s never a “right” answer – but we can review the raw data for ourselves and develop more on an informed view. 

And I believe that if we all asked more quality questions and challenged the data – then maybe – just maybe – the problem of “fake news” (and the phenomenon of “Karen said on Facebook“) would be less. 

Regards,
Adrian Tout