STORY OF THE WEEK

VALUE IS HISTORICALLY CHEAP

The stock market has staged a strong rally in recent weeks, gaining over 32% since bottoming on March 23rd. At this point, the S&P 500 is within 12% of its previous high and no longer represents a bargain. Luckily for investors, other areas of the market remain cheap by historical standards and continue to offer an attractive investment opportunity. Value stocks qualify here.

Value stocks represent a subset of companies whose share prices relative to some fundamental metric (such as book-value or earnings) are lower than the broad market. These stocks have historically delivered higher returns than the market, but for most of the period since the Financial Crisis of 2008-09, they have lagged. This trend has been exacerbated during the recent volatility that stemmed from the coronavirus response. As a result, the price discount of value stocks has been rapidly increasing. The chart below illustrates how big the discount for value has become. The higher the line goes, the cheaper they are. You can see that over the last 50+ years, they have never been cheaper!

Valuations have a strong tendency to ‘mean revert’ or return to normal levels after reaching extremes. This is evident in the chart above, where large discounts for value stocks compressed following the burst of the technology bubble in the late 1990s, and recovery from Financial Crisis in the late 2000s. Value saw strong relative performance after each of those episodes.

There is no way to know when value stocks will bounce back, and it’s entirely possible they will continue to get cheaper for an extended period of time. But while the S&P 500 as a whole may be getting more expensive, value stocks remain historically discounted. If the relative valuation normalizes, it should offer a strong tailwind for value investors.   

WEEK IN REVIEW

• The market started this week off on strong footing, with the S&P 500 gaining 3.15% on Monday. This marked the largest single-day gain for the index since early April. Positive results from the clinical trials of a potential COVID-19 vaccine were largely credited for the rally.
• Data published on Friday showed retail sales dropped 16.4% in April, versus an expected 12.3% drop. The clothing/accessories and electronics/appliances were the hardest hit categories, declining -78.8% and -60.6%, respectively. Online retail was the lone category in positive territory.
• Following the furious rally in April, valuations for the S&P 500 are moving back toward expensive territory. The P/E ratio for the index increased to 19.7, which is higher than the February level of 19.5 and has likely increased further in May.

HOT READS

Markets

• Most Investors Don’t Think This Rally Is For Real, According to Widely Followed Wall Street Survey (CNBC)
• Be Careful Handling White Hot Moderna Shares (WSJ)
• Terrible Retail Sales Report Shows Acceleration in fates of Struggling and Thriving Retailers (CNBC)

Investing

• Nothing Fails Quite Like Success in the Stock Market (AWOCS)
• Is (Systematic) Value Investing Dead (AQR)
• The Beginning of the End? (IrrelevantInvestor)

Other

• Federal Reserve Chairman Jerome Powell on the Coronavirus-Ravaged Economy (60 Minutes) Video
• Starved for Action, Bettors Turn Nebraska Horse Track Into Must-See TV (NYT)
• mRNA Vaccine Playlist (ReformedBroker)

LFS BLOG

• Portfolio Management for Retirees During a Financial Crisis
• Is Value Investing Dead?
• Why Investors Should Own International Stocks
• 3 Things All Investors Should Know

ECONOMIC CALENDAR

Source: MarketWatch

STORY OF THE WEEK

STOCKS LOOK BEYOND BAD ECONOMIC DATA

The impact from the economic shutdown has started to show up in the data, and the results thus far have not been good. GDP in the 1st quarter, for example, saw its sharpest decline since 2008, and the April jobs report showed the highest unemployment rate since the Great Depression. Despite these historically bad prints, stocks have continued to climb. How is this possible?

The answer largely relates to a concept we have written about in the past: the market is forward-looking. Rather than waiting for official news, asset prices move based on what’s anticipated. This helps to explain why the S&P 500 experienced one of its largest monthly declines ever in March (-12.5%), despite major COVID-19 outbreaks (like the one in New York) not peaking until mid-April. The market was expecting the response to the coronavirus outbreak to hurt business earnings, cost jobs, and slow economic growth. To some degree, prices moved in February and March based on the bad data we are just now getting. This similarly explains why the S&P 500 had one of its best monthly gains ever in April (+12.7%), potentially during the height of the health crisis. Unprecedented fiscal and monetary stimulus, progress on COVID-19 treatments, and the prospect of slowly reopening parts of the economy have investors looking beyond the ugly data and seeing better times ahead.  

When the S&P 500 is down over 30% like it was in late March, it doesn’t take much to justify a reversal. You don’t necessarily even need positive news, just being less negative than originally expected can do the trick. From this perspective, at least some of the market rally seems justified, given we appear to have avoided many of the worst-case scenarios related to the outbreak. As stock prices rise, however, the bar that growth must surpass to justify more gains also rises. The stock market may be forward-looking, but it can’t predict the future. If the rally gets ahead of itself, you could start to see bad news trigger declines again.

Things will get better. We just don’t know how long the recovery will take. In the meantime, investors should stay prepared for the potential for more volatility.

WEEK IN REVIEW

• Data published by the Labor Department showed that 20.5 million jobs were lost in April, pushing the unemployment rate up to 14.7% (slightly better than the 15.2% forecast by economists per MarketWatch). Both the number of lost jobs and the unemployment rate were the highest in the post-World War II era. Some of the details in the report were worse than the headline figures. The “U-6” unemployment rate, which includes workers not looking for jobs and the underemployed, increased to 22.8%.
• This morning the Bureau of Labor Statistics published its April Consumer Price Index (CPI) data, which showed prices increased by 0.4% in the past year. For context, the Federal Reserve targets 2.0% as a healthy level of inflation. The Core CPI figure (which strips out the volatile food and energy price segments) declined 0.4% in April, the largest monthly decline since records began in the late 1950s. Within the Core figure, apparel and transportation services saw the largest declines (4.7% each).
• So far, 66% of S&P 500 companies have reported Q1 earnings. If you blend the results of companies that have reported with the estimates for companies that have yet to report, earnings declined 13.6% during the quarter (the largest decline since Q3 2009).

HOT READS

Markets

• A Record 20.5 Million Jobs Were Lost In April as Unemployment Rate Jumps to 14.7% (CNBC)
• Consumer Prices Saw The Largest Monthly Drop Ever in April (CNBC)
• Off the Charts (Irrelevant Investor) The economic shutdown has broken many historical charts

Investing

• Does Covid-19 Prove the Stock Market is Inefficient (AWOCS)
• Latest Memo From Howard Marks: Uncertainty (Howard Marks)

Other

• ‘The Last Dance’ Winners and Losers (CBSSports)
• As Restaurants Remand Shuttered, American Cities Fear the Future (NYT)

LFS BLOG

• Portfolio Management for Retirees During a Financial Crisis
• Is Value Investing Dead?
• Why Investors Should Own International Stocks
• 3 Things All Investors Should Know

ECONOMIC CALENDAR

Source: MarketWatch

STORY OF THE WEEK

FIVE HIGHLIGHTS FROM THE BERKSHIRE MEETING

Berkshire Hathaway held its annual shareholder meeting in Omaha this past Saturday. The event, frequently referred to as the “Woodstock for capitalists,” typically attracts tens of thousands to the city for a chance to see Warren Buffett and Charlie Munger speak. Like many other facets of life, however, this year’s meeting was dramatically altered by the coronavirus outbreak. “It doesn’t look like an annual meeting, it certainly doesn’t feel like an annual meeting,” Buffett said as he addressed an empty arena. While it may have lacked the typical crowd and festivities, there was no shortage of headlines from the live-streamed event. Below are a few highlights from the meeting.

1. Omaha Impacted by Lack of Berkshire Attendees

According to Visit Omaha, the city’s tourism bureau, the annual meeting generates $21.3 million for the local economy. With the event essentially canceled for visitors, businesses already reeling from the coronavirus response missed out on a major revenue opportunity. Other significant events that have been canceled in Omaha this year include the U.S. Olympic Swimming Trials and The NCAA baseball College World Series. The economic impact of those two events is estimated at $74 million and $70 million, respectively, according to Visit Omaha.

2. The Cash Pile Grew to $137 billion

During the Financial Crisis of 2008/09, Berkshire took advantage of its strong balance sheet and made investments in many distressed companies at attractive rates. With the market in turmoil during the 1st quarter, many people expected Berkshire to put some of its massive cash hoard to work in a similar fashion. When asked about this, Buffett responded: “We have not done anything because we don’t see anything that attractive to do.” According to Buffett, the support programs enacted by the Federal Reserve (which he commended) opened the door for companies to obtain financing at levels Berkshire deemed inadequate. Additionally, the pace at which Berkshire repurchased its own shares slowed during the quarter and was concentrated in the period before market volatility spiked.

3. Berkshire Exited the Airline Business

Berkshire sold its roughly 10% stakes in the country’s four largest airline companies: American, Delta, United, and Southwest. “A low probability event happened, and it particularly hurt… the airline business,” said Buffett. While he indicated the companies and their management teams were not at fault for their predicament, Buffett believes the fundamentals for the airline industry have changed. Beyond the 90%+ drop in air traffic that the industry is currently battling through, if travelers are slow to return, issues with excess capacity could persist. Additionally, the large amount of debt the companies are taking on to survive the crisis will weigh on future earnings.

4. Buffett and Munger are in Good Health

Adding to the unusual feel of this year’s meeting was the fact that Charlie Munger was not on stage. Instead, Warren Buffett was joined by Greg Abel, vice chairmen of Berkshire’s non-insurance operations. Buffett indicated that they did not think it would be wise for Munger (age 96) to make the trip from his home in California, given current conditions and that Munger would be back next year. He joked that Charlie had surpassed him technologically after becoming a daily user of the Zoom video conferencing app, comparing the feat to “stepping over a peanut or something.” “Charlie is in good health, I’m in good health,” said Buffett.

5. Nothing Can Stop the American Economy

Buffett struck a cautious tone when discussing the near-term outlook, noting that we still face an “extraordinarily wide” range of possibilities given the coronavirus outbreak. This caution was evident in Berkshire’s action (or lack of) during the 1st quarter, as Berkshire largely kept its equity portfolio unchanged (aside from the airlines). Buffett then went on to reiterate his faith in the long term prospects of the U.S. economy: “But even facing that, I would like to talk to you about the economic future of the country. Because I remain convinced, as I have — I was convinced of this in World War II, I was convinced of it during the Cuban Missile Crisis, 9/11, the Financial Crisis – that nothing can basically stop America”.

WEEK IN REVIEW

• Data published last week by the Bureau of Economic Analysis showed that GDP shrank by 4.8% during the 1st quarter. The decline was more than economists forecast (-3.5%), marks the 1st negative reading since 2014, and represents the largest drop since the financial crisis. The market reaction to the data was muted, as investors widely expected a negative reading, and there were some positive news reports related to progress on a COVID-19 drug treatment. Economists expect the 2nd quarter GDP will be even worse since the lockdowns did not really begin until late in Q1.
• Last week the Federal Reserve held its Federal Open Market Committee meeting, which directs the central bank’s monetary policy. As expected, the committee voted to leave its benchmark interest rate (federal funds rate) between 0.00% and 0.25%. The official post meeting statement indicated that they expect to maintain that target range until they are confident the economy has recovered from the crisis, employment returns, and inflation moves towards their 2% target. In addition to lowering the benchmark rate to near-zero, the Fed launched an unprecedented array of other economic support programs. In his post-meeting press conference, Chairmen Powell indicated that they do not intend to withdrawal those programs until they are confident the economy is well on the way to recovering.
• The weekly jobless claims figure came in at 3.8 million last week, lifting the total number of claims filed to 30 million. As of April 18, 12.4% of the labor force was covered by unemployment benefits. One positive, in what is otherwise very painful data, is that the number of new claims has declined in each of the past four weeks.

HOT READS

Markets

• US GDP Shrank 4.8% in the First Quarter Amid Biggest Contraction Since the Financial Crisis (CNBC)
• Fed Pledges to Keep Rates Near Zero Until Full Employment, Inflation Come Back (CNBC)
• U.S. Services Sector Posts Biggest Contraction Since 2009 as Coronavirus Halts Economic Activity (CNBC)

Investing

• Finding Your Balance in a Topsy-Turvy Market (Zweig)
• What Happens When the Parts Are Bigger than the Whole? (Irrelevant Investor) Why the FANG stocks can’t grow this fast forever
• How Will the Crisis Impact Housing Prices? (AWOCS)

Other

• Coronavirus Canceled Warren Buffett’s Shareholder Party. Omaha is Suffering. (WSJ)
• ESPN Study: Fans Favor Sports Returning Without Spectators Rather Than Wait (ESPN)

LFS BLOG

• Portfolio Management for Retirees During a Financial Crisis
• Is Value Investing Dead?
• Why Investors Should Own International Stocks
• 3 Things All Investors Should Know

ECONOMIC CALENDAR

Source: MarketWatch

STORY OF THE WEEK

INVESTOR SENTIMENT JUST HIT THE LOWEST LEVEL OF THE YEAR

Every Thursday, the American Institute of Individual Investors (AAII) publishes a widely followed sentiment survey. The publication shows how mom and pop investors feel about the short-term prospects of the stock market. While not always meaningful, when the gauge hits an extreme, it’s often an accurate indicator of where things are headed.

The survey began in the late 1980s and is often used by professional investors trying to take the temperature of the market. It asks a simple question: “I feel that the direction of the stock market over the next six months will be…?”

1. Up (Bullish)
2. No Change (Neutral)
3. Down (Bearish)

The results from the most recent survey show that half of the respondents are expecting the market to be down over the next six months. This marks a large shift toward bearish sentiment from the previous week.

You can get a sense of how bullish (optimistic) or bearish (pessimistic) investors are in general simply by looking at the relative spread between the two groups. Based on the chart above, historically, 38% of respondents fall in the bullish camp on average, while 30.5% fall in the bearish camp. This suggests investors as a whole are generally optimistic, as there are 7.5% more bullish investors on average. The chart below illustrates the spread over the past few years, and provides some context to last week’s unusually bearish reading of -25.1%.

Source: Sentiment from American Institute of Individual Investors, Returns from Morningstar Direct. 1/3/2013 – 4/24/2020.

How well have our faithful survey takers predicted near-term market moves in the past?  Not well! When comparing the historical survey results since the 1980s to actual market returns, a few patterns emerge:

1. Investor sentiment typically reflects what has just happened. High pessimism typically followed periods where the market had negative performance, while high optimism followed periods where the market had above-average performance.
2. When sentiment hits an extreme level, the market tends to reverse. Excessive pessimism has often been followed by above-average returns, while excessive optimism is typically followed by below-average returns.

Investor Sentiment versus Market Returns

Source: Sentiment from American Institute of Individual Investors, Returns from Morningstar Direct. 12/31/1987 – 4/24/2020. Returns are not annualized. Three month periods are estimated based on survey release dates (weekly). 

Historically, when investors are as bearish as the most recent report revealed, the market has generated above-average returns in the near-term. To some degree, this seems to already be playing out, as the S&P 500 has gained 2.9% in the two days since the report was published. The strong performance over the past two days is part of a broader rally that has seen the index gain 28.7% off the March lows. While this is certainly a welcome development, it has generated fear that it may be too much too fast. Nobody knows whether we are in a sustained recovery, or if we will eventually retest the lows. Although much of the recent news flow has been negative, I see low investor sentiment as a positive sign for the market.

WEEK IN REVIEW

• Last Friday, a new $484 billion coronavirus relief bill was signed into law. The bill includes an additional round of funding for small businesses totaling $370 billion, hospitals will receive $75 billion, and $25 billion will be earmarked to help ramp up COVID-19 testing. There was some indication that an additional bill would be passed to assist states and municipalities.
• According to data from Factset, about 24% of the S&P 500 have reported earnings for Q1 thus far. If you blended the results from those companies that have reported, with the estimates for those companies that are still due to report, the blended earnings growth would be -15.8%. That represents a deterioration from -14.8% the prior week.
• Highlights for the week ahead include the conclusion of the next Federal Reserve meeting and the publication of the initial 1st quarter GDP estimates. No major monetary policy changes are expected to be announced following the Fed meeting on Wednesday, but investors will be looking for hints regarding future actions, including how long they plan to hold the benchmark interest rate near zero. According to the Wall Street Journal, economists are expecting a 3.5% decline in GDP during the 1st quarter, which would mark the first quarterly contraction since 2014 and the largest since 2009. Economists are expecting a substantially larger decline in Q2, as much of the coronavirus related shutdowns did not occur until very late in the 1st quarter.

HOT READS

Markets

• Markets Diverge in Assessing the Economic Freeze (WSJ)
• Trump Signs $484 Billion Coronavirus Relief Bill to Boost Small Business, Hospitals and Testing (CNBC)
• The Federal Reserve is Changing What It Means to Be a Central Bank (WSJ)

Investing

• As If (Humble Dollar) Ignore the media’s explanation of daily market moves
• What’s the Worst Case Scenario for Diversified Portfolios (AWOCS)
• When Your Fund Beats the Market, Ask: Which market? (Zweig)

Other

• Charlie Munger Will Not Take Questions at Berkshire Hathaway’s Annual Meeting This Year (CNBC)
• This Famous Poker Player Can Help Investors Play a Tough Hand (Barron’s)

LFS BLOG

• Portfolio Management for Retirees During a Financial Crisis
• Is Value Investing Dead?
• Why Investors Should Own International Stocks
• 3 Things All Investors Should Know

ECONOMIC CALENDAR

Source: MarketWatch