Everyone Wanting To Buy Suggests The Bear Still Prowls

"If you own 10% equities, as we do, and the market falls 100%, you will lose 10%. That said, you have 90 cents on the dollar to buy equities for free." - Michael Lebowitz

Let me explain his comment.

Last week, we wrote a piece titled: Risk Limits Hit. When Too Little Is Too Much in which we discussed reducing our equity risk to our lowest levels. 

For the last several months, we have been issuing repeated warnings about the market. While such comments are often mistaken for “being bearish,” we have often stated it is our process of managing “risk,” which is most important.

Beginning in mid-January, we began taking profits out of our portfolios and reducing risk. To wit:

'On Friday, we began the orderly process of reducing exposure in our portfolios to take in profits, reduce portfolio risk, and raise cash levels.'

Importantly, we did not 'sell everything' and go to cash.

Since then, we took profits and rebalanced risk again in late January and early February as well.

On Friday/Monday, our 'limits' were breached, which required us to sell more."

There are a couple of important things to understand about our current equity exposure.

 To begin with, we never go to 100% cash. The reason is that "psychologically" it is too difficult for clients to start "buying" when the market finally bottoms. Seeing the market begin to recover, along with their portfolio, makes it easier to fight the fear the market is "going to zero."

Secondly, and most importantly, at just 10% in current equity exposure, the market could literally fall 100% and our portfolios would only decline by 10%. (Of course, given we still have 90% of our capital left, we can buy a tremendous amount of "free assets.")

Of course, the market isn't going to zero.

However, let's map out a more realistic example. 

In this week's MacroView, we discussed the "valuation" issue

“If our, and Mr. Rosenberg’s, estimates are correct of a 5-8% recessionary drag in the second quarter of 2020, then an average reduction in earnings of 30% is most likely overly optimistic. 

However, here is the math:

• Current Earnings = 132.90
• 30% Reduction = $100 (rounding down for easier math)

At various P/E multiples, we can predict where “fair value” for the market is based on historical assumptions:

• 20x earnings:  Historically high but markets have traded at high valuations for the last decade. 
• 18x earnings: Still historically high.
• 15x earnings: Long-Term Average
• 13x earnings: Undervalued 
• 10x earnings: Extremely undervalued but aligned with secular bear market bottoms.

You can pick your own level where you think P/E’s will account for the global recession but the chart below prices it into the market.”

So, let's assume our numbers are optimistically in the "ballpark" of a valuation reversion, and earnings are only cut by 30% while the market bottoms at 1800, or 18x earnings. (I say optimistically because normal valuation reversions are 15x earnings or less.)

Here's the math:

• For a "buy and hold" investor (who is already down 20-30% from the peak) will lose an additional 22%. 
• For a client with 10% equity exposure, they will lose an additional 2.2%. 

When the market does eventually bottom, and it will, it will be far easier for our clients to recover 10% of their portfolio versus 50% for most "buy and hold" strategies. 

As we have often stated, "getting back to even is not an investment strategy."  

Is The Bear Market Over?

This is THE QUESTION for investors. Here are a few articles from the past couple of days:

• Here's A Few Reasons It Might Be A Good Time To Buy - Motley Fool
• Time To Start Bottom Fishing - RBC 
• 6-Signals Say A Bottom Is In - CNBC

And then you have clueless economists, like Brian Wesbury from First Trust, who have never seen a "bear market," or "recession," until it's over.

March 6th.

Why is this important? Because "bear markets don't bottom with optimism, they end with despair."

As I wrote last week:

"Bob Farrell, a legendary investor, is famous for his 10-Investment Rules to follow.

Bear markets have three stages – sharp down, reflexive rebound and a drawn-out fundamental downtrend - Rule #\8

1. Bear markets often START with a sharp and swift decline.
2. After this decline, there is an oversold bounce that retraces a portion of that decline.
3. The longer-term decline then continues, at a slower and more grinding pace, as the fundamentals deteriorate.

Dow Theory also suggests that bear markets consist of three down legs with reflexive rebounds in between.

The chart above shows the stages of the last two primary cyclical bear markets versus today (the 2020 scale has been adjusted to match.)

The answer to the question is simply this:

"When is it time to start buying the market? When you do NOT want to."

Bond Market Implosion

At the moment, the Federal Reserve is fighting a potentially losing battle - the bond market. 

• After cutting rates to zero and launching QE of $700 billion - the markets crashed. 
• The ECB starts an $800 billion QE program, and the markets fail to move. 
• The Fed injected liquidity into money markets, the credit market, and is buying municipal bonds. 
• And the market crashed more. 

The Fed has literally turned on a "garden hose" to extinguish a literal "bon(d)fire." 

This was no more evident than their action this past week to revive a program from the financial crisis called the Primary Dealer Credit Facility (PDCF) to bail out hedge funds and banks. Via Mike Witney:

"The Fed is reopening its most controversial and despised crisis-era bailout facility, the Primary Dealer Credit Facility. The facility’s real purpose is to transfer the toxic bonds and securities from failing financial institutions and corporations (through an intermediary) onto the Fed’s balance sheet.

The objective of this sleight of hand is to recapitalize big investors who, through their own bad bets, are now either underwater or in deep trouble. Just like 2008, the Fed is now doing everything in its power to save its friends and mop up the ocean of red ink that was generated during the 10-year orgy of speculation that has ended in crashing markets and a wave of deflation. Check out this excerpt from an article at Wall Street on Parade. Here’s an excerpt:

“Veterans on Wall Street think of the PDCF as the cash-for-trash facility, where Wall Street’s toxic waste from a decade of irresponsible trading and lending, will be purged from the balance sheets of the Wall Street firms and handed over to the balance sheet of the Federal Reserve – just as it was during the last financial crisis on Wall Street.”

- (“Fed Announces Program for Wall Street Banks to Pledge Plunging Stocks to Get Trillions in Loans at ? Percent Interest” Wall Street on Parade)

In other words, the PDCF is a landfill for distressed assets that have lost much of their value and for which there is little or no demand. And, as bad as that sounds, the details about the resuscitated PDCF are much worse."

If you have any doubt how bad it is in the bond market, just take a look at what happened to both investment grade and junk bond spreads. (Charts courtesy of David Rosenberg)

As they say: "That clearly ain't normal." 

More importantly, the "Bear Market" won't be over until the credit markets get fixed.

Hunting The Bear

It was a pretty stunning week in the market. Over the last 5-days, the market declined an astonishing, or should I say breathtaking, 15%. The last time we saw a one week decline of that magnitude was during the "Lehman" crisis. (Of course, with hedge funds blowing up all week, this is precisely what the Fed has been bailing out.)

Since the peak of the market at the end of February, the market is now down a whopping 32%.

Surely, we are close to a bottom?

Let's revisit our daily and weekly charts for some clues as to where we are, what could happen next, and what actions to take.

On a daily basis, the market is extremely stretched and deviated to the downside. Friday's selloff smacked of an "Oriental Rug Company" where it was an "Everything Must Go Liquidation Event." 

Remember all those headlines from early this year:

Well....

This selloff completely reversed the entire advance from the 2018 lows. That's the bad news.

The good news is the markets are now more extremely oversold on a variety of measures than at just about any other point in history. 

Such a reversal, particularly given the "speed and magnitude" of the decline, argues for a "reversal" of some sort. 

Warning: Any reversal will NOT BE the bear market bottom. It will be a "bear market" rally you will want to "sell" into. The reason is there are still many investors trapped in "buy and hold" and "passive indexing" strategies which are actively seeking an exit. Any rallies will be met with redemptions.

As noted above, bear markets do not end with investors wanting to "buy" the market. They end when "everyone wants to sell." 

And, NO, investors are "not different this time." 

This "bear market" rally scenario becomes more evident when we view our longer-term weekly “sell signals.” As we warned last week:

"With all of our signals now triggered from fairly high levels, it suggests the current selloff is not over as of yet. In other words, we will see a rally, followed by a secondary failure to lower lows, before the ultimate bottom is put in." 

Unfortunately, we have yet to see any attempt at a sustained rally. 

More importantly, with the failure of the markets to hold lows this week, both of our long-term weekly "sell signals" have now been triggered. Such would suggest that a rally back to the "bullish trend line" from 2009 will likely be the best opportunity to "sell" before the "bear market" finds its final low.

Where will that low likely be:

Let's update our mapping from last week:

1. A retest of current lows that holds is a 27% decline. - Failed
2. A retest of the 2018 lows, which is most likely, an average recessionary decline of 32.8% - Current
3. A retest of the 2016 lows, coincident with a "credit event," would entail a 50.9% decline. - Pending Possibility.

Given the magnitude, and multiple confirmations, of these signals, it is far too soon to assume the "bear market" is over. This is particularly the case, given the selloff is less than one-month-old.

Bear markets, and recessions, tend to last 18-months on average.

The current bear market and recession are not the result of just the "coronavirus" shock. It is the result of many simultaneous shocks from:

• Economic disruption
• Surging unemployment
• Oil price shock
• Collapsing consumer confidence, and
• A "credit event."

We likely have more to go before we can safely assume we have turned the corner.

In the meantime, use rallies to raise cash. Don't worry about trying to "buy the bottom." There will be plenty of time to see "THE" bottom is in, and having cash will allow you to "buy stocks" from the last of the "weak hands."