The fastest Bear market in history?

The S&P 500 bottomed (at least initially) on the 23rd of March 2020 following a 31.9% decline from it's peak 5 weeks ago. Modern finacial history only goes back about about 125 years, so if we take that as our guide, the table below from William O'Neil & Co. shows that this was the quickest and most intense (-7.2% change per day) bear market in history. Only 1929 (part 1 of the great depression) and 1987 come close in terms of velocity.

Source: William O'Neil. S&P 500 index performance. Pre 1957 the representitive index used is the Dow Jones Industrial Average as the S&P 500 did not exist.

Since then (as at market close Thursday 26th March) the US market has bounced an incredible 17.6% in 3 short days. A remarkable bounce to match the remarkable drop. So could this this fast forwarded bear market already be over? Given the economic and social catastrophe that we are living through right now, surely the stock market can't have found a bottom already? This seems absurd on the face of it.

Perhaps it is, but stranger things have happened so it pays to keep and open mind. I don't know the answer to when the bottom of the market will be found and using historical episodes only gets us so far. We don't have enough observations for any analysis to be statistically significant. And there are so many differences between each bear market..... The market structure (narrow illiquid markets consisting of a few industries like railroads and oil in 1901 vs. the vast and liquid markets of today), the type of shock, the speed and size of the policy response (or lack of) and levels of leverage in the system to name a few. One constant, pointed to by one of my favourite market strategists Tony Dwyer of Canaccord is human nature. Greed. Panic. Relief. Dispair. Fear. I think we can rely on these metrics regardless of how quickly we get through this. But this is all very high level... what is happening under the covers of the market?

The tale of two markets

Empirical Research Partners track "valuation spreads" as a signal for extreme behaviour or stress in the market. These measure the difference between the "cheapest" and most "expensive" stocks in the market based on a blend of valuation metrics. On March 18th, valuation spreads in the U.S. hit 4? standard deviations, their third highest reading in almost a century. Such spreads have only been bested in the Great Depression (a very different market) and the 2008-09 Financial Crisis. The rate of change is such that in the last few days alone, valuation spreads have come down by a full 1 standard deviation. The gigantic fiscal stimulus package and signs of slowing of coronavirus cases in Italy being the likely triggers.

Empirical Research Partners valuation spreads up to 26th March 2020

As previously explained (a market lifetime ago on 12th March here) the high growth, high free cash flow margin leadership group has had three things that the market has craved in recent weeks:

1. Stable or improving demand: Not suddenly seeing revenues going to zero (e.g. travel and retail) or significantly impacted (e.g. oil) and perhaps seeing increased demand for services (e.g. remote software tools)
2. Ability to supply: They have not had to worry about supply contraints due to physical supply chains or workers being in lock-down. They can still largely supply what they need to digitally or virtually (e.g. cloud software).
3. Strong balance sheet and cash flow: They often have oodles of cash on the balance sheet that they have been trying to figure out what to do with. And they are still awash with cash flow and due to the dynamics above.

So please.... lets all depart from any notion that there is some sort of irrational "momo tech bubble" here like 1999. The market response has been entirely logical in the context of where the stresses have been. However, that was then and the question is whether this divergence of valuation will continue to be justifiable? Well these growth stocks now trade at an 80% P/E premium to the market (the PE is not the best metric these days for reasons I won't go into but it is illustratively useful), the widest spread since 1999. On the flip side, value stocks trade near the lowest trailing multiples of the last 70 years, with the most equivalent extreme readings coming in 2008. All this does make me ponder...... what the future will bring?

I am not a huge believer in simple valuation mean reversals because by definition it assumes that fundamentals remains constant. However, my view is that these extremes will not sustain. The law of market reflexivity will almost certainly dictate a reversal of sorts. But the key question for me is what happens after than? Will the "value factor" will take over sustained leadership from "large cap growth factor" in the market?

Distribution of the 4 week relative returns to the lowest quintile of value stocks (US market). Daily cumulative returns from 1952 to March 20th 2020.

Distribution of the 4 week relative returns to the highest quintile of growth stocks (US market). Daily cumulative returns from 1952 to March 20th 2020.

Reflexive panic, relief and then......?

In my view, the recent 17.57% bounce in just three days has been a reflexive bounce driven by:

1. An historic oversold condition on the panic
2. Evidence of significant monetary and fiscal stimulus
3. Hints of the virus being contained in key locations like Italy
4. The prospect of pension rebalancing toward equities given the historic decline

If typical behavioural and technical frames are our best guide during the fog of war, we appear to be witnessing a relief rally. This suggests that a test of our recent bottom is likely. Whether the velocity continues or whether we will need a lot more patience before we get to the end of this remains to be seen.

Patience, integrity and pragmatism

"To know thyself is the beginning of wisdom" Socrates

Patience: First things first, as an investor you need to prepare mentally for the tough times. Bear markets typically require patience, lots of patience.

Integrity: Prospective hindsight or "pre-mortems" are a good way of protecting yourself from emotional "fast brain" decision making. Imagining ourselves in the future, asking ourselves why we got a decision (we are thinking of making now) wrong. This mental trick helps focus the mind. In the context of most of the "value" stocks that appear extremely cheap today, we know that many of them may well have >100% upside in the short term, but are ultimately disrupted, failing and unsustainable businesses. Our future selves could not forgive our present selves if we bought them. I have a clear investment philosophy which revolves around positive impact and disruptive innovation. That will remain.

Pragmatism: Bear markets often signal a shift in regime. A regime shift means that what worked in the last bull market suddenly stops working. The most successful active managers in one market cycle may be the least successful in the next. I think this is the most important strategic question today. Once we get through this bear market, where to from there? As an investor, I have been successful of late but I am always looking for signs that things are changing and what this means being flexible in the context the frameworks I might use to view the world. My big idea is that the intersection between multiple sustainability challenges and disruptive technology trends is inevitable and that huge economic value will be created at that intersection. I don't think this will change (in fact initial evidence suggests the opposite) but the frames I use to exploit it might.

Conclusion: When will this end? Should we buy "cheap" stocks?

I don't know when this will end. It is moving at a rapid pace, but if I were to give you a guesstimate (50-60% probability), I think we will re-test the bottom and perhaps go below it. Such is the extent of the economic impact we are seeing and how difficult it will be to re-start the econonomy, that it feels (note: gut feels don't work well in such times) like a bigger and more sustained decline is necessary to find the bottom. It is extremely difficult to estimate how much damage will be done to the psychology of the average entrepreneur and risk taker, not to mention their will to carry and take on financing (if available) to do so. As such, I suspect we are in the "relief" phase of the bear market.

So should be buy the cheapest looking stocks? There is no doubt that there is a big divergence in the market between stocks that screen as statistically cheap and those that screen statistically expensive. There is also no doubt that lots of these stocks are genuinely cheap rather than just optically so. But strategic positioning matters. And strategic positioning (generally closely matched with positive product impact) is rarely found in the basement of market valuations. Those businesses that have been fighting fires for the last 10 years due to their bad positioning (i.e. the disrupted incumbents) generally have anemic growth, no pricing power, high capital intensity, high financing costs and weak balance sheets.

The facts are clear, lowest quintile of "value" carry a heavier-than-usual debt burden. To quote Empirical Research, "those in the highest quintile of gross profit yield account for about 30% of all the debt owed by non-financial public companies, whereas those in the lowest quintile source less than 10% of the debt."

But that doesn't mean we should ignore valuation completely. To quote Empirical again, "Another way to approach the problem is to focus on the second?-lowest quintile of valuation, where some fallen angels reside. Such issues aren’t quite as statistically cheap of course but on average they’re less vulnerable should things go wrong." The difference between the bad and the cheap - in my mind - is that cheap stocks will eventually (depending on the length and depth of this recession) begin to sustainably grow revenues and profits again. Such businesses will be sustainable in terms of products and regain their lost pricing power.

Good value stocks are cyclical companies that will be heavily effected by this economic collapse, but exhibit long-term sustainable growth characteristics. Many of them will be small or mid-cap, an area of the market that has undoubtedly been exessively hit in this bear market (see below). This is where we aim to differenciate ourselves from the average (large cap quality) - active manager in the recovery. Tilting more towards good mid-cap, emerging cyclical businesses in structurally growing areas with positive impact solutions. We already own many companies with such characteristics and we will be leaning into them when we feel it is right to do so.

Relative performance of small vs. large cap stocks globally (source Factset, 17th March)

And these relative price moves in the small and mid cap space clearly feed through to valuations which appear to be pricing in a lot more negativity. Raymond James strategist Travis McCourt framed the differences very nicely in the charts below.

Source: Raymond James

We could yet witness the mother of all large cap value rallies and this would be a significant short-term headwind to us relative to the market, however, I believe the medium to long-term writing is on the wall for many of the so called "value" stocks. Unsustainable, low quality, overly indebted, structurally declining and disrupted. Basically the opposite of everything I stand for. Hopefully you'll agree this isn't just ideological "growth investor" beligerance. The fundamentals have moved to such an extent that many of the so called "value" stocks will exit the market over time regardless short-term stays of execution and relief rallies. But I must attach the requiste health warning - growth investors probably have some relative pain to endure in the coming months and this is something I am mentally preparing myself for.

MY OWN OPINION. NOT A FINANCIAL PROMOTION. NOT INVESTMENT ADVICE. PLEASE CONSULT YOUR FINANCIAL ADVISOR.