The Opening- What to Expect

May 11, 2020 

In the first four months of this year we have experienced a once in a lifetime event.  At the end of 2019 we were heading towards a mild recession, then Covid-19 hit and the game has changed completely.  We saw a sharp correction in equity markets and then an April rebound of historical proportions.  As I write this Nasdaq is only down -1.32%, the SP500 is down -11.83% YTD, having seen in March -30% lows.  The big question now is where do we go from here?  What should we be prepared for as the re-opening process takes place across the globe?

We first must consider the economic damage that has occurred.  We have never experienced an event of this magnitude.  The global supply chain came to a complete halt!  Getting it re-started will certainly be a challenge.  There will be shortages of all types as the wheels begin to turn again.  I would imagine it will take a quarter or two before we see the global supply chain running smoothly, what will the world look like from a demand side?  The economic damage done to corporations and consumers has been significant.  Fortunately, our Central Bank response has been swift and unprecedented in terms of size.  While this has for now given a backstop (for now) to prevent bankruptcies in the short term, it does nothing to address the demand side of the equation.  Demand will of course come back, but how fast and to what level?

There will be restrictions in place which will affect businesses particularly in the services sector that will have long lasting effects.  Just how we will conduct business in the future will change.  Covid-19 is not a one-off event as some may say, it will be with us for some time to come.  We will bear the consequences for two, perhaps three years.   Those hoping for a quick vaccine should not do so blindly, as the odds of a quick fix are long.  Experts agree, finding a vaccine will be difficult and take a minimum of 18 months to achieve.  More importantly, we know there will be a 2nd and perhaps 3rd wave of infections.  We are already seeing this happening in Singapore and Japan.  The hope is that these waves will be controlled and not bring the world to a grinding halt again.  Due to this concern, how we re-open will be very important.  Decisions must be made based on scientific evidence, adjusting the opening as needed based on the evolution of Covid-19.  A second complete closure would be disastrous for everyone.

Enough of the negative, there are positive aspects to take from this.  When exogenous events occur, we are forced to re-think our approach to everything.  With this comes a focus on priorities: profitability (simply survival), what really matters (lifestyle) and most importantly, innovation!  Adaptability is the most important trait to succeed in life.  This could not be more true today.  We will come out the other side of Covid-19 stronger if we force ourselves to adapt and change, which is not easy.  It is only human to like our routines, from the simple ones how we start our day, to how we do our work.  With Covid-19 all our routines (normal ways of doing things) have changed.  While this makes us uncomfortable in some ways, we will find new ways to approach business that in the end will be better than before.  We have to be open, be willing to experiment, and find the solutions for tomorrow.

I have been an equity investor my whole career (albeit with a strong macro influence), yet my portfolio right now has only a small net long allocation to equities.  Is this a risk?  Most certainly it is but it depends on one’s time horizon.  For me right now the two most important questions to ask are:

1.     What is the real “E” (earnings) that we should expect for 2020 and 2021?  

2.     Where is demand going to come from?  It is from demand that the earnings will come from.  How certain are we of future demand in all areas of the economy?  To determine this, we must go through sector by sector and then company by company for a complete analysis.

When one looks at current earnings estimates according to Refinitiv consensus expectations for 2020 are eps of -21.24% and +29.1% for 2021 for the SP500.  Consensus sits at 129.15  of earnings for 2020, 166.63 for 2021, and 188.13 for 2022 according to Refinitiv.  This puts the SP500 on 21.7 X forward PE.  The $100 question is how believable are current estimates?  I decided to dig into the earnings to see what the confidence level was of these estimates.  IN SHORT, it turns out the answer is low confidence.  Goldman for example has 2020 earnings estimate of $130 per share.  However, Goldman’s worse-case scenario estimate is at $70 per share.  I have seen this repeatedly among firms I asked.  Analysts are in effect shooting in the dark in an attempt to make an educated guess for future earnings.  It’s not surprising to have low confidence at this stage as we are only beginning to re-open the country for business.  I would imagine the next two months will give us much more clarity.  For me the absolute number bears little consequence, it is the confidence level of where future earnings will be that matters most.  I want to focus on the “knowns” for now.  For now, the market is moving on liquidity and the hope for a smooth re-opening, not fundamentals.

Clearly some sectors will face a very difficult future.  For example, tourism is a $2 trillion global industry that has come to a grinding halt.  This is an industry that will need to re-create how it operates in the future.  Anything related to travel and leisure will face inflation pressures for the end consumer due to the “new normal”.  How will this affect the demand for travel and leisure?  Technology, however, is likely to be a winner as all businesses will be looking for ways to use technology to create cheaper and more efficient ways to conduct business.  We have already seen early signs that corporates this year are increasing investment on technology.  This is the work we as investors must focus on in the coming months.  Determining not just who are the winners and losers, but also who will adapt best to the new operating norm.

I do not believe anyone can say that the SP500 is cheap or expensive with any confidence today.  We are still operating in the discovery phase of what our new norm will be.  The most important task is to find the new norm, and operate profitably for whatever business you are in.  There will be bumps in the road, set-backs, but I am a firm believer that good old ingenuity will pull us through.  Surely some things will stay the same, some will change, and some may even disappear.  We cannot stand still and wait for the future to come to us and tell us what to do.  We need to determine what we need to do to have a viable and successful business in the new environment we face.  

In the coming months my focus will be in determining which sectors and businesses are facing the strongest headwinds or tailwinds.  Meaning…which ones are being proactive in dealing with the new norm successfully to determine where we should focus our investments for the future.  For now, this is a very sentiment and macro driven market and we need to pay objective and rational attention every data point as their accuracy improves.  I am still of the belief that the recovery will be more of a “U”.  There will be many bankruptcies.  Businesses will just disappear.  But we will come out the other side with new opportunities, with many businesses thriving as before.

My portfolio allocations have not changed since my last article.  I remain more defensively positioned.  Very happy to discuss with anyone how to move forward in these challenging times.

Very best wishes, and be safe.

Alan