Michael Grant is preparing for rebound in equities and has positioned the long/short portfolio accordingly. To use a Wayne Gretzky analogy, he is skating to where the puck will be, not where it is.
Summary of Key Views
- We believe there is a price at which you’re adequately compensated for the unknown. And when we look at the equity landscape, we believe we are there.
- We see U.S. recession in 2020 as marking the end of the cyclical bear, not the beginning of one. In retrospect, we expect this market crisis to have lasted approximately three months. This interpretation argues for seeing further equity declines as opportunity. The initial wave of forced selling and price discovery will likely run its course by late March around 2400 on the S&P 500. Between April and early May, we think equities will have fully discounted the distress of transatlantic economies.
- We believe equities are carving out an important bottom. This forecast includes some back and forth and testing of the lows over the next six weeks. Between April and mid-May, anxieties concerning the virus will dissipate. Investors will start to discount a recovery in the global economy from mid-year.
- Under the surface of sectors and styles, equity markets have been anticipating this “late-cycle” setting since 2018. The transition to an investment regime driven by reflation and fiscal activism is underway. In turn, yield curves should begin to steepen and produce a rotational upheaval across equity styles. Equities are reaching valuation levels that are attractive for the long-term investor.
- As the crisis has unfolded, the long/short portfolio has increased its net equity exposures to reflect the shifting risk/reward for equities. We have reduced shorts and added to long positions where the valuation reset appears extreme. We have focused upon quality balance sheets and robust free cash flow yields. One area of long focus has been defense companies. We also dipped our toe into a handful of energy opportunities (<8% of long exposure), albeit too early given the recent OPEC price war.
- Commodities and oil have been at the front line of this crisis. The collapse of cyclically sensitive areas like energy has been so extreme that it should be complete by the end of March, coinciding with the low point of the Chinese economy. While oil may take a few months to adjust to the excess supply-demand situation, we expect stocks to bottom before.
- We were ‘days’ too early in making some of these adjustments. The sell-off of early March was the most extreme since Black Monday in October 1987 (and we remember that day well). The last instance of three consecutive -9%+ days on the S&P 500 was in 1929. Our short put positions, whose pricing is negatively affected by heightened volatility, can affect the portfolio’s day-to-day performance relative to our net exposures.
- The portfolio has shorted SPY puts at the 2300 level (June expiry), and these puts will effectively close out the bulk of our short S&P 500 position. In other words, we want to be buyers of equities at that level.
A Look at Fund Positioning and Attribution
As the crisis unfolded, we began to increase our net exposures to reflect the shifting risk/rewards for equities. Our timing was a bit earlier, however, as we shifted that net exposure to the 50% level. We accomplished this by reducing shorts as well as adding long positions where valuations appeared extreme. In addition, we focused on high-quality balance sheets and robust free cash flows.
In terms of industries, one area of our long focus is defense companies. We also began to dip our toe into a few energy offerings, albeit much too early given the subsequent OPEC price war. We added approximately 8% of our long book into what we believe to be the best energy companies that exist. Nonetheless, when the price of oil declined by nearly 50%, it proved painful. That said, we are expecting to benefit long term.
Commodities and oil have been at the front line of this crisis. The collapse in cyclically sensitive areas such as energy has been so extreme that it should run its course by the end of March, and that should coincide with the low point for the Chinese economy.
While oil may still take a few months to adjust to the supply and demand of a global recession, we expect stocks to bottom before this because of the extreme psychological stress in the markets. In hindsight, it is obvious that we were literally days too early in making some of these adjustments. The sell-off in early March was the most extreme since Black Monday of October 1987. The last instance of three consecutive days that were more than 9% down on the S&P 500 occurred in 1929.
However, I want to stress that this is exactly not the time to succumb to panic. It is the time to calmly do what is right by clients. I have been in the business of managing money for more than three decades. And when that risk/reward is finally in favor of equities, you have to believe again. After major liquidations and forced selling, which is what we are seeing now, history tells us that it’s a disaster for your clients to do likewise.
I want to make one last comment as to why our hedging activities in the short term have been detrimental. This relates to the role of put structures on the portfolio and how their effectiveness can be delayed when volatility is dramatic. The high market volatility has inflicted short-term negative effects. In any other environment—with a not-so-rapid down market nor overly dramatic volatility—these shorts would have been much more effective on a day-to-day basis. However, remember that they will still be effective on a several-months basis, as the time premium erodes, thereby helping the fund’s NAV.
Shifting to the outlook, I think it is very important to assign some rationale and context to what has become an extraordinary and volatile market.
The Road Back to 3000 (It’s Time to See the Glass Half Full)
Global markets have been hit hard by a trio of crises: valuation, virus and oil. As most of our clients know, we have been wary of equity markets since October 2018 based on the view that the risk/reward for equities did not add up.
While the speed of the reset is without precedent in U.S. market history, the retrospective view is that equities were an accident waiting to happen: risk pricing had decoupled from economic reality. Risks assets had ignored the likelihood of a fallback of global growth in 2020 and–in a few short weeks–investor expectations have been brutally reset.
Today’s anxiety is based on the realization that we have no clear idea how much damage COVID-19 will wreak on economic activity. And when investors sell into fear, positioning risk comes into play. This explains the latest drop below 2600 for the S&P 500. To put this in perspective, the S&P 500 return over the past month is a 5+ standard deviation move; the only larger moves occurred infamously in 1987 and 1929.
As risk has been viciously redefined, our understanding of the investment setting becomes crucial. The world is in the middle of a sudden stop in economic activity akin to the outbreak of war. At the same time, the strategic risk/reward for equities is improving notably.
Since 2018, we have argued that the U.S. financial cycle had entered an ‘end-cycle’ of economic vulnerability amidst highly priced levels of corporate debt. Today, we can be sure that global trade and output is in recession, and the U.S. economy is also near or in recession. Global travel, the center of vulnerability, accounts for around 4% of global GDP and is under intense pressure.
We view this in the context of a multi-year transition from the post-2008 investment regime. We have frequently portrayed the 2018–2020 period as the “end of an era” or the end of central bank supremacy. A U.S. recession combined with a global health crisis are galvanizing policymakers to take aggressive and reflationary fiscal steps. This transition is no longer controversial because it is urgently unfolding before our eyes.
The decisive question is whether this weakness in output, trade and business investment spills over into a sustained collapse of Western consumption and residential investment. While some shock to consumption is certain because of “social distancing,” we think the U.S. consumer will prove more resilient than expected. If this view proves correct, U.S. equites can eventually begin the long road back to 3000 for the S&P 500.
This interpretation implies that U.S. recession will be sharp but short. It also infers that equities have largely discounted this outcome around 2500 on the S&P 500. This resilience of the Western consumer reflects a mix of healthy income growth, demographics and the benefit of lower interest rates. And of course, government support is coming. While Fed actions will help to minimize financial stress, the nature of the fiscal support will be decisive in determining the secondary effects of virus shock.
Equally important to this view is the fact that China and parts of Asia are returning to work after their unprecedented lockdown. The contagion is beginning to recede in China. By mid-year, the global output cycle should regain its pre-COVID-19 capacity and investors can anticipate some sense of normalcy.
What’s In the Price?
Let’s start with our conclusion: The risk/reward for equities has turned positive. Volatility measures are back to the highs of the 2008 crisis, yet the global economy outside China faces none of the systemic risks of that former time. Investment timeframes should be extended. Volatility is telling us that our clients are compensated adequately to engage risk again.
With the major equity benchmarks down 30% to 40% off their highs, markets are pricing a 100% probability of U.S. recession; for context, the typical bear market during a recession is 30% from peak to trough. With the VIX (volatility) Index at higher levels than the Global Financial Crisis (GFC) of 2008, equities are incorporating a similar expectation of fundamental distress.
In contrast, we do not see a repeat or rhyme of that 2008 dislocation. This crisis is different and that interpretation is confirmed by indicators of less stress around the U.S. banking system. At these peaks of volatility in 2008, the S&P 500 had already declined by 50% from its highs. As hard as it is to imagine, U.S. equities and corporate credit are displaying comparative resilience.
There is much that we do not know, yet history is replete with instances of an “impossible market.” In former times, the shocks of 9/11, the oil embargoes of the 1970s, the Cuban missile crisis—all bolts from left field—were similar to what is occurring with the COVID-19 pandemic. With Canada shutting its borders and McDonalds and Starbucks closing their stores, these are chaotic shocks: rare by nature, but not unprecedented.
Broad-based liquidations across passive strategies implies the market is not distinguishing between winners versus losers. It implies market action may not be a reliable guide for how the business cycle unfolds in the coming year.
U.S. earnings estimates have been sharply reduced in the past week. This will continue through Q2, but hopefully bottom by June. This is similar to the trajectory of earnings expectations post 9/11. For 2020, we assume 0% revenue growth and a decline of 10-20% in earnings.
To clarify one difference with the GFC experience, Banks and Energy contributed ~40% of S&P 500 earnings in 2007. Today, those same sectors contribute about one-half that level, with Energy earnings near ~4%. Conversely, Technology-related sources account for ~30% of S&P 500 earnings today versus ~17% in 2007.
While new COVID-19 cases exceed the resolved cases globally, the growth rate of new cases outside of China has slowed. On the assumption that transmission across the U.S. is impeded by 1) warmer weather, 2) the lower density of the U.S. population and relative lack of public transport, and 3) “social distancing”, we expect the worst of the virus fears to pass by late April. Self-immunization and vaccines will ultimately remove this threat.
We anticipate a six-month U.S. recession that began in late February. Historically, the S&P 500 tends to lead recovery by four months, which implies we may bottom soon. While the Fed can do little to offset the first order impacts of social distancing, it can mitigate the second order effects such as financial stress. The S&P 500 at 2400 has probably discounted an earnings decline of 10%–20% in 2020, though uncertainty over earnings will need to dissipate for equities to recover.
From one perspective, the market reaction to this severe flu implies the “cure” for the pandemic is worse than the disease, at least for the broader economy. Social distancing is creating ripple effects that we failed to appreciate. The good news is that acute social anxiety is hard to maintain for more than brief periods before people adjust. We think markets will regain confidence before the end of the virus crisis is visible, just as they did in early 2009 when the GFC still loomed large.
The worst is not inevitable. Projections of the effects of every previous epidemic of the last quarter century have proven outrageously alarmist. While there may be more shocks to come, this is what investors are already fearing. Despite the dislocation from the collapse of oil prices, there is abundant liquidity in the financial system. This is simply not 2008.
Toward the end of his call, Michael fielded questions from advisors. Here is a sampling:
Q. How are you managing the fund through the current crisis versus the GFC of 2008?
A. The shocks are different. The good news: this is not a banking crisis, which proved so bedeviling in 2008. Therefore, the system should be able to recover more quickly. Post 2008, it was much harder for the economy to come back because the banking system needed time to heal.
In terms of the market, I think the calculus is relatively similar. Post 2008, our clients faced three choices: The first alternative was they could liquidate their equity exposure, and that would have been a potentially disastrous thing to do.
The second alternative was to purchase puts. However, that’s like buying home insurance after the earthquake has hit and leveled the house. So back in 2008, I recall that a year’s worth of puts would cost 20% to 30% of a client’s NAV. Today, a 12-month option is priced similarly.
The third alternative is to look very hard at the companies being bought and be confident that the bottom-up fundamentals of those businesses make sense. For example, if we buy a U.S. defense company that has a cash flow yield of 10%, that is something that will pay out handsomely for clients over time. Could that stock still drop 20%? The answer is “of course.” However, if we’re right about the cash flow yield, the 10% cash flow yield has now gone up to 12% and that doesn’t change the dynamic of how we get paid over time. It just means we have to live through the short-term volatility. Our ultimate responsibility to clients is to engage equities when the math makes sense. We believe the market dynamics of this crisis rhyme enough with 2008. That is exactly why at the apex of this crisis, we need to be leaning into equities’ exposure, not backing away.
Q. How do you respond to the client who is concerned about the fund taking on more equity exposure, versus being market neutral?
A. I would say it made a lot of sense to be market neutral last year; it does not make as much sense after we’ve just gone through the fastest, most severe decline in recent memory. I am thinking about this as if I am the client, and actually I am a client since I have 90% of my own capital in this product. When I’m looking at the fund, I’m thinking about the opportunity set relative to how I would build my own wealth most sensibly over time. My message to clients would be not to go market neutral at this point. This fund will be more volatile by nature, but if we’re right about the outlook, volatility will pay on the upside when equities come back.
Q. When you look at the equity world, does the math make sense?
A. My answer today is 180 degrees different from what I was telling clients 12 months ago. Obviously, none of us knows what will happen in the next four weeks, nor the next three months for that matter, but volatility is not something we should have a fight or flight fear response to every time. In fact, the only person who guaranteed low volatility was Bernie Madoff. Volatility is at higher levels today than it was in 2008. Now the reason for that is this still little-known, hard-to-predict virus. Even so, this plague, like all the others in history, will eventually run its course. I believe the systemic issues of 2008 were actually more difficult to resolve. I think clients need to be just as concerned about not being invested should we experience a very sharp snapback in equities. Our base case is that the S&P 500 can get back to at least 2800.
Q. What are your thoughts on the fund liquidations that are occurring?
A. This goes back to the notion that good price discovery is not happening in the market. So we have some stocks in our portfolio that have been absolutely crushed, even though we understand their fundamentals. We understand their business. They’re not at risk for at least the next 12 months. So what’s going on? Well, it turns out there was a big closed-end fund that was overleveraged and is now liquidating. They are chucking literally everything overboard at any price. Our response is to go back, scrub the businesses and make sure we understand their balance sheets, so we are not put in the position of being a forced seller. For now, it is a mistake to read too much into these desperate situations. If clients sell into this chaos, they are selling at prices that are not real.
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