Risks Are Elevated. Is It Time for You To Off-Load Risk?

The speed and the magnitude of shifting stock market sentiment has been breathtaking during the past couple of months. Setting record highs amid a general level of optimism in mid-February, markets crashed as sentiment abruptly reversed. What followed was the quickest, and one of the most intense, bear markets in history. Markets bottomed by mid-March as pessimism reached historic and extreme levels.

Incredibly, just a few weeks after experiencing “peak-fear,” a new bull market has emerged.

Admittedly most stocks are more than a fifth off their highs but the S&P 500 Index (NYSEARCA: SPY), thanks to its concentrated bet on a relatively few technology companies, is technically in a new bull market. It is is up over 25% from the lows and is back to levels where the Index spent most of last summer. A new complacency among investors has taken hold.

The future is always uncertain, but we are in truly unprecedented territory. A modern economy has never been shut-down before. Assessing the amount of damage inflicted by COVID-19 and the policy response effectiveness is unknowable. Common sense says the scale of the challenges that lie ahead cannot be quantified but they are massive. Determining if and how the world has changed for good is pure conjecture.

Accordingly, the powerful stock market rally investors are enjoying right now seems like the mother of all counter-intuitive moves. Let us summon our inner Marvin Gaye and ask, “What’s going on?”

To be clear. I do not believe one can “time-the-market.” That is a fool’s errand. Every now and again, however, a reality check is needed to assess whether risks are truly elevated and, if so, does reducing exposure to risk-assets make sense?

A word on risk. My definition of risk is in the value-investor tradition and is different than what they teach in business schools. Risk relates to the value an investor receives in exchange for the price they pay for an asset. Generally, the higher the price you pay for an asset relative to its cash flow, the lower the value you receive and therefore, the higher the risk you have assumed. In my world, stocks were the less risky in mid-March, when “peak-fear” ruled, than now because prices have rebounded.

Back to market-timing. The father of value investing, Benjamin Graham, did not believe in market timing but he did believe there is a time for every activity, including being underweight stocks. He believed there are times when investors should have as little as 25% of their financial net-worth in stocks. Other times 75% can make sense, but no more. Investors should choose the allocation based on their time-horizon and the number of attractively priced assets available. It is never a bet on the direction of the stock market.

The goal is to be overweight stocks when they are near a bottom and underweight them at market peaks. Clearly an impossible goal, but it comports with the key value-investor objective of trying to buy low and sell high.

There are two narratives, bullish and bearish, for us to review so we can frame our analysis.

The bullish case. Simply put, this rally is rational because investors are looking beyond the current difficulties and like what they see. As has been the case for over a decade, the Fed “has our back” and is doing whatever it takes to prop up security prices and avert a financial crisis. Everyone knows “fighting the Fed” is a losing proposition and thanks to their innovative ways and boatloads of cash, we will get beyond these difficulties.

Furthermore, Federal elected officials also “have our back.” Unlike the Great Recession when most Republicans suddenly decided they were fiscal hawks and resisted providing economic stimulus, there is bipartisan agreement that averting an economic collapse is job one. Doing whatever it takes, Congress has provided loads of stimulus, running at 13% of GDP and counting. Now that America is re-opening, a “V-shaped” recovery is likely.

Bulls can also reference the fact businesses are long-dated assets and for purposes of valuation, losses are amortized over a long period. Think of a 30-year mortgage. It takes many years for the equity to build, and for the debt to be reduced. In the same way, the “amortization” of corporate losses reduces equity values only slowly. Therefore, the true amount of corporate wealth destruction is less than one might intuitively think.

Finally, in a world of extremely low interest rates, with 20-year Treasury Bonds barely yielding 1%, stocks represent excellent value. The S&P 500 yields double that amount.

The bearish case. As in 1929, the sell-off was so fast and so brutal that a 50% re-tracement of the decline, a “dead-cat” bounce, was always going to be baked into the equation. The economic effects of the lock-down both on businesses and governments are unknowable and a “V-shaped” recovery in the weeks ahead is a low probability event. We are nowhere near being out-of-the-woods, and we should expect setbacks in the months ahead, including a possible testing of the March lows.

Bears point out the rally in stock prices is being fueled by an extreme bout of liquidity pumping which will have unintended and eventually negative consequences. The money supply grew by 4.9% last month alone and during the final two weeks of March, the Fed’s balance sheet increased by $1.14 trillion. By way of perspective, prior to the Great Recession the Fed’s entire balance sheet was less than $1 trillion.

Most Fed watchers believe liquidity pumping has only begun and by year’s end, the Fed’s balance sheet will exceed $10 trillion, nearly 50% of GDP. A bull market based on excess liquidity and not fundamentals is a bubble. It has created moral hazard in the extreme by subsidizing companies that are over indebted and badly run. Think of the airlines or independent energy companies. Keeping these zombie companies alive will serve as a drag on an economy that already has too much debt.

Pessimists finally note the stock market remains in the top decile of historical expensiveness. In all previous bear markets associated with economic downturns, stocks needed to become undervalued relative to history before a bottom was reached. There is no law requiring valuations to revert to historical patterns, but a bullish bet on the stock market today means you believe “this time is different,” the four most expensive words in an investor’s lexicon.

My own view is the bullish argument is lacking. The Fed “has our back” theme implies the Central Bank can control events and bend history at will. In the short run this view has merit, but it cannot last forever.

After all, even Zeus, the most powerful god on Mount Olympus in the old-time Greek religion, could not always get his way. Notwithstanding the fact Jerome Powell is a competent and imaginative public servant, he is no Zeus. More like the Wizard of Oz actually.

In the months ahead, we very well could see markets propelled to all-time highs due to the liquidity sloshing around looking for assets to buy, but I believe the valuation argument, that the stock market is expensive, should be our focus.

Prior to the current difficulties the S&P 500 Index was significantly overvalued relative to nearly all metrics. Only in relation to the bond market, which is arguably experiencing the mother of all bubbles, can one characterize the stock market as being reasonably valued.

Complacent investors who scoff at the valuation argument should read the long-term forecasts provided by Research Affiliates or GMO. Even assuming a V-shaped recovery, there is a strong case to be made that the S&P 500 Index will produce disappointing, if not negative, returns from current levels over the next 7-years or so.

Specific advice.

I believe there is a good likelihood that more dividends will be cut, and more companies will miss interest payments during the remainder of this year. There will likely be bad news about COVID-19 such as stories from Singapore where it has reemerged as a problem. Accordingly, there will be more bouts of fear and anxiety among investors.

Combining this reality and the fact the stock market is priced for a “V-shaped” economic recovery, it is a good time to be underweight stocks. Risks are truly elevated.

Therefore, first off, remember how you felt in mid-March. If you were freaked-out or angry or anxious or fearful regarding your investments, you had too much money committed to risk-assets. Use this rally to lighten up.

Second, comb through your holdings and only keep assets you believe can survive a prolonged economic slump. We hopefully will not experience a long recession, but why take the chance? Avoid highly indebted companies, even “blue-chip” ones such as AT&T Inc. (NYSE: T). Interest rates will probably remain extremely low, but why take the chance?

Third, avoid bonds unless you believe we are headed for negative interest rates in the US and they will remain negative for a long time. In which case, only own Treasuries because the implications of such a scenario are too scary to assume any credit risk.

If you want to participate in depressed industries, only own the financially strongest. In energy, that means dumping nearly any company not called Chevron (NYSE: CVX) or Exxon Mobile (NYSE: XOM). An exception would be a debt-free, asset-light royalty company located in an attractive area such as the Texas Pacific Land Trust (NYSE: TPL). The American energy industry will eventually rebound, and profits will follow but with fewer participants. You want a vehicle that will not conk-out in bankruptcy before we get there.

Finally, once you own only high-conviction assets, practice the under-appreciated virtue of patience.  In the face of a market that continues to chug higher, I believe the Spanish proverb, “patience is bitter, but its fruit is sweet” will prove to be true. 

Please note: I own shares in Chevron, Exxon and the Texas Pacific Land Trust.