Three Bad Bears
Turns out, winter is longer this year. A lot of smart people are writing that the virus has changed our world forever, and some are writing that the world will always be what it has always been. While reading those well-crafted words, I am reminded why I was a business major. Business is per capita. People want goods, people organize to make these goods. A business is worth the present value of cash flows. This 2020 crash had many of us reaching for the textbooks to refresh on pithy things like that. The decline was stunning as nearly the fastest 20% drop in S&P 500 price history, aside from the flash crash in 1987, from the peak on Feb 19, it took just 22 days to turn a 3999-day bull market into a bear. And if the 3/23 bottom holds, this rally is also the fastest jump off the bottom, up 24% since the March 23rd trough through April 15.
Our strategies did not perform well during this quarter, and we wouldn’t expect them to. Equities don’t always perform well, they just perform better than most other things in the long run. When expectations for corporate cash flows fall, values fall. We did manage to beat our benchmarks, and there is performance and best/worst holdings detail later in this letter. We’ve had a long-time preference for companies that produce consumer needs rather than consumer wants and those names have been holding up a bit better in an uncertain time. What now?
Our work goes on. We assess the value of future cashflows, measure business opportunity based on product features that help customers do things better, faster or cheaper, and how they work better than their competitors, understand the difference between E and P/E. Discover stocks with attractive risk adjusted expected returns. With prices down and investors scared and confused, these are the times stock pickers love to hunt for bargains.
What is always different than a prior cycle is how the downturn will affect per capita behavior on the other side. What will the experience bring to per capita spending decisions that drive the consumer economy? How will government spending shift and which sectors will benefit? Where is short term fear overwhelming long term value? These are the questions that active equity research teams are working on to find the best path forward for clients’ returns.
The 1973-74 oil crisis was always held up by the old-timers as the motherlode of downturns, falling 48.2% back to prices last seen 12-years earlier in December 1962. But when you do the homework, the 1974 decline was bad, but not the worst in recent memory. Using daily S&P 500 price data measured from peak to trough, the 2000-02 down cycle was worse, down 48.8%. But the motherlode was the 2007-09 decline, down 56.7% from the peak on 10/12/2007 to the trough on 3/9/2009. I remember that well, because as the market retraced back to levels last seen in the summer of 1996, nearly 13 years earlier, all we could think about in the office was how was it possible that the market was giving away CBS as a small cap name.
But in that ’73-74 downturn, the US faced the very real prospect of losing access to foreign oil which at the time was approaching 50% of US supply. Many homes, factories, vehicles, and electric generators had no other fuel options. Oil and gas prices more than quadrupled and stayed there for decades (until now), pushing inflation and interest rates to new highs. Airlines went bankrupt, gasoline became scarce, hot wars broke out, unemployment hit 8%. The seventies were a period of inflation and economic stagnation as the economy adjusted to higher costs all through the supply chain.
What changed after that was that people bought smaller cars for a decade, and the same high oil prices allowed engineers to profitably invent more expensive methods to extract oil, which obviously worked as price signals are intended to. Still, a long-term view of falling energy prices dialed into operating margin and earnings forecasts was both rare and profitable during the 1980’s.
There have been four bear markets since 1973-74, and none felt good. (Please see the table on page 7). But the 2008-09 downturn was the worst of them, not only delivering a worse return, down 56.7% from the peak, but the trough price revisited levels last seen nearly 13 years earlier, in July 1996, eclipsing the 2000-02 cycle trough and falling back even further than the 11.8 year re-trace in the 1974 downturn.
In 2008-09, a cascade of mortgage defaults created by lax underwriting standards and lax controls over the few standards that there were led to a freezing of mortgage-backed debt markets, and a collapse in regulatory capital at banks and insurance companies. Sometimes overlooked when talking about this period, oil was spiking to all time highs along with other basic commodities and a recession on that basis alone, choking off corporate profits, seemed likely. Companies could not get working capital loans to pay employees and their insurance company could not write policies because FASB’s mark-to-market rule defined bonds facing frozen markets as unworthy of a primary capital designation due to the lack of liquidity.
But the rule didn’t make sense when a $zero value on fully performing loans was causing employees to miss paychecks. Just like now, commerce was being forced to lurch to a halt because of regulation. Once FASB changed the rule in April 2009, companies were able to get back to business, but the easy mortgages of the prior few years unwound with years of foreclosures and real estate woes that are still affecting many.
What changed after that was a decline in household home ownership and more regulation of the financial system. Just like higher oil prices spurred more capacity and ultimately lower prices in oil, here we had a rapid increase in the costs of banking, with higher capital requirements, more regulation, and large losses on past investment. These higher costs passed on to customers combined with advances in technology allowed new tech-driven entrants to find profitable solutions to customer banking needs. A long view of the weakness in residential housing and the growth in non-bank financial companies made for profitable investments during the next decade.
In comparison to all those recent bear markets, this one is stunning in its speed. Because this contraction was in effect decreed by local governments within a few weeks of each other, the market had certainty of timing in a way that was different than the evolving bad economies in ’73 and ‘08. Even in wartime, the U.S. has not purposefully shuttered so much productive capacity. But on the good side, and unlike some past declines, because of the strong market returns of the past few years, the 3/23/2020 trough (so far) re-visited prices last seen just over three years ago, not bad at all compared to 2008-09 or 1974-75.
In thinking about what will change this time, it isn’t everything or really very many things, because it usually isn’t, but it’s a few important things. If we can get those big themes right it will be wind at our back for a long time. First, we estimate that roughly 15% of the economy, namely travel, leisure and hospitality, will be badly impacted for at least a full quarter. That means we are expecting a very big negative quarterly GDP comparison, bigger than we are used to, so get ready. But then the comparison will begin to annualize helped along by pent up demand. The market appears to have largely digested that news.
Beyond that, which consumer spending habits are apt to change? Obviously, just as households have fire extinguishers and mosquito repellent, we will now make room in our pantries for masks and gloves. That seems like an easy fix to save $5 trillion next time. Also obviously, the rapid adoption of on-line shopping and media streaming over the past few years is accelerating. Consumers in mass have just learned that many like working from home, and many employers may have learned they can save money on real estate by reducing the enterprise corporate footprint, another existing trend that is apt to accelerate. Might society need fewer planes, trains, and buses? We don’t think consumers will seek less leisure time, but maybe fewer crowded spaces? Will that mean more RV’s and fewer B&B’s Maybe more VR and less DIS. Maybe businesses will see that sales relationships work just fine on Zoom without the big travel expense? On the government side, it seems a lot of unemployed energy workers could staff up a big infrastructure effort, social distancing included. There are precedents for this.
As I write, this evolving recession is also seeing the collapse of oil prices, the down cycle to the one started in 1973-74. That will bring its own changes, but with energy the smallest piece of U.S. GDP in decades, and an input into almost all goods and services, lower prices are a boon to the U.S. and other advanced economies. It’s quite an unusual time, including the first time that as we plough into a certain economic downturn, the economy gets a giant energy price cut to help pay for it. That’s different. So we continue to work hard to find good ideas to put to work in our strategies. As this is one of the most rapidly changing markets in recent history, it is also a beautiful time to discover value in the shifting consumer spending trends that can work for a decade. Thank you for your interest in Sterling Partners Equity Advisors.
Kevin E. Silverman, CFA
Chief Investment Officer
John A. Schattenfield
Head of Distribution