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The bull case (and its risks)

Summary:
In the past few weeks, a number of investors and strategists have turned bullish. I would like to address the reasoning for the bull case for equities, and the risks to the reasoning. History shows that recessions are bull market killers, and bear markets do not resolve themselves this quickly without a prolonged period of adjustment. Here are the bullish arguments: The lockdowns are ending. A possible drug treatment breakthrough. The Fed is coming to the rescue. Investors are looking ahead to 2021, and 2020 is a writeoff. Easing lockdown = Growth revival One point made by bullish analysts is the coronavirus induced lockdown and distancing policies are easing. Confirmed COVID-19 case growth and death rates are leveling off and declining. Parts of Europe, such as Germany, are

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In the past few weeks, a number of investors and strategists have turned bullish. I would like to address the reasoning for the bull case for equities, and the risks to the reasoning. History shows that recessions are bull market killers, and bear markets do not resolve themselves this quickly without a prolonged period of adjustment.

The bull case (and its risks)

Here are the bullish arguments:

  • The lockdowns are ending.
  • A possible drug treatment breakthrough.
  • The Fed is coming to the rescue.
  • Investors are looking ahead to 2021, and 2020 is a writeoff.

Easing lockdown = Growth revival

One point made by bullish analysts is the coronavirus induced lockdown and distancing policies are easing. Confirmed COVID-19 case growth and death rates are leveling off and declining. Parts of Europe, such as Germany, are starting to ease their lockdown restrictions, and Trump has issued guidelines for a phased re-opening of the economy. These measures should lead to a growth revival, which would be bullish for stock prices.

The growth revival can be an important bullish catalyst, if it works. Bloomberg reported that there was an important caveat in the much publicized Goldman Sachs bullish U-turn. The bullish call was based on “no second surge in infections”.

A combination of unprecedented policy support and a flattening viral curve has “dramatically” cut risks to both markets and the American economy, strategists including David Kostin wrote in a note Monday. If the U.S. doesn’t have a second surge in infections after the economy reopens, equity markets are unlikely to make new lows, they said.

The Street is already penciling in a V-shaped rebound in consensus earnings expectations. Earnings are expected to bottom out in Q2, and return to normal by Q4.

The bull case (and its risks)

How realistic are those expectations?

Ask Singapore about what happens if you try to open up an economy prematurely. David Leonhardt outlined the risks in a NY Times Op-Ed. The island nation’s response has been a model for other countries, and it was able to avoid many of the draconian distancing measures imposed elsewhere:

Singapore’s approach has certainly been aggressive — and more effective than the American approach. In January, as the virus was spreading within the Chinese city of Wuhan, Singapore officials began screening travelers arriving in their country and placing anyone who tested positive into quarantine. Singapore also quarantined some travelers who didn’t have symptoms but had been exposed to the virus. And Singapore tested its own residents and tracked down people who had come in contact with someone who tested positive…

Thanks to that response, Singapore had been able to avoid the kind of lockdowns that other countries had put in place. Restaurants and schools were open, albeit with people keeping their distance from each other. Large gatherings were rare. Singapore, in short, looked as the United States might look after the kind of partial reopening many people have begun imagining.

The preventive measures eventually failed, and Singapore has reverted to the standard lockdown methods used elsewhere:

But Singapore doesn’t look that way anymore. Even there, despite all of the successful efforts at containment, the virus never fully disappeared. Now a new outbreak is underway.

The number of new cases has surged, as you can see in the chart above. In response, the country announced a lockdown two weeks ago. Singapore’s “present circumstances,” Carroll writes in a piece for The Times, “bode poorly for our ability to remain open for a long time.”

The bull case (and its risks)

Even if lawmakers wanted to open up the economy, the inevitable questions come up of how willing are people to return to restaurants, movies, or to send their children to camp this summer. A recent Gallup poll found that only 20% of respondents were willing to return to pre-pandemic normal activity immediately.

The bull case (and its risks)

Attitudes were most divided among the urban-rural axis, and by party identification. Still, only 23% of rural residents and 31% of Republicans were willing to return to normal immediately. These figures represent significant minorities of the population.

The bull case (and its risks)

Other polls confirm the Gallup results.

  • An Axios/Ipsos poll found a similar level of skittishness.
  • A Harris poll found that most Americans wanted to wait a month before “starting to return to work and life as normal”.
  • A Seton Hall poll found that 72% would not attend a live sports event like a football game unless a vaccine is found.

The polling data suggest that any effort to reopen the economy will not be instant. Even if the easing measures are successful, growth and employment are likely to return slowly.

For the last word on this topic, I refer you to Wall Street executive and Morgan Stanley CEO James Gorman. Gorman stated in a CNBC interview that he believes the economy will not return to normal until late 2021:

Morgan Stanley CEO James Gorman sees the coronavirus-induced global recession lasting for the entirety of this year and 2021.

When asked about how a potential economic recovery expected in the second half of this year would take shape, Gorman said that while he hopes it will be a sharp “V” recovery, in reality it will probably take longer to reopen cities and factories.

“If I were a betting man, it’s somewhere between a `U’ or ‘L’” shaped recovery, Gorman told CNBC Thursday in an interview. “I would say through the end of next year, we’re going to be working through the global recession.”

A treatment breakthrough?

Some of the expectations about the pace at which the economy can be reopened could change. A report from Stat created some excitement after the market closed Thursday. There were reports of promising results from the Gilead drug remdesivir in the treatment of COVID-19 patients:

The University of Chicago Medicine recruited 125 people with Covid-19 into Gilead’s two Phase 3 clinical trials. Of those people, 113 had severe disease. All the patients have been treated with daily infusions of remdesivir.

“The best news is that most of our patients have already been discharged, which is great. We’ve only had two patients perish,” said Kathleen Mullane, the University of Chicago infectious disease specialist overseeing the remdesivir studies for the hospital.

Before anyone gets overly excited, these results are highly preliminary. This test had no control group. The drug is given intravenously, and hospitals would still be overwhelmed if public health policy allow the infection rate to surge. A New England Journal of Medicine article which outlined the “Compassionate Use of Remdesivir for Patients with Severe Covid-19” had considerably less exciting results, as “clinical improvement was observed in 36 of 53 patients (68%)”.

The bull case (and its risks)

In addition, Gilead has a limited supply of the drug.

As of January 2020, we were not actively manufacturing remdesivir. The manufacturing supply chain was scaled to periodically make small amounts of product for a compound in early development. We had inventory of finished product to treat just 5,000 patients.

Since then, we have proactively and rapidly scaled our supply chain. As of late March, using the active ingredient we already had in our inventory, we have increased our supply to more than 30,000 patient courses of remdesivir on hand, assuming a 10-day course of treatment for patients. As new raw materials arrive over the next few weeks from manufacturing partners around the world, our available supply will begin to rapidly increase.

Even if the trials were proven to be successful, ramping up production will be a challenge. Gilead’s stated production goal, which may or may not be successful, is shown as:

  • More than 140,000 treatment courses by the end of May 2020
  • More than 500,000 treatment courses by October 2020
  • More than 1 million treatment courses by December 2020
  • Several million treatment courses in 2021, if required

In short, remdesivir is potentially a promising treatment, but production problems may make this a “too little, too late” solution in light of the number of widespread incidence of COVID-19 around the world. The time frame for the widespread availability of this drug isn’t significantly better than a vaccine, assuming that a vaccine could be found in a relatively short time. Moreover, the drug does not protect anyone against infection, or COVID-19. It is just a treatment for patients who are in ICU.

Assuming that remdesivir were to become an effective treatment with limited availability, here is what that means to the US economy over the next 6-12 months. Initial jobless claims have skyrocketed to all-time highs in recent weeks. The continuing jobless claims report, which is released in conjunction with initial claims, measures the devastation to the jobs market. Arguably, reported continuing claims is under-reported because the latest figures are inconsistent with the last few weeks of rising initial claims, and it is difficult to believe that people have magically found jobs in the current environment. In all likelihood, the lower than expected continuing claims figure is attributable to the inability of state bureaucracies to process the flood of claims.

Now imagine a best case scenario where the economy opens up again, and half of the laid off workers suddenly found jobs as the fear of dying from COVID-19 recedes. Even under this rosy scenario, continuing claims would be worse than the highest levels seen during the Great Financial Crisis. Are those recessionary conditions in anyone’s spreadsheet?

The bull case (and its risks)

The economic impact of the job losses are probably higher than most analysts’ expectations. So far, the initial round of layoffs have largely been concentrated in low-wage service jobs. A recent WSJ article reported that a second round of layoffs is now hitting better paying white collar workers, which will have greater effect on consumer spending because of their (previous) higher spending power. No one is immune, Bloomberg reported that even Google has announced that it is significantly slowing its hiring for the rest of this year, and it has announced selected cost-cutting initiatives.

The bull case (and its risks)

The Fed has your back

Another point made by the bullish camp is the flood of stimulus that has been unleashed by the fiscal and monetary authorities. In particular, the Federal Reserve and other central banks around the world have acted quickly to provide a tsunami of liquidity for the markets.

That’s bullish, right?

The answer is a qualified yes. Bear in mind, however, this latest crisis is different from previous recessions like the GFC. The COVID-19 recession began on Main Street, while most of the past recessions began on Wall Street. Fiscal and monetary measures can remedy financial recessionary conditions, but they have limited effectiveness if the crisis begins in the physical economy.

The question investors have to ask themselves is what this flood of stimulus will do to the Main Street economy. Congress and the Fed, despite all of their fiscal and monetary powers, cannot find a vaccine or a treatment. If the effect of these measures only act to compress risk premiums, which is important to financial stability, the stimulus is less likely to leak into the real economy.

Remember the monetary equation, GDP = MV, where GDP growth is a function of money supply growth and monetary velocity. During past recessionary periods, the Fed has engaged in monetary stimulus, which boosted M1 growth (blue line), but monetary velocity (red line) fell. Will 2020 be any different?

The bull case (and its risks)

Can stock prices regain their long-term footing without a revival in economic growth?

Look over the valley

The last major advice made by bullish analysts is to look over the valley. Equity valuation appears expensive now, but 2020 is said to be a writeoff and investors should be looking forward to the recovery in 2021.

Here is the key risk to that bullish argument. The market trades at a forward P/E ratio of 18.5, based on bottom-up derived blended forward 12-month EPS estimates from company analysts. This valuation is higher than the 5-year average of 16.7 and 10-year average of 15.0.

The bull case (and its risks)

Right now, bottom-up earnings estimates are little better than fiction because company analysts have little guidance from corporate management on the 2020 outlook, never mind 2021. On the other hand, top-down strategists have developed 2021 EPS estimates based on economic models, based on their best guess assumptions of the economy next year. The consensus top-down 2021 estimate is about 150.

Based Friday’s prices, the forward 2021 P/E ratio is a nosebleed 19.2. This begs a number of difficult questions for the bulls:

  • How much more upside do you expect when the market trades at a forward P/E ratio that is higher than its 5 and 10 year averages? That’s assuming that earnings are in recovering in 2021. Should investors start to discount what amounts to a highly uncertain 2022 earnings two years in advance?
  • If you accept that a forward P/E ratio that is above its 5 and 10 year average as appropriate, how do you model the Fed’s withdrawal of stimulus, which would expand risk premiums and therefore depress P/E multiple?

In conclusion, I find the risks presented by the bullish arguments unsatisfying. I continue to believe that, in the absence of a vaccine or immediate availability of a treatment that mitigates the effects of COVID-19, the US equity market faces significant downside risk (see The 4 reasons why the market hasn’t seen its final low).

Please stay tuned for tomorrow’s tactical market update.

About Cam Hui
Cam Hui
Cam Hui has been professionally involved in the financial markets since 1985 in a variety of roles, both as an equity portfolio manager and as a sell-side analyst. He graduated with a degree in Computer Science from the University of British Columbia in 1980 and obtained his CFA Charter in 1989. He is left & right brained modeler of quantitative investment systems. Blogs at Humble Student of the Markets.

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