Co-produced with Trapping Value
Nothing changes sentiment like price. Merely 3 weeks back, it appeared that the sky was the limit for the stock market, and even news that was slightly less horrible was enough to propel the S&P 500 to 3,200. Things look quite a bit different today. We take a quick look at the indicators, both fundamental and sentiment related, and give you our take.
The Fundamental Landscape
While states have been reopening, some faster than others, the spike in infections in some places has been epic. Florida’s 7-day moving average of infections has jumped more than 800% in the last 3 weeks.
Texas has seen a similar steep trend that accelerated since the middle of June.
California is also struggling with similar issues though the trend increase there has been less steep.
Some have been quick to attribute the increase in cases to more testing, and to a smaller degree that is definitely true. Tests were highly restricted initially and wider availability has allowed us to catch more cases. We would be careful though to attribute all the increase to that. If more testing was the only reason, we would expect the percentage of positive tests to fall. The opposite has been the case.
The good news on the other hand is that deaths related to COVID-19 continue to trend lower.
There are many possible explanations for this, but the one that strikes us as most relevant is the declining median age of infected individuals.
Florida Gov. Ron DeSantis said many of those testing positive for the coronavirus now don’t have any symptoms and many of them are young. “What we’ve seen now has been a really significant increase in positive test results for people in the 20s and 30s,” he said. The median age of those testing positive in Florida has declined rapidly, going from 65 in April to under 30 now in some counties. “Our cases are shifting in a radical direction younger,” DeSantis said.
Why Is The Median Age Decreasing?
Dr. Natalie Dean has the following explanation.
The median age of new COVID-19 cases is dropping in some areas, but what does that mean? Biostatistician Natalie E. Dean, PhD, explains three things that might be going on: more testing, better protection for older individuals, and more infections in younger adults.
“The reality is almost certainly some mixture of all three explanations,” she writes, “and will vary from location to location.”
But the recent spike has been so high that the states are still worried about exceeding maximum hospitalization capacity. Texas has paused its reopening with Harris county issuing a red alert on Friday encouraging people to stay indoors. Even before that, businesses were beginning to dial down activity. Below we show weekly average hours worked by hourly employees in Florida, Arizona and Texas. Notice the peak mid-June.
Source: Joe Weisenthal – June 24
The Warning Signs On Sentiment
While fundamentals have deteriorated, they are always best interpreted in context of sentiment and technicals. When sentiment is washed out, even bad news can seem like good news and vice versa. So where is sentiment today?
On June 19, we noted the chart below. It shows the 10 and 21 day moving averages of the equity Put-Call ratio. As can be seen both reached the lowest levels in 2 decades.
To us, that implied that fear had become non-existent in the market and it was time to hedge some positions. We did so by recommending a short position on S&P 500 ETF (SPY) at $312. Last Friday, on June 26, we finally got to see investors drop the idea that markets can only go up. The broader indices plunged, and the equity Put-Call ratio registered in at 0.74. But while that was a single day of fear, the moving averages of these two ratios are still extremely low.
Historically, over the last two decades, the 10-day moving average has often climbed into the 0.8X range while the 21-day moving average has moved to 0.75X range before sustainable bottoms have been formed. So while Friday was a step in the right direction, lots more work needs to be done to rebalance sentiment. Citigroup Inc.’s panic-euphoria model is also still high in the “euphoria” zone and generally takes 4-6 weeks to reset.
Source: Helene Meisler – June 27
A minimum of three weeks and likely a minimum of 300 SPX points will be required to rebalance sentiment.
Where Most Of The Damage Should Occur
Below we show the ratio of the Nasdaq Composite to the S&P 500. Currently, that ratio sits more than 20% above its 200 week moving average. It has also been 7 years since that ratio even traded below this line.
Right now, there is an incredible belief that technology companies are somehow immune to this recession. That is absolutely incorrect in our view as lower levels of capital expenditures at all levels will ultimately feed through to the technology companies. Less employment will mean less license renewals for companies like Microsoft Corporation (MSFT) and pricing wars will intensify in the next 12 months. We expect very heavy selling in the technology index and since the SPY’s top holdings are all technology related, we believe it will form a good short hedge.
Another area that is likely to see some spread contraction is the growth vs value trade. This spread has hit an all-time high just as the economy has gone into extreme contraction.
We have extremely over-extended technicals and sentiment, with declining fundamentals. While another lockdown is extremely unlikely, there are likely to be measures at government and individual levels that don’t necessarily play nice with the economy. Below, we can see the abject failure of policies in four states versus the European response.
These 4 states make up 32% of US GDP and represent a serious downside case to our best estimates of a rebound. At a minimum, we need sentiment to reflect this reality before we dive headfirst into opportunities. Investors are also extremely optimistic on earnings. On average it takes 12 quarters to surpass peak earnings.
Consensus puts 2021 as matching 2019 numbers and we don’t believe that is remotely possible.
Our Strategy at “High Dividend Opportunities”
At “High Dividend Opportunities”, we have been recommending to our investors value, high-dividend stocks. Energy, financials, and REITs are significantly cheaper than the rest of the market. Companies with strong cash flows and defensive nature (non-cyclical stocks) are the best place to be. We recommend that investors nibble on those as sentiment resets. We have also recently recommended a hedge position by shorting the S&P 500 index (SPY) with a value equivalent to 10% of one’s overall portfolio. This hedge (short position) was timely, and reduced the volatility of our income portfolio.
In essence, emphasize value and emphasize it very heavily, because growth stocks are the most expensive they have ever been relative to value stocks. Further, defensive REITs like WP Carey (WPC), and other defensive stocks like Altria (MO) are some of our income favorites and should remain resilient in this environment. WPC yields 6.2% and MO yields 8.6%. We continue to recommend a heavy overweight in preferred stocks, bonds, baby bonds, and fixed-income CEFs. The bulk of the returns over the next couple of years are likely to come from dividends rather than capital gains. This is why investors looking for income should overweight dividend stocks including preferreds and bonds.
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Disclosure: I am/we are long WPC, IMBBY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
Originally published on Seeking Alpha