A review of 5 myths that are tripping up the bears.
Many of the bears these days have either thrown in the towel or, at minimum, shifted from “Armageddon is upon us” and “We will retest and crack through the March lows” to “I’m struggling to understand how the market is going up despite the terrible economic situation.” I don’t know whether they actually are struggling or simply remain bearish but don’t want to say so. In any case, in my long career on Wall Street, I’ve often found when I’m confused about the market, it’s usually because I’ve organized my thinking within the wrong framework to explain what is going on. More and more, my focus has been to get the framework right, first and foremost. That’s why, once the Corona Crisis arrived in late February, Federated Hermes spent the first couple of weeks simply thinking through the new framework we’d use to manage through it.
That framework, as readers of this space know, was as follows. The underlying economy is sound, with few signs of systemic risks within the banking system. The problem was first, the uncertainty around how the virus will evolve and second, how much economic damage might it do. The key was to track both forces carefully, looking for changes in trend—the so-called “second derivatives.” So when news on both fronts improved as we anticipated, investors generally moved from worries about Armageddon and L-shaped recovery to our base case, a U-shaped recovery into mid next year, followed by renewed, steady growth. Importantly, as I pointed out in a March “framework” piece, the five key drivers of the secular bull that should take us to new highs and beyond by late next year remain very much in place, reinforced by this crisis: the digitization of the global economy; the biotech revolution; the U.S. manufacturing renaissance; a supportive policy backdrop; and structurally cautious investor sentiment.
The result has been a dramatic market recovery, faster to be fair than even we’d anticipated. Led initially by the stocks that have been winning in this new Corona economy, especially in technology, health care and online retailing, the recovery has since broadened to perceived winners and/or “survivors” in more cyclical areas that stand to benefit from an earlier-than-expected return to normal. All of this is rational, quite frankly, if you frame the problem the way we’ve been framing it. The question now is, where do we go from here? Our view is that from 3,200 on the S&P 500, the going will get tougher near-term though we continue to expect new highs and even 3,500 within the next 12 months. Given this, we are, as we’ve been saying for months, in a stock-picking environment that favors investors who have the flexibility to diverge substantially from market benchmarks. As an active manager, this is our game. Stock picking is at the heart of what we do.
5 MYTHS MISLEADING THE BEARS
For ongoing sceptics, we offer five leading framework miscalculations—myths, if you will—that have the bears confused and “struggling.”
- Myth No. 1: “We’re fighting the last battle.” This common theme of many bears views the present economic calamity, though different in origin, as bringing the same result and following the same pattern as the 2008-09 global financial crisis. This morning, for instance, one cautious bear noted the S&P rallied hard after the Bear Stearns bailout in the spring of 2008, thinking the worst was over, only to fall flat on its face once Lehman went down. These bears assume a “Lehman moment” lies ahead. This seems misguided to us. In 2008, the key issue was the bubble that had evolved in the real estate markets, exaggerated in impact by the levered instruments Wall Street had developed for investors to participate in that bubble. Worse still, the problem was systemic within the highly levered financial system, so that once the dominoes started falling, there was no stopping them. None of this presides in the current case. This economic downdraft wasn’t caused by systemic overpricing within the system, or a systemic banking crisis, or even a systemic health-care crisis for that matter. While there will be individual company aftershocks, for sure, we don’t see a systemic aftershock ahead. So waiting on the sidelines for one to hit could be like “Waiting for Godot.”
- Myth No. 2: The monetary and fiscal responses were designed as “economic stimulus measures,” similar to the case in past crisis. This is just wrong. I said this then and I’ll say again now: the extraordinary measures the government took to address the Corona Crisis were much needed BRIDGE LOANS TO THE ECONOMY, nothing more. This is the first time in the country’s history that the government had to extend the economy and all its players a bridge loan, and bridge loans are very different than stimulus. Bridge loans are made to healthy borrowers that simply have a short-term liquidity squeeze they need to overcome with extra, one-off cash flow. Once the crisis passes, the healthy borrowers pay back the loan and resume activity, their health preserved by the short-term loan. Stimulus, on the other hand, is provided to an unhealthy economy that needs a shot in the arm to boost demand or supply, or both, quickly in order to get the wheels of commerce turning again. In our framework, little or no actual “stimulus” will be needed, other than the burst of activity likely in the weeks ahead as the fear of the virus dissipates and consumers feel comfortable starting to spend the wall of cash many have accumulated during the low-spending days of the lockdown. Bears holding on to gloom on the belief the present rally solely reflects “central bank liquidity” being infused into a fundamentally flawed economy are missing the positive fundamental backdrop at the company level. In other words, they are waiting for a second crisis that is unlikely to come.
- Myth No. 3: Trust the scientists. Much of the commentary I see from the bears references “what the scientists are telling us.” This is the same group whose models were predicting 2 to 3 million U.S. deaths, by the way. Now, while they’ve backed off that number, they remain as a group fixed on a large second wave, and as a group, continue to point to the inefficacy of certain treatment protocols adopted in the field by the doctors on the ground trying to save lives, including such drugs as Hydroxychloroquine and Remdesivir. Vaccines, they tell us, will take years, not months to develop. News flash: scientists are like accountants, lawyers, and economists. They are not paid to weigh risk and reward but rather to avoid at all costs being wrong. Thus incented, they tend as a group, in my view, to make very conservative assumptions in all their forecasts. As investors, we are charged with analyzing the facts and making a risk-reward judgment. We are not trying to get every call 100% right, but if we are making our calls with a disciplined process and can get 80% of them right, there’s a payoff. So in my view, while we consult the scientists diligently, we don’t delegate decision-making to them.
- Myth No. 4: There are no winners in this thing. At a broad macro level, the Corona lockdown has produced a lot of obvious economic damage, with whole industries (think tourism and travel, restaurants and hospitality, airlines, energy, etc.) virtually shut down, overnight. Amid all the carnage, it is easy sometimes to overlook the winners emerging from the wreckage, companies that have actually thrived in the new work-at-home economy and whose revenues, cash flows and valuations (i.e., fundamentals) have soared to new heights. Amazon is the most obvious example, but at Federated Hermes, our portfolios are dominated by dozens of companies that are seeing continued strong growth through the lockdown. As I noted a few weeks ago, once you take this effect into account, then 3,100 S&P did not seem so odd; it was simply an average of the winners reaching new highs, the losers plumbing new lows and most of the remaining “survivors” retesting their near-Armageddon lows of March 23. It’s only when one ignores the impact of the winners’ continued advance on the overall market that the S&P at 3,100 or now, 3,200, seems a stretch.
- Myth No. 5: “I know more than everyone else does.” Fundamentally, a key flaw of much of the bear case rests on the same problem most investors have when their positioning is out of line with the market: they believe that somehow they possess a special insight that the broader market participants don’t share. Although sometimes a special insight, particularly at market extremes, is not only possible but necessary, too often we don’t recognize that “wisdom of crowds.” Individually, anyone of them may be less astute than you; but collectively, analyzing every data point out there including many anecdotal ones that you can’t possibly assess, the crowd more often than not gets it right. Betting against it can be a loser’s game.
WHERE WE STAND
At Federated Hermes, we remain constructive on the overall equity market over the next 12 months, though for sure there appears less potential upside in the averages than was the case back at the market lows. Accordingly, we downshifted that overweight from a near maximum 7% at the early Corona Crisis lows to 5% and now 3% as the market has advanced. For now, we remain at this level, assuming that even if we get a correction in the bumpiness that is surely ahead, we will be at significantly higher market levels in the intermediate term. Encapsulated within this view is a conviction that stock picking will be more important than market picking, hence our continued recommendation to stick with active stock pickers with demonstrated track records. We are holding on to our long-term core overweight in large-cap growth and are otherwise overweight in areas where stock-picking has the biggest edge: small-cap, international small-cap and emerging markets.
For my bearish friends struggling to understand all this, give us a call. We’ll be glad to help.