The Speaker was worried coming into March because of what he called The Three Body Problem, taking inspiration from China’s most beloved science fiction novel written by Liu Cixin.
First, it was politics and the rise of the economic left under Bernie Sanders. Super Tuesday cleared up this risk as Joe Biden became the Democratic front-runner. Second, it was the coronavirus. Based on his early evaluation, there was no chance of a perfect vaccine and re-infections were going to be normal. “How does the world prepare for this?”
Third, it was the “irresistible force” (unprecedented stimulus) meeting the “immovable object” (the sharpest GDP decline in history). “The economy just stopped. There is no model, there is no precedent, there’s nothing you can look to for what just happened. So, it is inherently unpredictable.”
The Speaker, who runs a long/short fund out of Boston, has been cautiously positioned. However, he believes it’s more important than ever to keep an open mind given an exceptionally wide range of outcomes.
Source: Empirical Research Partners
His chart shows that when intra-sector valuation spreads are narrowing from really high levels—as they are now—cuts in earnings estimates haven’t mattered. There is some legitimacy to look through the negative upcoming earnings and focus on 2021. It took 17 quarters to recoup all lost earnings after the Great Recession, and up to eight years after the Great Depression. Analysts see profits rising as much as 35 percent in 2021 to $155 a share.
Speaking with his Boston community of large asset managers, the Speaker said no one believes in this rally. This is confirmed by Bank of America’s latest fund manager survey which shows “extreme investor pessimism” with cash levels jumping to the highest since the 9/11 terrorist attacks. Just 15 percent of respondents expect a V-shaped economic recovery. He is aware that fighting the Fed—the irresistible force—was historically a losing proposition.
One of the participants noted, however, that the equity multiple can surely rerate lower. The stock market is still expensive on lower earnings. To this, the Speaker said multiples are “magic” and it’s hard to define what would be deemed fair value in this macroeconomic environment.
The Speaker’s chart also shows that dividend cuts matter, so one idea is to short companies that may cut their dividends. Overall, the large valuation spread is creating exceptional opportunity for long/short managers.