L U V, what will it be?

Would you ever have thought you would read these numbers? The lead indicators announced on April 23 (keep in mind that <50 is already recessionary):

09:15 France PMI: previous month 28.9, expected 24.5, actual 11.2

09:30 Germany PMI: previous month 35.0, expected 28.5, actual 17.1

10:00 EU PMI: previous month 29.7, expected 25.7, actual 13.5

10:30 UK PMI: previous month 36.0, expected 29.5, actual 12.9

15:45 US PMI: previous month 40.9, expected 31.0, actual 27.4

Well and truly off the chart:

Market reaction?

After already rallying 20 to 25% in the previous 4 weeks, equity markets swung up another 2% on the news! How to explain?

L U V !

These three letters stand for the economic recovery scenarios that had been discussed since the market low a month ago. The pessimists say “L” as in no recovery after the virus lockdown, the optimist “V” as in everything back to normal, while “U” describes a slow recovery back to previous levels. While there are some very smart strategists, economists are notoriously bad at forecasting, with track records worse than active fund managers underperforming their benchmarks.

So rather than work top-down, perhaps a bottom-up approach could be more useful. At the end of the day, company earnings determine the value of equities. Usually, you would model an earnings recession and subsequent recovery in some form of mean reversion to the long-term trend based on past recessions. In this crisis, we had a supply shock (China) followed by a unique demand shock (global lockdown). Despite two months of corporate profit warnings, we can see from the current earnings reporting season on Q1 that consensus estimates are still way off the mark. Sellside-analysts are slow to adjust their models. In this case you cannot blame them as the exit out of lockdown is political, top-down, not bottom-up. Nonetheless, some Wall Street firms have attempted to come up with an aggregated earnings number for the S&P500 which can then be multiplied by an historic earnings multiple. Goldman estimates $110 earnings per index point. A multiple of 20 (reasonable in times of zero interest rates) would give you an S&P500 target of 2200, which was close to the market low in March. We are now already over 25% above that target. It seems to me that the PE multiple is the wrong way to look at it. In 2009, with the S&P500 at around 900, earnings declined below 10 resulting in a PE of over 100. We are once again experiencing a FED-driven multiple expansion that will offset large parts of the earnings compression.

If you should not look at top-down macro indicators, nor at bottom-up earnings and valuations, what should you look at?

In order to answer the question from our title, it is more fruitful at this point to concentrate on sentiment analysis. Emotions run high in high volatility markets and can be exploited by systematic analysis. Here, I would like to highlight two valuable tools:

(1) Fear & Greed Index (CNN): This index (0 to 100) contains seven indicators of market sentiment such as put/call ratio, volatility, junk bond spreads and other. Using the index in a contrarian fashion can help in timing the market, i.e. buy when fear is high and sell when greed is high. We entered the year with readings in the 90s (extreme greed), but the market continued to rise nonetheless. However, the index reading of 2 at the market low mid-March was an excellent buy signal. It recently bounced back to neutral near 50 and now reads 40. My long-term work with such indicators confirms that they generally work on market lows when fear becomes almost universal, but less so for timing market tops.

(2) B of A (Merrill Lynch) Fund Manager Survey: This is the longest running, consistent survey of global investor positioning (approximately 200 institutional, mutual and hedge fund managers around the world). In recent years, this monthly survey has added many questions on investors’ opinions which makes for good marketing, but is less helpful. The gem is the consistent analysis of changes in investor positioning. The latest publication, dated April 14, is quite revealing in answering our question, what will it be? By far the largest portion of investors, 52%, believe in a “U”-shaped recovery. 15% in “V” and only 7% in “L”. 25% expect a “W” or other. This may explain why the stock market already seems to play the “V”. But consensus opinion is not always wrong.

Positioning data is another matter, i.e. if most investors are out of the stock market, who else will sell? If everyone is already overweight drug stocks, who else will buy? This is the most recent snapshot with positions measured in standard deviations of the historical average:

Conclusion:

In these abnormal markets, we need to use different tools to make wise investment decisions. Ignore employment data, GDP growth, consumer data, etc. and even lead indicators such as PMIs. Of all the economic activity data, do look at China, since they went into lockdown about 4-6 weeks before the rest of the world did. Otherwise, we do need to distinguish between the real economy, real events/virus updates and the stock market behaviour which is all about emotions vs expectations.

Given the positioning data, it looks as if putting cash back to work in equites and moving some of the pharma stocks into energy/materials in not such a bad idea.

Given the Fear&Greed Index data, it looks like the current “V” may well turn into a “W” or several “W”s in a row. Keep in mind that the Japanese stock market was in a 25-year toward trend with strong intermittent rallys, or …

… just a new way of spelling love: LWWWWW…

#recovery #sentimentanalysis #equities