<May 28, 2020>
With the majority of youth activities canceled over the past two months, my kids and I have had more free time together. We’ve spent part of this time watching movies—mostly sports related. We started with the boxing classic Rocky. One of the benefits of getting old is if you haven’t seen a movie in 30 years, it’s almost as good as new! We followed Rocky with, Rocky II, III, IV, and V (I didn’t even know there was a Rocky V!). We concluded our boxing binge with Creed and Creed II. The movies were great, but I could have done without my son punching me in the ribs and yelling, “Yo, Adrian, I did it!”
After completing Creed II, we watched ESPN’s special on Michael Jordan, The Last Dance. The 10-episode series documents Michael Jordan’s career and the Chicago Bulls’ 1998 journey to their sixth and final championship. As far as documentaries go, I thought it was very well done and entertaining. In case you haven’t seen it and plan to watch it with your family, I highly recommend the profanity-free version!
As I reflect on financial markets over the past two months, there is little doubt in my mind a documentary will eventually be made attempting to explain recent investor behavior. However, unlike ESPN’s The Last Dance, I suspect the documentary will not end with celebration, but with questions, debate, and considerable head-scratching.
After completing our review of Q1 earnings reports, conference calls, and management outlooks, we are somewhat surprised to see the equity markets so vibrant. From a bottom-up perspective, the economy is in shambles, with corporate earnings and employment deteriorating noticeably. Many corporate and consumer balance sheets have been impaired, harming business valuations and suppressing future consumption. Government debt and fiscal deficits are exploding, with the Federal Reserve resorting to debt monetization to pay the bills! Meanwhile, many stocks are approaching or exceeding levels seen prior to the COVID-19 outbreak and the resulting decline in business fundamentals. We can’t help but wonder if investors are clairvoyantly discounting the future or if they’ve lost their minds!
Those buying equities at today’s valuations will likely argue that they are looking beyond the sharp decline in Q1 earnings. Wall Street analysts are encouraging this view, with expectations of sharply rising sequential earnings beginning in Q2 and continuing throughout the second half of the year. While we agree there will likely be a second half recovery, we are far less certain it will be sufficient to justify current equity valuations.
Although the second half recovery narrative is one of Wall Street’s favorites, the devotion to this year’s rebound is the strongest we’ve ever seen. Based on our review of management commentary and outlooks, we believe investors’ confidence in the second half recovery far exceeds Corporate America’s. Similar to Warren Buffett’s cautious tone during his recent meeting with shareholders, most corporate executives we follow remain very uncertain about the intensity of an economic recovery. Yes, most believe Q3 and Q4 will improve, but by how much, few are even willing to speculate.
Below are recent comments from Park Aerospace’s CEO, Brian Shore (fiscal Q4 2020 earnings call). We’ve followed Park Aerospace and Mr. Shore for many years and have found him to be one of the most honest and straight-shooting CEOs within our possible buy list. We thought his comments on the second half recovery summarized what we’ve been hearing from many corporate executives—visibility is limited and second half results are far from certain.
"Q3 and Q4, just don't know, there are so many variables. We don't know about Q2 either. We're guessing. I just want you to understand that…we could be wrong. Q3 and Q4, we're not even going to guess because there's so many considerations that could affect Q3 and Q4, like what happens to the aircraft industry. Does it start to get a little bit better? Is there a little bit of light at the end of the tunnel? I know, now there's no light at the end of the tunnel. It's kind of almost sad, and I shouldn't say pathetic, but it doesn't really reflect well on these analysts because next week, they'll have light at the end of the tunnel. This week there's no light at the end of the tunnel. So I guess, maybe that’s the lesson…don't listen—don’t spend a lot of time listening to the analysts."
In a world where equity prices convey certainty, it’s refreshing to hear an executive of a publicly traded company speak so openly about not knowing the future. Even better, a CEO advising investors to avoid listening to Wall Street analysts! In our opinion, there is nothing wrong with acknowledging uncertainty, especially in environments similar to today’s. Conversely, pretending to know the unknowable and convincing others you know, now that can be a very dangerous game! We’ll leave that to Wall Street and central banks. 😊
The outcome of the presidential election is another unknowable that could influence the second half of 2020. While we rarely discuss politics, we believe extrapolating the current presidency, along with historically low corporate tax rates, is becoming an increasingly risky assumption. While asset prices are being protected by aggressive central bank policy, many working-class jobs and incomes are not. Growing inequality, in our opinion, is becoming too difficult to dismiss and even more difficult to defend. If voters oust politicians overseeing this cycle’s sharp rise in wealth inequality, we believe historically low corporate tax rates would be at risk.
With that said, sometimes we wonder if corporate tax rates and earnings even matter anymore to most investors. In effect, the recent rebound in financial markets may have less to do with fundamentals and more to do with the Federal Reserve’s commitment to protecting asset prices. Just as the Chicago Bulls cheered on Michael Jordan, the Wall Street bulls can’t get enough of Chairman Powell! Global central bankers are playing along as well, trying their best to be like Jerome (Mike). As the battle between fundamentals and money printing intensifies, policy makers appear to have gained the upper hand—for now.
Although central banks have succeeded in resuscitating the financial markets, we will not ignore what many businesses are experiencing (pain) and forecasting (uncertainty). We have always viewed the economy and our opportunity set from the bottom-up—never relying on Wall Street or central banks for information, guidance, or narratives. Based on our recent bottom-up analysis, we believe there is a growing disconnect between equity valuations and fundamentals. The disconnect is so large, we feel investors could be setting themselves up for one of the most meaningful second half recovery letdowns in the history of financial markets. Similar to the 1998 Chicago Bulls, we believe investors are experiencing their final dance of the current market cycle. However, instead of chasing a championship, investors are chasing a seductive bear market rally built on aggressive second half expectations and the aging belief that policy makers will never allow them to fail.
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Definitions:
S&P 500: The Standard & Poor's 500 is an American stock market index based on the market capitalizations of 500 large companies.