Questions for U.S. Equity Markets

April 3, 2020 — In March, equity markets saw intense drawdowns followed by extraordinary rebounds, with percentage moves that were last seen back in the 1930’s — an economic period we hope will not be revisited any time soon. Despite markets taking the highest ever jobless claims reports in stride at the end of March and beginning of April, we suspect they will have to digest a fair amount of bad news in coming weeks. In an effort to make some sense of the current market environment we spoke with Tobias Levkovich, Chief U.S. Equity Strategist at Citi Research, and asked him a few questions about U.S. equity markets.

Markets rise and fall all the time, why is this selloff different than past drawdowns?

The duration of the COVID-19 virus’ spread and the related shelter-in-place responses to contain it are the big issues for the market as many companies are witnessing revenues dry up rapidly but they still have payrolls to meet, plus rent and debt payments to make. The number of possible layoffs are staggering with the hotel trade association suggesting as many as one million workers in the next month and that is one industry. Even allegedly safe stocks selling items such as makeup are collapsing. Hence, we are finally discerning real worry beyond the norm. We haven’t yet picked up on revulsion towards the asset class as many investors are still willing to talk about the markets but we can sense a change occurring as is likely when the Dow Jones is off substantially from its February 12th closing peak.

The sharp sell-off in equity markets in March was followed by an equally impressive three-day rally before markets consolidated again. A question everyone wants to know is where do you see the S&P 500 bottoming?

Portfolio managers are watching technical charts for support to make that assessment and therefore believe that a break below the December 2018 low of roughly 2,350 means a retest of 2,100 on the S&P 500. We contend that valuation already has gotten intriguing when the S&P 500 dropped below 2,300 but investors almost desperately want to understand the potential decline in earnings for this year.

We have received many inquiries about 2021 and the recovery of profits and we are using $130-$135 as a respectable starting point for recession-like EPS versus 2019’s roughly $164 final result. We suspect that one may want to think about a 20% recovery versus typical 10%-15% since individuals may want to get out and about again after being cooped up at home. The key is production trends, if industrial activity declines 10% in the second quarter of 2020, EPS may contract by 30%+ year-over-year (see igure below) but that would not include likely provisioning by banks for greater credit losses. And, improvement in the second half of 2020 could be limited with likely job losses and businesses shuttering their doors. The pandemic’s ramifications are vast and worrisome of both the health issues and economic effects.

Once we start to climb off the bottom, which groups do you think can rebound more significantly?

There is obviously a preference for quality under the current trading environment and somewhat more of a focus on companies with large market capitalizations (large cap), as small cap companies have underperformed throughout the month of March. And, even companies with more than 30% Asian sales exposure have not acted that differently than the rest of the names in the S&P 500. But, when things turn, there may be a desire to own deeply beaten-up names that can bounce like coiled springs. Essentially they get readjusted from ‘priced for extinction’ to then ‘survive’ (even if they do not thrive). We saw that occur in 2009 and the latter part of 2002 and the same may happen in late 2020 for some service industries, for example.

Given you believe this sell-off is different than past sell downs, do you think we’ll see structural changes in the market going forward?

One big thing that we are wondering about is the impact of the virus on how we conduct business in the future. Since the work from home experiment has gone well enough, companies may choose to utilize this option to reduce in-office operating expenses including rent if one uses less square footage. Travel, in certain instances, can be replaced with videoconferencing. Does this alter assumed secular growth trends that were perceived last year? In addition, recessions often end up providing the change of market leadership and the last slump led by bank write-offs allowed growth to outperform. As cyclicals bounce after a downturn, could value outpace growth? Our lead indicator model suggests that it is plausible and production helps cyclical earnings turn. An adjustment to inflation expectation also may be forthcoming next year given an economic recovery plus all of the monetary and fiscal stimulus which then boost cyclicals again providing value stocks with an edge.