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Virus Muddies Outlook, but Stocks Already Prices for Recession

As the pandemic rages on, the equity market continues to be turbulent and possibly disconnected from economic reality. On May 20, 2020, the CFA Society Chicago Women’s Network hosted an event featuring Gina Martin Adams, CFA, CMT, chief equity strategist with Bloomberg Intelligence. In her role, Adams provides top-down perspectives on the equity market, sectors and industries with a multi-disciplined approach that utilizes fundamental, quantitative and technical analysis. Adams offered her perspectives on U.S. equity market dislocations and how long those may last. She also presented her fair value model, factor and sector strategy, and a customized equity market playbook for the COVID-19 recession and recovery. Tiffany Greenhouse, CFA, co-chair of the CFA Women’s Network moderated.

Adams opened the presentation by stating her belief that we are nearly “out of the woods.” Her belief is grounded in research related to many stocks’ current price level, investment trends, and technical indicators. Specifically, Adams noted that many stocks are currently trading above their 50-day moving average. At the sharpest point of the market drop off, only about 1% of stocks were trading above this marker. That trend has nearly fully reversed. Additionally, Adams and her team have seen a rotation of investments into more risky investments, such as high yield debt, recently. The final supporting piece to Adam’s belief is her claim that the market has hit its bottom—which was covered in more depth throughout the presentation. Based on this claim, Adams stated that the end is in sight because, historically, the end of a recession follows about 130 days after the earning trough.

To support the claim that markets have bottomed, Adams pointed to more technical indicators and the government policy response. Adams’ market valuation hinges on a macro model based on earnings growth and price. When considering earnings growth and recessions, the bigger the drop, the bigger the recovery. Adams pointed out that there is a common misconception that GDP declines correlate with market declines, but her team’s research shows otherwise. Instead, they have found that the longer the recession experience the deeper the market decline. Further, the recession experience can be shortened by policy response. Policy makers have a great impact on stocks. Specifically, stocks find the bottom at the time policy makers make announcements and start implementing policies. As an example, stocks found a bottom in 1932 soon after FDR began implementing New Deal policies and increasing government spending through deficit financing. Stocks also found a bottom in 2009 soon after the FED started experimenting with Quantitative Easing and Open Market Operations. Given the rapid policy response with the current recession, a quicker recovery could be expected. A “V”-shaped recovery may not mean great growth but perhaps modest improvement. Following this thoughtful defense, Adams shared her thoughts on what P/E ratios, equity risk premiums, and inflation would look like after the pandemic.

When looking at forward P/E ratios, stocks have been at below average multiples. A 15X long-term average may not be a good analysis but 10X earnings are typically seen in a recession. This value may not be observed but deeper recessions are known to have stronger bounces and Adams’s team expects a return to P/E multiples of 22x twelve months after the earnings trough.

The equity risk premium is at record levels. Breaking this down further, the Altman-Z/ Price to book relationship indicates that the market has priced in bankruptcy risk in certain sectors. Adams noted that this has happened very quickly with the COVID-19 crisis and within a matter of three weeks versus the financial crisis of 2008-2009 where risk was priced in over a period of two years.

There has been a lot of discussion among financial professionals about how the governmental response to the COVID-19 pandemic will impact inflation. Adams believes the inflation regime will change over the next decade. We should anticipate deflation or disinflation but macro data suggests a different scenario. Imports and inflation go hand in hand and if deglobalization accelerates, the consumer price index may inch higher. Inputs into the supply chain will become more expensive causing cost-push inflation, which will flow through to the consumer. Additionally, accommodative policies may cause inflation if not carefully rolled back. What does this mean for the equity market? One change we might see is a rotation into commodity-sensitive sectors that benefit from rising commodity prices and inflation.

The presentation concluded with a question and answer session moderated by Tiffany Greenhouse, CFA.

Which metrics are most helpful in trying to determine if there will be an extended recovery or recession?
Adams offered that the infection rate is important as it could drive further shutdowns. Elaborating further she said most indicators are lagged but risks don’t really come up until 3rd or 4th quarter. Technical indicators suggest the bear market may be over but the market seems decoupled with stocks bottoming before fundamentals and earnings catch up. Interest rates and policies are determining stock prices.

What are your predictions for the biotech and healthcare sectors?
With the vaccine race being such a critical part of being able to return to normalcy, the biotech sector has been volatile. Adams commented that the sector’s earnings stability is second to those of technology and close to those of consumer staples.

What’s your position on value versus growth?
Adams stated that an improvement in inflation is needed to get better performance for value. Value is not that cheap and expensive value stocks are making value expensive overall. Value is not producing earnings growth. Value will also do better with a momentum reversion.

What impact will companies with furloughed workers see on returns?
Adams responded that stocks bottom one year before unemployment peaks. While some companies may not survive and this type of destruction may be necessary to move forward, she expects reasonable returns over the next twelve months for companies that do survive. Moving forward is what all of us want.

Watch the full presentation.