June 2020 - Noisy Signals

June! The weather has finally turned for the better and stay-at-home restrictions start to loosen around the country. The stock market has certainly taken to heart the possibility that the economy will improve dramatically in the months to come. As of this writing the S&P 500 is shockingly above 3,000 points, off only ~6% from the start of the year and ~11% off from the market’s peak in mid-February. While I enjoy seeing the recovery, this a quite a noisy signal. Contrary to this recovery, pressure is mounting on BDC’s and leveraged loans. The credit market is still on uncertain grounds as many businesses are forced to operate differently, and millions are still unemployed or furloughed. The 10-Year yield is still near all-time lows (sub 1%), suggesting many investors are not yet certain on when to transition to risky assets. The disparity in the equity and credit markets is a noisy signal, resulting from massive monetary intervention and a relative perspective on the recovery of the economy. Uncertainty will be the theme for the remainder of 2020, and with that the financial markets (including the stock market) will remain volatile as we search for the right signals.

Below is a year-to-date price chart for the S&P 500 and a year-to-date Yield Chart for the 10-Year Treasury.

For reference the recovery in the stock market has resulted in an elevated P/E ratio, >20 times, suggesting an expensive market at the least, and more likely overvalued U.S. equities (WSJ).

A more consistent characteristic of the last three months has been the pressure on leveraged loans. Total outstanding leveraged loans as of April 30th was just under $1.2 trillion with lending across a diaspora of industries from retailers to oil fields to hot dogs (WSJ). Banks were forced to pull-back from riskier lending after the financial crisis, this provided BDC’s and other non-bank lenders a larger borrower pool. Using leverage to juice returns these lenders have become a staple in private equity and middle-market transactions (Private Debt Investor).

These lenders are just now starting to feel the damage, and more is likely; given the sluggish pace with which the U.S. and global economy is returning to normal activity. Signs of this mounting pressure are already showing. A bankruptcy and restructuring lawyer in the linked Private Debt Investor article is quoted suggesting equity investors and lenders are having to make the difficult decision of which portfolio companies to save. These aren’t Fortune 500 companies or might not be included in the S&P 500 but these middle-market companies play a vital role in supply chains, distribution, manufacturing, services, etc. for these companies and businesses across the world. At present it doesn’t appear this risk is included in the current price in the S&P 500.

Adding to the noise in the financial markets is only a partial impact on Q1 Earnings. FactSet analyzed the results of Q1 earnings; revenue growth was above expectations (0.9%) but earnings growth was -14.6%, the largest year-over-year decline since Q3 2009 at -15.7%. Unique to this decline has been the belief of the extreme abnormality and discontinuation of these conditions in the very near term.

Paradoxical to the rally in the S&P 500, analysts surveyed in the report projected continued declines in earnings through 2020, with the biggest drop expected in Q2 at -42.9%. The consensus was earnings growth would not returning until Q1 2021. If earnings decline anywhere near the levels expected, the P/E ratio will easily surpass the height reached in the dot-com bubble.

The market’s optimism (or possibly synthetic optimism from Fed) will be seriously challenged following Q2 results. Cost cutting might provide a temporary relief to negative earnings pressure, but too extensive, and the cuts can will cause more harm than good.

Add all these factors together; continued flight to safety via the 10-year Treasury, pressure on leveraged loans / middle-market lenders and significant earnings pressure for the next 6 months, there is going to be an array of noise in the market. We’re likely to see more volatility as we fast approach Q2-end and through earnings season. It’s everyone’s hope that the worst of the pandemic and the shutdown are past us. Unfortunately that is yet to be determined. Until then, such high public valuations might just be that, hope.