THE RISKS TO THE BULL CASE · 4/20/2020  · there was an important caveat in the much publicized Goldman Sachs bullish U-turn. The bullish call was based on “no second surge in

Cam Hui, CFA | [email protected] Page 1

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Quantitative & Strategy

THE RISKS TO THE BULL CASE

April 20, 2020

EXECUTIVE SUMMARY

In the past few weeks, a number of investors and strategists have turned bullish. We would

like to address the reasoning for the bull case for equities, and the risks to the reasoning.

History shows that recessions are bull market killers, and bear markets do not resolve

themselves this quickly without a prolonged period of adjustment.

The bullish arguments are:

The lockdowns are ending

A possible drug treatment breakthrough

The Fed is coming to the rescue

Investors are looking ahead to 2021, and 2020 is a write-off

After unpacking each of the bullish cases, we have found the risks presented by the

bullish arguments unsatisfactory. We continue to believe, in the absence of a vaccine

or immediate availability of a treatment that mitigates the effects of COVID-19, the

U.S. equity market faces significant downside risk.

Cam Hui, CFA [email protected]

Table of Contents

Reasons to Be Bullish .............................. 2

Easing Lockdown = Growth Revival ......... 3

A Treatment Breakthrough? ..................... 7

The Fed Has Your Back ......................... 10

Look Over the Valley .............................. 11

Cam Hui, CFA | [email protected] Page 2

April 20, 2020

Quantitative & Strategy

Reasons to Be Bullish

In the past few weeks, a number of investors and strategists have turned bullish. We would like

to address the reasoning for the bull case for equities and the risks to the reasoning. History

shows that recessions are bull market killers, and bear markets do not resolve themselves this

quickly without a prolonged period of adjustment.

Exhibit 1: Recessions Are Bull Market Killers

Source: FRED, Federal Reserve Bank of St. Louis

The bullish arguments are:

The lockdowns are ending

A possible drug treatment breakthrough

The Fed is coming to the rescue

Investors are looking ahead to 2021, and 2020 is a write-off

Cam Hui, CFA | [email protected] Page 3

April 20, 2020

Quantitative & Strategy

Easing Lockdown = Growth Revival

One point made by bullish analysts is the coronavirus-induced lockdown and distancing policies

are easing. Confirmed COVID-19 case growth and death rates are leveling off and declining.

Parts of Europe, such as Germany, are starting to ease their lockdown restrictions, and Trump

has issued guidelines for a phased re-opening of the economy. These measures should lead to

a growth revival, which would be bullish for stock prices.

The growth revival can be an important bullish catalyst, if it works. Bloomberg reported that

there was an important caveat in the much publicized Goldman Sachs bullish U-turn. The

bullish call was based on “no second surge in infections”.

A combination of unprecedented policy support and a flattening viral curve has “dramatically” cut

risks to both markets and the American economy, strategists including David Kostin wrote in a note

Monday. If the U.S. doesn’t have a second surge in infections after the economy reopens, equity markets

are unlikely to make new lows, they said.

The Street is already penciling in a V-shaped rebound in consensus earnings expectations.

Earnings are expected to bottom out in Q2 and return to normal by Q4.

Exhibit 2: Quarterly EPS Estimates Indicate a V-shaped Recovery

Source: FactSet Information Systems

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April 20, 2020

Quantitative & Strategy

How realistic are those expectations?

Ask Singapore about what happens if you try to open up an economy prematurely. David

Leonhardt outlined the risks in a NY Times Op-Ed. The island nation’s response has been a

model for other countries, and it was able to avoid many of the draconian distancing measures

imposed elsewhere:

Singapore’s approach has certainly been aggressive — and more effective than the American approach.

In January, as the virus was spreading within the Chinese city of Wuhan, Singapore officials began

screening travelers arriving in their country and placing anyone who tested positive into quarantine.

Singapore also quarantined some travelers who didn’t have symptoms but had been exposed to the

virus. And Singapore tested its own residents and tracked down people who had come in contact with

someone who tested positive...

Thanks to that response, Singapore had been able to avoid the kind of lockdowns that other countries

had put in place. Restaurants and schools were open, albeit with people keeping their distance from

each other. Large gatherings were rare. Singapore, in short, looked as the United States might look

after the kind of partial reopening many people have begun imagining.

The preventive measures eventually failed, and Singapore has reverted to the standard

lockdown methods used elsewhere:

But Singapore doesn’t look that way anymore. Even there, despite all of the successful efforts at

containment, the virus never fully disappeared. Now a new outbreak is underway.

The number of new cases has surged, as you can see in the chart above. In response, the country

announced a lockdown two weeks ago. Singapore’s “present circumstances,” Carroll writes in a piece

for The Times, “bode poorly for our ability to remain open for a long time.”

Exhibit 3: New COVID-19 Case Growth in Singapore Has Exploded

Source: Worldometer

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April 20, 2020

Quantitative & Strategy

Even if lawmakers wanted to open up the economy, the inevitable questions come up of how willing are people to return to restaurants, movies or to send their children to camp this summer. A recent Gallup poll found that only 20% of respondents were willing to return to pre-pandemic normal activity immediately.

Exhibit 4: If Politicians Opened the Economy, Would Americans Show Up?

Source: Gallup

Attitudes were most divided among the urban-rural axis and by party identification. Still, only 23% of rural residents and 31% of Republicans were willing to return to normal immediately. These figures represent significant minorities of the population.

Exhibit 5: Attitudes Split Along Urban-Rural and Political Divides

Source: Gallup

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April 20, 2020

Quantitative & Strategy

Other polls confirm the Gallup results.

An Axios/Ipsos poll found a similar level of skittishness

A Harris poll found that most Americans wanted to wait a month before “starting to

return to work and life as normal”

A Seton Hall poll found that 72% would not attend a live sports event like a football

game unless a vaccine is found

The polling data suggests that any effort to re-open the economy will not be instant. Even if

the easing measures are successful, growth and employment are likely to return slowly.

For the last word on this topic, we refer readers to Wall Street executive and Morgan Stanley

CEO James Gorman. Gorman stated in a CNBC interview that he believes the economy will

not return to normal until late 2021:

Morgan Stanley CEO James Gorman sees the coronavirus-induced global recession lasting for the

entirety of this year and 2021.

When asked about how a potential economic recovery expected in the second half of this year would

take shape, Gorman said that while he hopes it will be a sharp “V” recovery, in reality it will probably

take longer to reopen cities and factories.

“If I were a betting man, it’s somewhere between a ‘U’ or ‘L’” shaped recovery, Gorman told CNBC

Thursday in an interview. “I would say through the end of next year, we’re going to be working through

the global recession.”

Metal prices also show a similar lead-lag pattern with stock prices. While gold has its unique

characteristics and bullion marches to the beat of its own drummer, silver, copper and platinum

all turned up ahead of stock prices at the last two bear market bottoms. There is no evidence

of similar buy signals today from any of these commodities.

Cam Hui, CFA | [email protected] Page 7

April 20, 2020

Quantitative & Strategy

A Treatment Breakthrough?

Some of the expectations about the pace at which the economy can be re-opened could change.

A report from Stat created some excitement after the market closed Thursday. There were

reports of promising results from the Gilead drug remdesivir in the treatment of COVID-19

patients:

The University of Chicago Medicine recruited 125 people with Covid-19 into Gilead’s two Phase 3

clinical trials. Of those people, 113 had severe disease. All the patients have been treated with daily

infusions of remdesivir.

“The best news is that most of our patients have already been discharged, which is great. We’ve only

had two patients perish,” said Kathleen Mullane, the University of Chicago infectious disease specialist

overseeing the remdesivir studies for the hospital.

Before anyone gets overly excited, these results are highly preliminary. This test had no control

group. The drug is given intravenously, and hospitals would still be overwhelmed if public

health policy allow the infection rate to surge. A New England Journal of Medicine article which

outlined the “Compassionate Use of Remdesivir for Patients with Severe Covid-19” had

considerably less exciting results, as “clinical improvement was observed in 36 of 53 patients

(68%)”.

Exhibit 6: Compassionate Use of Remsdesivir for Patients with Severe COVID-19

Source: Annie Leutkemeyer, University of California San Francisco

In addition, Gilead revealed that the company has a limit supply of the drug.

As of January 2020, we were not actively manufacturing remdesivir. The manufacturing supply chain

was scaled to periodically make small amounts of product for a compound in early development. We

had inventory of finished product to treat just 5,000 patients.

Since then, we have proactively and rapidly scaled our supply chain. As of late March, using the active

ingredient we already had in our inventory, we have increased our supply to more than 30,000 patient

Cam Hui, CFA | [email protected] Page 8

April 20, 2020

Quantitative & Strategy

courses of remdesivir on hand, assuming a 10-day course of treatment for patients. As new raw

materials arrive over the next few weeks from manufacturing partners around the world, our available

supply will begin to rapidly increase.

Even if the trials were proven to be successful, ramping up production will be a challenge.

Gilead’s stated production goal, which may or may not be successful, is shown as:

More than 140,000 treatment courses by the end of May 2020

More than 500,000 treatment courses by October 2020

More than 1-million treatment courses by December 2020

Several million treatment courses in 2021, if required

In short, remdesivir is potentially a promising treatment, but production problems may make

this a “too little, too late” solution in light of the number of widespread incidence of COVID-

19 around the world. The time frame for the widespread availability of this drug isn’t

significantly better than a vaccine, assuming that a vaccine could be found in a relatively short

time. Moreover, the drug does not protect anyone against infection, or COVID-19. It is just a

treatment for patients who are in ICU.

Assuming that remdesivir were to become an effective treatment with limited availability, here

is what that means to the U.S. economy over the next 6–12 months. Initial jobless claims have

skyrocketed to all-time highs in recent weeks. The continuing jobless claims report, which is

released in conjunction with initial claims, measures the devastation to the job market.

Arguably, reported continuing claims is under-reported because the latest figures are

inconsistent with the last few weeks of rising initial claims, and it is difficult to believe that

people have magically found jobs in the current environment. In all likelihood, the lower-than-

expected continuing claims figure is attributable to the inability of state bureaucracies to process

the flood of claims. Now imagine a best-case scenario where the economy opens up again and

half of the laid off workers suddenly found jobs. Even under this rosy scenario, continuing

claims would be worse than the highest levels seen during the Great Financial Crisis. Are those

recessionary conditions in anyone’s spreadsheet?

Exhibit 7: Continuing Jobless Claims

Source: FRED, Federal Reserve Bank of St. Louis

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April 20, 2020

Quantitative & Strategy

The economic impact of the job losses are probably higher than most analysts' expectations.

So far, the initial round of layoffs have largely been concentrated in low-wage service jobs. A

recent WSJ article reported that a second round of layoffs is now hitting better paying white

collar workers, which will have greater effect on consumer spending because of their (previous)

higher spending power. No one is immune, Bloomberg reported that even Google has

announced that it is significantly slowing its hiring for the rest of this year, and it has announced

selected cost-cutting initiatives.

Exhibit 8: White Collar Jobs Are Not Immune to Layoffs

Source: Ziprecruiter

Cam Hui, CFA | [email protected] Page 10

April 20, 2020

Quantitative & Strategy

The Fed Has Your Back

Another point made by the bullish camp is the flood of stimulus that has been unleashed by

the fiscal and monetary authorities. In particular, the Federal Reserve and other central banks

around the world have acted quickly to provide a tsunami of liquidity for the markets.

That’s bullish, right?

The answer is a qualified yes. Bear in mind, however, this latest crisis is different from previous

recessions like the GFC. The COVID-19 recession began on Main Street, while most of the

past recessions began on Wall Street. Fiscal and monetary measures can remedy financial

recessionary conditions, but they have limited effectiveness if the crisis begins in the physical

economy.

The question investors have to ask themselves is what this flood of stimulus will do to the Main

Street economy. Congress and the Fed, despite all of their fiscal and monetary powers, cannot

find a vaccine or a treatment. If the effect of these measures only act to compress risk

premiums, which is important to financial stability, the stimulus is less likely to leak into the

real economy.

Remember the monetary equation, GDP = MV, where GDP growth is a function of money

supply growth and monetary velocity. During past recessionary periods, the Fed has engaged

in monetary stimulus, which boosted M1 growth (blue line), but monetary velocity (red line)

fell. Will 2020 be any different?

Exhibit 9: Monetary Velocity Has Fallen in Past Recessions

Source: FRED, Federal Reserve Bank of St. Louis

Can stock prices regain their long-term footing without a revival in economic growth?

Cam Hui, CFA | [email protected] Page 11

April 20, 2020

Quantitative & Strategy

Look Over the Valley

The last major advice made by bullish analysts is to look over the valley. Equity valuation

appears expensive now, but 2020 is said to be a write-off and investors should be looking

forward to the recovery in 2021.

Here is the key risk to that bullish argument. The market trades at a forward P/E ratio of 18.5,

based on bottom-up derived blended forward 12-month EPS estimates from company analysts.

This valuation is higher than the 5-year average of 16.7 and 10-year average of 15.0.

Exhibit 10: S&P 500 Forward P/E

Source: FactSet Information Systems

Right now, bottom-up earnings estimates are little better than fiction because company analysts

have little guidance from corporate management on the 2020 outlook, never mind 2021. On

the other hand, top-down strategists have developed 2021 EPS estimates based on economic

models, based on their best-guess assumptions of the economy next year. The consensus top-

down 2021 estimate is about 150.

Based Friday’s prices, the forward 2021 P/E ratio is a nosebleed 19.2. This begs a number of

difficult questions for the bulls.

How much more upside do you expect when the market trades at a forward P/E ratio that is

higher than its 5- and 10-year averages? That’s assuming that earnings are recovering in 2021.

Should investors start to discount what amounts to a highly uncertain 2022 earnings two years

in advance?

If you accept that a forward P/E ratio that is above its 5- and 10-year average as appropriate,

how do you model the Fed’s withdrawal of stimulus, which would expand risk premiums and

therefore depress P/E multiple?

In conclusion, we have find the risks presented by the bullish arguments unsatisfactory. We

continue to believe that, in the absence of a vaccine or immediate availability of a treatment

that mitigates the effects of COVID-19, the U.S. equity market faces significant downside risk.

Cam Hui, CFA | [email protected] Page 12

April 20, 2020

Quantitative & Strategy

Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am

confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit

every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but

final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing

this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for

the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may

contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and

assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of

the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,

express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.

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