Valuentum Exclusive Analysis for the Discerning Investor

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The emergency 50-basis point Fed rate cut announced March 3 was largely expected by the marketplace in light of growing economic concerns due to COVID-19, but it does nothing to immunize against COVID-19 and little to stabilize the situation. We continue to monitor the situation closely, and we expect ongoing volatility in the coming days and months as the situation with COVID-19 remains fluid. Having moved to defensive positions in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio in January and having capitalized on the “crash protection” put, we are preparing for our next move. For now, we’re watching and waiting, and we encourage readers that have not yet picked up their copy of Value Trap to do so.

By Brian Nelson, CFA

Let’s first recap some current events. On Thursday, February 27, the Dow Jones Industrial Average (DIA) dropped the most in its history, falling 1,191 points. Just a few days later, on March 2, the Dow Jones Industrial Average rose the most in its history, increasing 1,294 points. According to my good friends at Morningstar, “Last week's showing was indeed rare. The final week of February 2020 rates as the third- worst Monday-through-Friday by performance by the S&P 500 since 1976. There haven't been many weeks that placed close to it, either.”

Headlines across the media have been marking stock market history, “The S&P 500 suffers its quickest correction since the Great Depression.” Never before has the stock market gone from a record high to a “correction” (a decline of 10%+) in such a short amount of time. Black Monday in October 1987 was a cataclysmic one-day event, but the market had peaked a couple months before that. In the case of these past couple weeks, we’ve gone from euphoric and irrational highs to fall more than 10%, a harrowing, whipsawing episode.

Though we maintain that the COVID-19 outbreak remains a serious situation with material global economic implications, it has only served to expose the shakiness of market structure. For example, the market closed up 1,294 points March 2, but prior to the open that day, Dow Jones Industrial Average futures had been indicated down about 300 points, making the trading session one of the biggest ranges on record. Through most of last week, moves in the Dow Jones Industrial Average of 400-500 points or more in a matter of minutes during trading sessions have somehow become “normal.”

Expect More Market Volatility Ahead

The book Value Trap: Theory of Universal Valuation is much more than a theory that ties together quantitative multi-factor models to the expected return function of enterprise valuation, showing that risk factors must be forward-looking in nature (a huge shift in quantitative thinking). The book is much more than a documented thesis in the value-timing dynamics of overlaying technical/momentum indicators with tried-and-true enterprise valuation. In showing how all valuation multiples are but shortcuts and ambiguous, as in the failures of the traditional quant B/M value factor, the text is more than a warning about the demise of traditional quant value analysis, which is off to one of its worst start in 2020 in decades.

The book Value Trap is more than a telling of the story of a team of analysts that identified a mispricing across a major sector, went against the crowd with their unpopular views, and despite all odds, was proven correct in time. On a price basis, from mid-June 2015 through March 2, the S&P 500 (SPY) has advanced 46%, while the Alerian MLP ETF (AMLP) has declined nearly 58%, a huge source of alpha. According to data from CBRE Clarion through September 2019, there have now been 111 distribution/dividend cuts. Many more have occurred since then, too.

Value Trap offers much more than this. It also warns about the current market structure, and how the markets have become in some ways, a risky place for even the most risk-tolerant retirees to park their hard-earned savings. Volatility has always been part of the stock market, but swings of the magnitude of last week and on Monday, March 2, are simply not “normal.” Quite simply, if we have to point to the Great Depression and Black Monday of 1987 as analogs for what is becoming normal trading activity these days, we’re stretching to rationalize current market behavior, like a frog in boiling water.

Why We Closed “Crash Protection” For Now…

During the trading session March 2, we released the following note (edited lightly for clarity):

I wanted to thank each of you so much for the kind words expressed this week about our service and how once again we were ahead of the herd with respect to "crash protection." …we are now removing that "crash protection," and closing the put option position in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio for a solid double ($6.50). 

As we have announced previously, beginning April 2020, we'll be starting to release via email options-related ideas (two per month) and commentary, as well as educational information, to those that have subscribed to this feature. We will denote options commentary with the word 'OPTIONS' at the start of any email title for those adding this feature.

Depending on market opportunities, ongoing ideas could include commentary associated with writing covered calls for income, identifying mispriced securities over distinct time horizons and identifying mispriced volatility, as well as other considerations. The additional options commentary will only be released to members that subscribe to this feature. It will not be published on any website, or produced in any newsletter.

Please consider subscribing to this new options-commentary feature here ($500/year). We continue to expect heightened volatility accentuated by price agnostic trading, and we'll be looking to add more protection in the future as the COVID-19 news remains fluid. Our March 1 piece on COVID-19 can be found here. Thank you!

We received a number of questions on this move (e.g. Is the worst over?), and we wanted to further expand on our rationale for why we made that move March 2. When we wrote our piece February 22, “Is A Stock Market Crash Coming…,” we thought the market had been mispricing the COVID-19 risk on the broader economy and forward estimated earnings, and we also noted the vast overpricing of equities in light of the current situation at that time.

One week later, the magnitude of declines in the market were fierce, prompting the Fed to start talking about cutting rates (in fact, the Fed just cut rates 50 basis points while we were writing this). On the basis of the magnitude of declines since we added “crash protection,” one might have only expected some retracement Monday (which happened) before additional news regarding community spread in the United States might send the markets lower again.

Hence, it made sense to take the put option off the table…for now. We exercise prudence and care with respect to our idea generation and the significant success of this put-option idea was worth locking in, from our perspective at that time (options have eroding time value). The situation with respect to COVID-19 remains fluid, and we could see additional downside, which may warrant “protection” again.

A number of weeks before last week’s crash, we had moved the simulated newsletter portfolios to more defensive positions. This latest put idea is just another example of how are able to add significant value to those that manage portfolios. We may add “crash protection” again in the near-future as we assess time duration and volatility pricing.

On the Emergency Federal Reserve Rate Cut

The Fed’s emergency 50 basis-point rate cut may bring some relief to the market selling, but whether it will act as sustainable support for more selling to come is questionable. Lower rates may help some businesses impacted by COVID-19 to access capital to stave off a cash crunch, but by and large, the emergency 50-basis point rate cut is largely inconsequential. Lower borrowing costs do nothing to immunize the United States from COVID-19.

From our perspective, the move is psychological and may end up backfiring if investors see through the Fed’s intentions to prop up the equity markets with monetary policy. In some ways, for the Fed to act in such a manner, it may only contribute to the fear that is already wreaking havoc across the global economy and local communities impacted by COVID-19.

Moody’s believes that “Fed Rate Cuts May Fall Short of Stablizing Markets,” and the credit rating agency notes that a “A pandemic will result in global and U.S. recessions during the first half of this year. The economy was already fragile before the outbreak and vulnerable to anything that did not stick to script. COVID-19 is way off script.” We’ve been outlining a similar thesis since January, “Coronavirus May Trigger Long-Anticipated Global Recession,” and if the latest February data from China is indicative of what to expect in other infected countries, markets still have a ways to fall.

In our February 22 note, “Is A Stock Market Crash Coming…,” we detailed a scenario where valuations could reset the S&P 500 to levels 20%-30% lower. At that time, we also indicated that investors should expect moves in the 1,000-2,000 point range in the Dow Jones Industrial Average. These types of unbelievable moves on the Dow Jones Industrial Average have materialized.

In our latest COVID-19 note, released March 1, we have now more officially established a short-term target range for the S&P 500 of 2,350-2,750 (significantly below current levels). We expect things to get much worse, before they get better. The fluff has yet to leave market valuations, in our view, as many appear all-to-eager to put new capital to work as the complacency of the past decade and a buy-the-dip-at-any-price mentality remains present. We maintain our view that the “buying opportunity” is not yet here.

Concluding Thoughts

The emergency 50-basis point Fed rate cut announced March 3 was largely expected by the marketplace in light of growing economic concerns due to COVID-19, but it does nothing to immunize against COVID-19 and little to stabilize the situation. We continue to monitor the situation closely, and we expect ongoing volatility in the coming days and months as the situation with COVID-19 remains fluid. Having moved to defensive positions in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio in January and having capitalized on the “crash protection” put, we are preparing for our next move. For now, we’re watching and waiting, and we encourage readers that have not yet picked up their copy of Value Trap to do so.

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