The risk premium today, March 29th, is 6.29%. In March 2000, at the Tech Bubble peak, the risk premium was -2.07%. That month Robert Shiller published Irrational Exuberance which showed that the S&P 500 was the most overvalued since 1929. The future is unknown regarding the future of COVID-19, oil prices and the market; however, there appears to be a contagion of panicked concerns regarding the current state of the economy, markets and COVID-19 that we are in a state of Irrational Pessimism.
The risk premium objectively compares the valuation of bonds versus stocks. It compares the yield of the 10-year US Treasury to the earnings yield (the inverse of the Price Earnings ratio) of the S&P 500. Today’s 6.29% level argues that equity investing today makes sense compared to bonds. A prudent investment program might allocate capital to equities over the next several months and/or picking up selective opportunities.
The Federal Reserve Risk Premium model below shows the 22-year history of the S&P 500, its earnings, 10-year Treasury yields, and the risk premium since 1998. The Fed Model below shows historically compelling valuation levels for the S&P 500.
The Coronavirus Crash
The principal driver of the market’s decline has been the coronavirus aka COVID-19. This deadly virus is a relatively unknown enemy compared to economic recessions which have historic precedents that can be studied to provide investment insight and perspective. The coronavirus has had precedents, but those precedents exist in the opaque world of virology. This opaque and deadly virus has exacerbated health and economic pessimism affecting the markets.
The picture below shows a study done by the Royal Bank of Canada (RY) or “RBC”. Its curves-based coronavirus projections demonstrate that the worst-case scenarios are not proving out. We did not have 90,000 dead (Blue Line) from the coronavirus on March 22nd. Nor did the next worst case (Red Line) has not played out either. We do not have 90,000 dead today from the coronavirus either. As of March 29th, US deaths are 2058 and global deaths are 31,971.
Other Positive Facts:
- China and South Korea have turned the corner.
- The US is responding. Safe distancing practice will slow the spread while therapeutics and vaccines are being studies and developed.
- Worst-case projections are not playing out in terms of COVID-19 modelling. See COVID-19 Curves above.
- The two trillion dollar economic stimulus bill should help to blunt the economic impact of the more than three million people who lost their jobs.
- The Federal Reserve is aggressively adding to liquidity to reduce the economic impact of this global health crisis.
- Some promising cures, like Chloroquin, 60 treatment programs and 40 vaccine programs suggest effective medical defenses will be available.
- Testing is ramping up for disease and antibodies to COVID-19. With contact tracing, more powerful protocols can be developed to stop the spread of COVID-19 with less economic impact.
The picture below presented by Dr. Oz of Professor Didier Raoult study of Chloroquin and Azithromycin shows compelling statistical significance through P values of >0.002. Since it was given to patients already sick, it failed to meet the randomized double-blind criteria of the FDA. However, Dr. Oz feels that the P value was so compelling that the high clinical standard of a randomized double-blind study is not needed. Doctors are now using Chloroquin “off label” and the FDA has begun randomized double-blind studies.
A British Forecast is Dramatically Revised Down to Flu Levels.
The article above suggests that Neil Ferguson of the Imperial College of London overstated this coronavirus estimate. He had projected 510,000 would die in the UK. This past week, he revised it to 20,000. That is a revision downward of 25x. Since he projected 2,200,000 million deaths in the US. Adjusting the US number by the same factor - dividing by 25 - equals 88,000. The typical flu kills 10-70,000 people a year in the US.
Since the CDC and the US government do modelling, to what degree, did Ferguson’s numbers or methodology exaggerated potential outcomes leading to draconian economic responses? These examples show that this pandemic is not as grave as our worst fears. How many of these store and restaurant closings might have been an overreaction to flawed data?
Fear is contagious. Psychological negative feedback loops spread and reinforce declining stock markets. The spread of good news and better stock market action is slowing this negative feedback loop in the markets. A bottoming process has begun. This level of irrational pessimism is consistent with a bottom in the S&P 500.
The table below shows the Fed Model Data in March 2000, March 2009 and March 2020. This data shows the historic peak and troughs of the last two decades.
Note the high S&P 500 PE ratio at the Peak in 2000 and the low S&P 500 PE ratios at the Financial Crisis Bottom and today. Note the 10-year US Treasury yields and risk premiums at each of those extremes.
This week’s 3.28 million unemployment claims number suggests a significant economic disruption and risk to S&P 500 earnings. Economist David Kostin of Goldman Sachs now estimates a 33% decline in S&P 500 earnings to $110 in 2020 which will be followed by a 55% rise in S&P 500 earnings to $170 in 2021.
The chart of the S&P 500 below shows the record 31-day 35% peak to trough decline and a rapid 20% rally from March 18 to March 26th. With the likely 33% decline in earnings to $110 and a 55% rebound in 2021, the market’s initial decline has discounted much of the impact of the coronavirus. A bottom is being formed in the market.
Attractive Investments: KYN and KMF
We have bee accumulating Kayne Anderson MLP/MLP Midstream Investment Company (KYN) and Kayne Anderson Midstream Energy Fund (KMF) as these closed ended mutual funds have fundamentally solid Master Limited Partnerships or Midstream energy investments which should provide relatively stable cash flows and income from the impending economic decline.
- KYN and KMF are unusually attractive because forced liquidations which created extremely oversold valuations.
- The underlying cash flows should see a single-digit declines which are not in proportion to their price declines.
- The extraordinary yields of 41% (KYN) and 30% (KMF) should normalize to around 10% leading to likely triples over the next year. The discounts to NAV are 19% (KYN) and 22% (KMF).
- Closed end MLPs may be excellent defensive investments in the event of a recession.
The KYN chart below shows the history of sharp declines and rebounds during the 2008-9 and 2015-6 oil declines.
We have successfully invested in the MLP declines of 2008 and 2016 and expect a similar sharp rebound. Our optimism is based on the stability of the cash flows in the midstream sector combined with the unusually high yields which these investments offer.
Wall Street Loves To Leverage A Good Idea.
Wall Street loves to leverage up a good idea and then take it too far. The positive carry of the high-yielding MLPs financed with short-term investments became widely popular. When the corona crash came, liquidations rained down on leveraged players forcing MLP sales in closed-end funds and margin accounts. This forced selling created the rare opportunity John Templeton and Benjamin Graham look for when bargain hunting: “the opportunity to buy when everyone is selling.”
MLPs were not the only sector to experience forced selling. Mortgages, too, were heavily leveraged and experienced forced selling. Redwood Trust, Inc. (RWT) a mortgage REIT came under intense selling pressure. Last week, on March 25th, they announced mortgage sales and that they were no longer facing margin calls. Mortgages such as the type in Redwood's portfolio should be beneficiaries of the Federal Reserve’s massive unfolding monetary simulative efforts.
Both Redwood Trust and the Kayne Anderson CEFs have delayed their dividends a few months to capitalize on their positive carry trade and accumulate cash. While frustrating to some shareholders, it will give these portfolio management teams more flexibility to reposition their portfolios and maximize their dividend yields during these extraordinarily volatile markets.
The three equities Redwood Trust Inc., Kayne Anderson MLP/MLP Midstream Investment Company and Kayne Anderson Midstream Energy Fund saw 85%, 85% and 86% declines respectively. Their charts are below. The principal reason for these declines is the ferocity of the market decline combined with their inherent leverage which required them to sell securities to risk manage their portfolios. This forced selling has created an opportunity for a bargain. The stability of their cash flows combined with their 21%, 41% and 30% yields, respectively, is why we expect a significant rebound in these securities.
Source: InteractiveBrokers Trader Workstation
In 2008, MLPs Led The S&P Recovery
In September 2008, Lehman Brothers went bankrupt. In November 2008, the Triborough Bridge and Tunnel Authority of New York tried to sell $600 million in bonds unsuccessfully. The deal was pulled. The same week, Kinder Morgan (KMI) priced a similarly large deal which was successfully closed. The fact that an MLP could raise capital, when one of the most stable of municipal issuers could not, supports our confidence in the high-quality cash flows of Master Limited Partnerships.
In November 2008, MLPs bottomed. Five months later, during March 2009, the S&P 500 also bottomed. When S&P 500 earnings bottomed, the S&P 500 turned up. We expect a similar phenomenon to occur in the coming months. Underpriced defensive and income securities will outperform more cyclical and broad-based indices. While earnings will be pivotal to timing the final bottom, clarity on the COVID-19 recovery and an OPEC deal will be critical factors in timing a bottom in the broad-based indices. We expect a final bottom to jump-start a major market rally within six months.
COVID-19 and the OPEC oil collapse have created two sources of uncertainty which have led to a historically rapid and sharp decline in the market. The debunking of the most dire scenarios of COVID-19 like that published by Neil Ferguson of Imperial College of London may lead to a less draconian government response to the pandemic. Goldman Sachs (GS) already anticipates a full and rapid recovery. This decline offers and will offer many great investment opportunities like those available in the aftermath of the Great Financial Crisis.
MLPs bottomed last week on March 18, 2020. The stable cash flows of MLPs will find buyers due to their unusually high yields. MLPs have shown positive relative strength since Wednesday, March 18th. Other yield investments like Redwood Trust, Inc., a residential mortgage REIT, should also enjoy a sharp recovery. Redwood Trust yields 21% and has a $15 book value. These sectors, where there have been forced liquidations due to excessive “carry trade” leverage, are still priced well below the levels they normally trade.
In the coming months, we will look to pick up quality investments which have suffered from the corona recession. Starwood Hotels is a great hotel operator that we will target once traffic begins to return to hotels. Quality franchises which have cut their dividends and or stopped their stock repurchases will also find selling pressure as first quarter earnings are reported. Some of these dividend-cutting quality franchises include Boeing (BA), Marriott International (MAR), Goldman Sachs, JPMorgan (JPM), Delta Air Lines (DAL), and McDonald's (MCD).
These are challenging times, but there are also tremendous opportunities in change and following historic bear markets. We welcome your thoughts and comments.