The black swan event that Wall Street has long feared materialized with the coronavirus epidemic, rattling equity markets and badly shaking investor confidence after an 11-year bull market.
The scale and speed of the recent U.S. stock market losses were stunning. The Dow Jones Industrial Average (.DJI) plunged 3,583 points, or 12%, last week, capped by a 357-point drop on Friday. It was the steepest weekly percentage decline since the financial crisis. The index now stands 14% below its all-time high of 29,551 set on Feb. 12. The S&P 500 index (.SPX) has declined 13%, to 2,954 from its Feb. 19 peak of 3,386, and the Nasdaq Composite (.IXIC) is down 13%, to 8,567.
The old saw is that the one thing Wall Street hates more than anything is uncertainty, and that is true now. The coronavirus impact on the economy and profits is difficult to quantify, and investors fear the worst.
Treasury yields fell sharply, with the 10-year note ending the week at a record low of 1.17%. Muni bond yields are even lower, as risk-averse investors pile into the hot tax-exempt market. The double-A-rated Los Angeles International Airport sold $738 million of bonds last week at a range of just 0.63% for a one-year maturity to 1.44% in 20 years.
Cracks are appearing in the junk-bond market, with the yield spread relative to Treasuries widening by a percentage point. The average junk yield is still less than 6%, but yields in the 10% to 15% range are common in battered energy-sector bonds from leveraged companies like Range Resources (RRC), Southwestern Energy (SWN), EQT (EQT), and Diamond Offshore Drilling (DO).
Treasury bonds hold little appeal relative to stocks and inflation, now running at more than 2%, Berkshire Hathaway CEO Warren Buffett said on CNBC last week. Fearful equity investors, however, are taking little comfort from that relationship out of concern that earnings could crater.
Buffett was also unfazed by the coronavirus, saying on Monday, “It makes no difference in our investments. There’s always going to be some news, good or bad, every day. If somebody came and told me that the global growth rate was going to be down 1% instead of 1/10th of a percent, I’d still buy stocks if I liked the price, and I like the prices better today than I liked them last Friday.” He may like them even better now.
He compared the 10-year Treasury to a stock “trading for 70 times earnings that can’t increase its earnings for 10 years.” This calculation involves taking the inverse of the 10-year yield, then 1.4%. The effective price/earnings ratio on the Treasury is up to 85 now, with the yield down at 1.2%. The earnings yield on stocks—the inverse of the P/E ratio, is more than 5%.
“If somebody came to you with a stock and said, you know, ‘This is a terrific stock. It sells at 70 times earnings. The earnings can’t go up for 10 years,’ you’d say, ‘Well, explain that to me again,’ ” Buffett said.
Investors looking for a haven may want to consider Berkshire (BRK/B) and technology leaders like Alphabet (GOOGL), Microsoft (MSFT), and Apple (AAPL) that have cash-rich balance sheets and durable businesses.
With more than $120 billion in cash and $24 billion of annual earnings power, Berkshire is the ultimate large-cap haven, but it hasn’t been acting like one lately. Investors may be focused on a drop in the value of its equity portfolio that totaled $250 billion at year end, including a big holding in hard-hit Apple and bank stocks. Berkshire’s Class A shares, at $309,000, are down 9% this year, trailing the S&P 500’s total return of negative 8%.
“Berkshire is cheap and misunderstood after all these years,” says Larry Pitkowsky, manager of the GoodHaven fund (GOODX). Berkshire’s big cash position provides Buffett with the “ability to be a capital provider when markets are in disarray.” Buffett did so successfully during the 2008 financial crisis and may get some new opportunities in the coming weeks. He probably has at least $50 billion to readily deploy. Pitkowsky says the stock looks appealing trading for an estimated 1.3 times its current book value. The nearby table shows Berkshire’s net cash of $87 billion after subtracting debt and excluding its railroad, energy, and utility units.
Technology features the best collective balance sheet of any major sector. Google parent Alphabet was sitting on $115 billion of net cash at year-end 2019, 13% of its market value, while Apple had $99 billion of net cash and Microsoft, $65 billion. “Alphabet has a dominant, predictable business, with top-line revenue growth at almost 20%,” Pitkowsky says. The stock, he says, trades for a high-teens multiple of next year’s earnings, excluding its cash and losses in newer businesses.
In industry after industry, it may pay to stick with the strongest companies, including a defensive Verizon Communications (VZ) in telecom, JPMorgan Chase (JPM) and Bank of America (BAC) in banking, Comcast (CMCSA) in cable television, and Chevron (CVX) and ConocoPhillips (COP) in the hard-hit energy sector.
The risks are tough to calculate, but stocks look more attractive. “This is scaring the heck out of people, but it’s rapidly revaluing stocks,” says Jim Paulsen, strategist at the Leuthold Group. “The odds are this will turn out to be good deal for investors that ultimately results in higher highs later this year.”
Corporations “are buying this dip,” according to Goldman Sachs, one of the leading Wall Street firms that execute repurchase programs. In a client note on Friday, Goldman said that corporate buybacks from Monday to Thursday were the “most active days since February 2018,” with two of those days “grabbing spots in our top 10 most active days since 2017.”
Monetary stimulus—with the Federal Reserve expected to cut interest rates at least twice this year—will provide an added boost, Paulsen said. On Friday, the Fed indicated that it was prepared to cut if needed. “The Federal Reserve is closely monitoring developments and their implications for the economic outlook,” Fed Chairman Jerome Powell said in a statement.
One of the biggest challenges is projecting corporate earnings, given the uncertain impact of the coronavirus on the U.S. economy.
Goldman Sachs strategist David Kostin took a shot at it last week, cutting his 2020 S&P 500 earnings forecast to $165 a share from $174, a flat showing versus 2019. That reflects, he wrote, “severe decline in Chinese economic activity in the first quarter, lower-end demand for U.S. exporters, supply-chain disruption, a slowdown in U.S. economic activity, and elevated uncertainty.”
If the economy lapses into a recession, he wrote, S&P earnings could be down 13% this year to $143. If the virus is contained, Kostin sees $170 in operating earnings. With the S&P 500 at 2954, the index trades for 17.4 times Kostin’s high estimate, 17.9 times his middle estimate, and 20.1 times his low projection.
Big energy companies have some of the best yields in the stock market after the group fell to its lowest level since 2009 last week. Oil prices cracked with Brent, the international benchmark, falling 14% last week to $50.50 a barrel, amid fears of weaker demand for jet fuel and other products. Brent is now down 23% this year, while West Texas Intermediate crude is off 27%, to $45 a barrel. The Energy Select Sector SDPR ETF (XLE), dominated by Exxon Mobil (XOM) and Chevron, is now off 25% so far this year, to $45, and yields 5.2%.
Dividend coverage from free cash flow may be insufficient this year at Chevron and ConocoPhillips, but their strong balance sheets give them the ability to borrow to pay their dividend. J.P. Morgan analyst Phil Gresh puts the cash-flow dividend break-even at $56 a barrel Brent crude for ConocoPhillips, $55 for Chevron, and $88 for Exxon Mobil. The high break-even for Exxon reflects its heavy capital spending as it seeks to increase production by about 25% by 2025.
Chevron, at $93, now yields 5.5%; Conoco, at $48, 3.5%. Exxon finished at $51.44, after hitting its lowest level since 2005. It now yields almost 7%. What a comedown for a company that was the largest by market value in the world less than a decade ago. Expect Chevron and Exxon to address their dividends at annual investor day events this week. BP (BP) and Royal Dutch Shell (RDS/B) have lower—and therefore safer—dividend break-evens than their U.S. peers and higher yields. BP, at $31, yields 8.1%, and Royal Dutch Shell, at $45, yields 8.4%.
Gold and mining shares were hit on Friday as investors took profits after the recent run-up. The metal fell $75.90 an ounce on Friday, to $1,564, but is still up 3% this year. Gold’s haven appeal is rising as U.S. rates move lower.
The major gold-mining companies, long known for focusing on growth rather than profits, are now more shareholder-focused, while offering a leveraged play on the metal. Barrick Gold (GOLD), at $19, is run by Mark Bristow, who may be the industry’s best CEO. Newmont (NEM), at $44.63, sees $1.6 billion of annual free cash flow at $1,600 an ounce, a 4.4% free cash flow yield. Its free cash flow rises $400 million for each $100 change in the price of the metal.
“I don’t mind having exposure to an alternative currency, gold, with the macro backdrop of negative rates around the world and increasing fiscal deficits,” Pitkowsky says.
Bank stocks have been clobbered during the selloff, as investors see weaker interest income in a lower-rate environment, increased credit risks, and lower revenue from investment banking and trading.
The major stocks are down an average of nearly 20% since Feb. 19 and now trade for an average of 10 times projected 2020 earnings or less even after recent reductions in earnings estimates.
Industry leader JPMorgan, at $116, trades for 11 times projected 2020 earnings and yields 3.1%. Bank of America, at $28.50, has a 2020 P/E of about 10. Goldman Sachs Group (GS), at $200, trades below its tangible book value of $205 share. So does Citigroup (C), which at $63.46 has a tangible book value of $70. Tangible book has often proven to be a floor under bank stocks, since it amounts to a conservative liquidation value.
The selloff comes after banks have emphasized their greatly improved balance sheets compared with levels before the financial crisis.
“This is an opportunity for the banks to show their strength and demonstrate that they are much more resilient than in the past,” says Wells Fargo analyst Mike Mayo. Leaders in other major industries are also in a position to flex their muscles. If they do, stocks could be a lot higher by year end.
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