Brad Neuman, CFA Senior Vice President Director of Market Strategy
Brad Neuman, CFA, the firm’s director of market strategy, shared his views on the markets and the economy on a recent conference call.
leverage, and as I mentioned, value are underperforming. Economic estimates right now are extremely in flux, but a lot of the numbers that we're seeing from our economists that we work with are kind of down low-to mid-single digits in the first quarter, down double digits for the US in the second quarter, and then a rebound in the second half. Now interestingly, the last time the GDP was down double digits for a quarter was the first quarter of 1958. That's somewhat interesting because that was the last time that we had global pandemic. It was the Asian flu pandemic. It killed 1.1 million globally and 116,000 people in the United States. Also, the next three quarters after that global pandemic GDP was up 3%, up 10% and then up 10%. So there is some precedent for a very sharp decline and somewhat of a sharp comeback. I think, economists are taking their cues from China, which may look – they report year-over-year numbers, but they're sequentially probably in the first quarter were down something like 30%, and we believe they're going to be up significantly in the second quarter. Based on China's experience and based on history, we think it's not unreasonable to expect double-digit declines in the US GDP followed by some significant snapback.
Please note this transcript is from a call on March 20, 2020 and it has been edited for clarity and brevity.
Brad Neuman: Thank you all for joining us today. The format of this call is that I'm going to go over five points: so what's happened in the market so far and the economy; number two, what the sentiment is; three, what stimulus is looking like; four, where we are with the virus; and five, what to do with your capital and what valuation looks like in areas that we think are attractive. Number one, what's happened so far? Well, the markets are down 30% in the U.S. peak to trough, that is fully pricing in a recession. The peak to trough average in around a recession is 22%. In fact, this drop would put us number three in the past 11 recessions. So one of the larger peak to trough declines so far. Globally, stock markets around the world have lost $25 trillion. Under the covers a little bit, what's happening within the stock market? We'll go into this a little bit further later on. But growth is dramatically outperforming value in large cap by nearly a 1,000 basis points, Russell 1000 Growth versus the Russell 1000 Value.
In terms of factors, over the past month, size and profitability are dramatically outperforming while
One important metric that you can watch is weekly jobless claims. It's one of the most frequently released economic indicators. And it exceeded expectations for last week dramatically. We think that it could easily exceed 1 million and possibly even hit 2 million coming up this Thursday. The old peak was 665,000 in March 2009 during the Global Financial Crisis. Just to put it in context, 2 million people filing for initial jobless claims would be 120 basis point increase in unemployment. So that's going to be kind of a good real-time indicator. So that's the first point about what the overall backdrop is in terms of the market and the economy. Number two, I want to tackle sentiment. Obviously, investors are extremely anxious and afraid. We can quantify that a bit. The VIX, which is the implied volatility in S&P 500 options, hit a record high recently, even higher than the Global Financial Crisis. People are taking money out of assets. You can see that with very high correlation between asset classes. Money market funds just a hit nearly $4 trillion, that's up over 20% with the highest weekly inflow ever, including the Global Financial Crisis last week of nearly $100 billion dollars. gold and treasuries to trade down with risk assets, which is unusual. And there's a sign of a liquidation mode. I'd contrast that a little bit with what executives are doing. We look at insider buying from our partner, InsiderScore. They've been looking at this data for over two decades and they're seeing insider buying across market caps the highest in over a decade, and specifically in small caps, the highest ever. Executives at these companies who are seeing real-time fundamentals and are aware of the long-term value of these companies are buying in significant numbers and quantity, while investors are selling. I think that's an interesting dichotomy to be aware of. Moving on to number three--stimulus. Seems like every hour there's increasing amounts of stimulus being announced. Obviously, the U.S. quantitative easing over $700 billion at a faster pace and then QE3. The European Central Bank is on track to purchase €1 trillion by December. And, of course, fiscal stimulus recently proposed in excess of $1 trillion or $1,200 per person. You have monetary and fiscal stimulus. Investors are very fearful. They're selling what they can that's causing, on many days, safe haven assets like
But I would take a step back and look at in the following way. Ultimately, there's a trade-off between the economy and health. And if we want to preserve – keep people as healthy as possible and stop the economy, we can do that. There's a cost to that. In my view, it would be something like $1 trillion a month. I say that because the U.S. GDP is approximately $1.8 trillion a month. And if we're going to stop the economy and many industries are completely stopped, of course, there's going to have to be significant stimulus. So if the government wants to keep things closed and keep people healthy, it can do that, but it's going to need to stimulate. I'm pretty optimistic that the government is in “whatever it takes” mode. I think the government realizes that if the economy is going to be stopped, those stimulus checks have to come. I think the most encouraging score there is that the phase two bill for coronavirus was recently passed by the Senate 90 to eight. There is some bipartisanship, which is, of course, very nice to see and shows that people on both sides of the aisle are willing to do whatever it takes to stimulate. And I think you're seeing some elements of that around the world. I want to address the virus in what we're tracking. First of all, we're very focused on individual country curves. Obviously, the media reports that the virus has been increasing exponentially, and that's of course true. We know from science though that infectious disease doesn't spread exponentially forever. There's what we call an epi curve, where virus transmission increases rapidly, peaks as more people become immune and infected, or in this case, potentially social distancing works to some extent, and then ultimately declines. That's what happens with the flu. It's what happens with all sorts of infectious diseases. Korea and China have already bent that curve and have seen significant deceleration. We’re watching Italy extremely closely. Unfortunately, it's been about 3,000 to 4,500 new cases per day for the past five days. But I would look at that one very closely over the next five days to see if there's some deceleration. I'm hopeful that there will be.
Interestingly, and while we've been dialed in, there's been even some more breaking news on some treatments. I think that the most promising may be chloroquine, which is an anti-malaria drug. Bayer is donating 3 million tablets. Teva is donating 6 million tablets. While we were on the phone and dialing in, the French Infectious Disease Board said the combination of that drug and another is working extremely well. There was recently a trial that showed extremely strong results. And there were other drugs as well that are showing some promise. We're looking at the curves very closely and we certainly would not count out American and global innovation to stem this disease. Finally, I want to tackle what to do with your capital, where valuations are, what areas of the market we think are attractive, and how to look at capital markets right now. In terms of valuation, the earnings yield, if you look at it on a trailing basis – we don't really know what forward earnings numbers are right now because of the changes in the economy. But if you look at trailing earnings yield on stocks, that's just the inverse of the price earnings multiple, so earnings divided by the price. That trailing earnings yield is exceeding Treasury yields by about as much as it did in the Global Financial Crisis, nearly six percentage points. And that's about three times as long- term average. Stocks based on trailing earnings, or we'll call that earnings power, look attractive in our opinion. I'd also take the long-term view for your clients and your outlook. In the long term, stocks are much more likely to outperform than in the short term, obviously, they're much more volatile. According to our analysis of Morningstar data, stocks outperform two-thirds of the time on a one-year basis when we've looked over the past (from 1950 – 2019), but they've outperformed bonds 100% of the time over 20 years. In fact the worst 20-year rolling return for stocks is still a mid-single-digit type of return.
mentioned earlier. So one is that growth is much less cyclical than value stocks. We've gone back and looked at the past couple of recessions. And while value stocks have seen their earnings decline approximately 40% in recessions, growth stocks were able to hold their earnings relatively constant. The second reason is growth stocks traffic in much more digital areas of the economy than physical. And, of course, physical goods are subject to border closings etc. In fact, right now, while the production of automobiles and other industrial equipment has come to a standstill and supply chains are, of course, very adversely affected as goods are having trouble going around the world, internet traffic is surging. It's up 60% and 90% in the UK and Italy, respectively. The fourth reason is growth stocks have dramatically better balance sheets. They're much less levered than value stocks. And we think having a strong balance sheet is really the key to getting through this crisis. Large companies that don't have to compromise on their growth initiatives and don't have risk of restructuring their debt because they are cash rich. Those are the companies that we believe can survive and thrive in the future. So it’s an important point. And I mentioned earlier that levered companies are underperforming and they underperformed significantly in the Global Financial Crisis. And then finally, growth stocks are more innovative and we've written a lot about that. I invite you to look at Alger Insights page for more information. But basically growth and value stocks are typically divided up by the price-to- book value ratio. And we think that that ratio is structurally flawed, given that most companies are investing in innovation, R&D and tangible assets these days, which are not reflected in the balance sheet. Third reason is that growth is less exposed to low interest rates. Value stocks have a lot more exposure to financials that struggle with lower interest rates.
In terms of where to invest? We favor growth for several reasons. And growth is dramatically outperforming, as I
I'd mentioned that, that within these areas of growth – these growth stocks, there are always areas of growth no matter what's happening in the economy. I know that's hard to believe with regard to the current situation when it seems like the entire world has stood still. So first off, historical example in the Global Financial Crisis, when GDP didn't grow for three years and retail sales were flat and the stock market was stagnant, e-commerce and internet advertising, both grew 30%. And what we try to do at Alger is, one, look for those areas of the economy that are going to grow, irrespective of what's happening in terms of recession, panic, what have you, and, two, to find companies that are levered to those areas of growth. So, for instance, Amazon obviously levered e-commerce in that very difficult Global Financial Crisis in the three years from the second quarter of 2008 to the second quarter of 2011, went from over $70 a share to over $200 a share. Today, we actually had one company that I won't name for compliance reasons. But one company that we hold in some of our portfolios, let's say, a cybersecurity company, report earnings today. And not only did they beat expectations but they guided above consensus significantly. And it just shows you that some industries are really non-discretionary like cybersecurity. You just can't cut back on that and are still in growth mode. And the other – so that's the one area that we like. Another thing we would highlight is a software-as-a- service. A lot of our strategies are overweight software in general. That’s our probably our largest overweighted industry across the firm. And not only is software we think a growing industry because of the digitalization across the American and global economies, but it's also a subscription-based service, which means that large companies, like Microsoft, we may get the estimates slightly wrong because of what's happening in the economy. But when you have a company like Microsoft that generates more than 80% of its revenues on a subscription basis, it's hard to get the revenues and earnings dramatically wrong. And so we favor companies where their revenues and earnings are more locked in rather than being simply discretionary.
Lastly, I just wanted to point out in thinking about how to invest. We're talking about what areas of the market that we like in terms of active management. Active management may be setting up for a very good period coming up. I mentioned earlier on the call that correlations between asset classes are very high. Well, correlations within the S&P 500 between stocks within the S&P 500 are actually the highest they've ever been since the two or three decades that we have on record in terms of data. And what that means to us is that a lot of good quality companies are going down with the companies that are less well-positioned, in other words, throwing babies out with the bathwater. And so we think that if managers are able to sift through that rubble and pick good quality companies, there may be significant amounts of alpha to be generated in the months and quarters going forward. Speaker Question : I was wondering if you could comment about what's going on in the bond market. I realize you’re growth equity guys. But the bond market and the potential for the disruption, ripple effects, whatever that it could carry over to the equity market. Brad Neuman : There is a lot of disruption and the Treasury markets haven't been functioning that well amazingly. Muni market hasn't been functioning that well and the corporate bond market, of course, has been under duress. The Fed just this morning announced some support for buying municipal. So hopefully that will help there. They've, of course, already given support to the commercial paper market and the money market funds. I believe that the Fed is in whatever it takes mode on those areas. So with that operator, I'd like to open it up to your questions.
Treasuries, the Fed purchased a lot at the beginning of this week. I think it was $40 billion, and that helped earlier on in the week. And then when the fiscal stimulus proposal was announced, I think, we saw the largest increase in interest rates in decades. I would look for the central bank to continue to print money and purchase until those gyrations in the bond market decline. But you were probably focused more on corporate bond market in that question. Corporate spreads have risen by well over a 100 basis points and they’re under significant duress there. In the high yield market the weighting to energy stocks where there's going to be significant amount of bankruptcies if oil stays anywhere close to where it is now, that weighting is over 10% for the energy sector in the high- yield market, whereas in equities, it's only a low-single digit number, 2% or 3% in the U.S. So there's no doubt that there will be significant corporate losses and bankruptcies. In fact, if you looked at what corporate spreads imply for the P/E multiple, they would still imply the P/E multiple to go lower. So that's something that we're watching carefully. And at the end of the day, this is why at Alger we're so focused on good balance sheets, because if you have leverage, you have two problems. You have to service your debt, which means that as your cash flows go down, you have to redirect cash flows from investments that are good for your business to investments that are simply keeping your business alive. And two, you are dependent on the capital markets to roll over your debt. Obviously, debt has – matures and not everybody's maturities are all many years from now. Some of them – there's a lot of maturities this year and next. And so you're relying on the capital markets to stay open. And while we're very confident in our growth companies growing through these types of recessions, because we've seen it time and time again, in fact, I've written a paper on it called The Enduring Force of Innovation, where we've looked back 150 years and seen areas of growth in any type of economy. The fact is, is that the company has to survive and it can't be restructured,
because then equity holders lose out no matter how strong the company is. So that's why we're very focused on good balance sheets. Speaker Question : I know you are a traditionally fundamental buyer from the perspective of looking at individual equities. I'm wondering how much attention do you pay to market technicals? It looks like we're getting a bit of a relief rally from a deeply oversold condition. Do you look at that? Do you consider that we may roll over and we'll test the low or do you not think we'll do that? Brad Neuman : You're right. We are fundamentally based and we try not to trade based on stock charts and momentum, but we certainly look at technicals and where support is and we are kind of near a support line at 2,400. But that's not something that guides us in terms of how we invest. We really invest bottom-up, one company at a time. It’s something that I look at from a macro perspective, but it's not something that our portfolio managers use when they invest in individual companies and construct the portfolios. I wouldn't say that we rely on it or have anything too meaningful to say about the technicals right now. The things that I'm more focused on in terms of technicals are kind of the sentiment technicals. I think sentiment is very important. So not only do we watch VIX, like I mentioned to you, and as a firm, we're very aware of insider buying as I mentioned, and flows into money markets. But there are even other technicals that we look at, the put-to-call ratio for instance, how many puts are being bought for every call. We watch that as a measure of contrarian kind of technical indicator. And that is very high, and, again, indicative of extreme pessimism, which oftentimes can mean a bottom, although it also oftentimes can be early. It was early in the Global Financial Crisis. So those are the technicals that I'm more focused on rather than the actual stock charts.
If you have any further follow-up questions that come up in the course of the next week, please contact your local Alger representative. Thanks very much for your time.
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