Last week we wrote, “The S&P 500 is very oversold and due to bounce this week. How high and how long the bounce lasts are in doubt … Regardless, a bounce to around 3063 is quite possible this week, a gain of about 3.7%. The real question is whether investors should sell the bounce.” Investors did sell the bounce, or rather both. Monday saw the S&P 500 rally 4.6%, finishing the day at 3090.23. Tuesday saw selling which knocked the index back to 3003.37. Another big bounce Wednesday took the average back to 3130.12 only to see the index sell-off again on Thursday and Friday to finish the week at 2972.37. The index finished up 0.6% on the week, but the wild volatility probably means more big moves to come. The question, of course, is which way. (Update: The futures index this morning indicates a big down open).

It’s a coin flip whether the market stabilizes and moves higher from here in the coming months or continues falling. John Kolovos, chief technical market strategist with Macro Risk Advisors, looked at 121 one-day moves of 4.2% or more since 1929 and told Barron’s it’s a toss-up. Half the time the market rose over the next 65 trading days and half the time it fell. Bonds are screaming recession and the Federal Reserve cut rates by 0.5% during an emergency meeting last week, which means it’s concerned about the economy. Let’s go with down over the next few months for the market.

Economic Update

Economic data is still showing a reasonably strong economy. It may be looking in the rearview mirror at this point given the disruption in economic activity in China and the likelihood of something similar happening in the U.S. The jobs report was a blow out with 273,000 jobs added in February. However, the jobs report is a lagging indicator and the big number is pre-Covid-19. Likewise, the latest reading for the Institute for Supply Management Services (ISM) was 57.3, the highest in a year. What will it show in the coming months now that Covid-19 has reached U.S. shores? Goldman Sachs has reduced S&P 500 earnings estimates for 2020 to zero. A parade of companies likely waits in the wings to disclose that earnings estimates are too high and need to come down, perhaps sharply. Let’s put the risk of a mild recession at about 70% for now.

Don't follow the herd

Value (contrarian) investing is hard. It’s hard for many reasons not the least of which is that most clients just don’t get it. Sure, they may understand the concept of buying a good company after its stock has sold off significantly, but they almost always come up with (irrational) reasons not to buy the companies. They often still don’t get it even after they’ve made lots of money from contrarian investing.

My best example of the still-don’t-get-it investor is from the late ’90s. I was managing a private fund. We practiced concentrated, value (contrarian) investing with a focus on small-cap stocks. The fund had a trailing six-year record of around 600% compounded at the time the investor called. He was angry because we’d bought an agricultural equipment company named Agco. It competed with John Deer and Caterpillar among others. The stock had fallen from around $20 per share to $10 per share. It was trading for about half book (equity) value and only three-or four-times cash flow. The price-to-earnings multiple was somewhere around six. Lee had made big money with us over the years, but he was still very agitated on the call.

“What the heck are you doing?” he asked me. “Don’t you read the research?” He went on to berate me for buying Agco. He told me he thought we were making a huge mistake. I remember trying to explain why the investment was quite likely to work out well (it did) but he didn’t really want to hear it. Of course, I offered to cash him out of the partnership. He declined. We eventually said our goodbyes and he remained an investor in the partnership.

The point of the story, of course, is that even an investor who’d done exceedingly well with contrarian investing still just didn’t get it. I read a long time ago in the Financial Analyst Journal that only about 10% of people are wired to be contrarian investors. After three decades of contrarian investing and dealing with investors, I’m going to suggest that the 10% number is probably too high.

(We sold two stocks a month or so ago prior to the market’s declines because those companies had reached fair value. We’ve bought two new stocks since the market declines began and both are down, one substantially since we bought them. We will likely bring them both back to a full weighting sometime in the next couple of months. We also took advantage of the decline in emerging markets to increase our exposure. Additionally, we have five more companies we will be buying sooner rather than later. Broad market pullbacks are a wonderful buying opportunity, but you must buy without trying to time the market. Unfortunately, most people can’t help themselves, letting their fear of losses lead them down the market timing path, almost always to their detriment.)

Regards,

Christopher R Norwood, CFA

Chief Market Strategist