Authored by Doug Kass (@DougKass) via Seabreeze Partners,
Like Diogenes with his lantern, I am, again in 2020, a cynic looking for truth (and an honest investor) – as I engage in my annual assault on the consensus and “Group Stink.”
More than any year in the last decade, the contour of the U.S. stock market will likely be importantly influenced and shaped by politics and profits in 2020. Surprises in the political arena and in corporate profitability are my first two and most important deviations from the consensus.
2020 could be the year of mean reversion – a year of the vanishing Fed (and global central banker) put and a surprising turn in central bank policy (by the ECB), weakening global economic growth and less than expected corporate profits (again), political upsets (again), rising geopolitical risks (and global conflicts), a general recognition of the risks associated with untamed deficits and large debt loads and general market instability.
Remember, my Surprise List is not a set of forecasts. Rather, the List represents events that the consensus views as having a low probability of happening (20% or less) but, in my judgment, have a better than 50% chance of occurrence. In betting parlance this is called an “overlay.”
* * *
Surprise #15 A Credit-Related Event Causes a Market Liquidity Crunch as Covenant-Lite, Leveraged Loans, BBB-rated Downgrades All Pose a Potential Threat to Both the Debt and Equity Markets
Credit conditions tighten with more differentiation between CCC and BBB corporate and consumer credit. More companies fall out of CCC and out of BBB into high yield.
Surprise #14 Market Structure Haunts Our Markets Throughout the Year
The dominance of ETFs and quant strategies (e.g. risk parity) shows its ugly side.
The 2019 movie is in reverse this year – the ETFs and quant products and strategies that delivered a recipe for the relentless advance last year are reversed and, with so many looking to exit, liquidity evaporates. ETF prices, in particular, exhibit greater volatility than the underlying constituent holdings. The dominance of passive strategies is threatened and active strategies begin to garner inflows after a lengthy period of losing market share. Over one quarter of the listed ETFs are delisted.
A “Flash Crash” takes the S&P Index down by over -5% in one day. Volatility rockets to over 35 and stays elevated for most of the year.
Surprise #13 FANG(A) Gets Redubbed FAMG(A) With Microsoft Replacing Netflix
The competition from other streaming services causes Netflix (NFLX) to lose millions of domestic subscribers. The whole pricing power story unravels and market loses faith in the cash burning narrative. Netflix’s shares trade down to $200/share.
Surprise #12 A Large Sell-Side Brokerage Firm Abandons its Research Department
Owing to Unbundling of Services and the General Lack of Profitability Associated With Their Efforts
Surprise #11 A Well Known TraderInvestor Who Frequently Appears on Bloomberg, Fox Business and CNBC is Indicted By the SEC For Failure to Disclose His Transactions and Investment Positions In a Proper and Timely Manner
The SEC discloses that many others have failed to fully disclose positions and their trading. The SEC releases a broad edict to all financial media outlets, websites, etc. to adopt new transparency and reporting requirements similar to what is currently required by sell-side brokerage firm’s research departments.
Surprise #10 The SoftBank Unraveling Spreads to Sand Hill Road
WeWork isn’t the last failed unicorn that tries to IPO itself. The private values on a basket of money losing unicorns falls by over 30%.
Venture capital becomes scarce. There are negative knock on effects throughout the Northern California economy. Late in the year Facebook (FB) , Alphabet (GOOGL) and Amazon (AMZN) begin to show the signs that a chunk of their revenue comes from venture based start-ups – their share prices suffer.
Private equity does not escape the turmoil in venture capital.
Surprise #9 Stock Surprises Abound – Boeing, General Electric, Tesla, ViacomCBS, Comcast, Google, Facebook, Kohl’s, Ford, Square,Twitter, Federal Express, European Banks, U.S. Pharma/Healthcare and U.S. Energy
Boeing’s (BA) shares experience a one day rally of nearly +10% – not because of an earlier than expected return of Max 737 production but because Airbus (EADSY) encounters its own set of major safety issues and problems.
General Electric’s (GE) shares climb to $20/share as the company’s makeover succeeds faster than expected. (Stan Druckenmiller reports that he made $200 million personally on his investment in GE and commits his $0.2 billion personal gain to expanding the reach of Harlem’s Children Zone – Stan is Board Chairman of HCZ).
Tesla’s (TSLA) shares rise to $600/share before it poops out. Elon Musk marries Grimes, his pregnant girlfriend. The couple divorces by year-end.
Old media outperforms new media – ViacomCBS (VIAC) and Comcast’s (CMCSA) shares surprisingly outperform Facebook and Google’s common stock.
European bank stocks are global stock winners – rising by +30% to +40%.
With Democrats gaining control of the Congress and Presidency – healthcare and pharmaceutical stocks are global losers and drop by more than -30%.
Iran waits until the summer and then unleashes physical attacks (through sleeper cells) and cyber attacks in the Middle East, Europe and the U.S. President Trump retaliates. The Strait of Hormuz is closed. The price of oil spikes to over $80/barrel (and stays high through most of the year). Energy stocks run counter to the market’s losses and surprise to the upside in 2020 – with gains of nearly 20%. Several, low-priced energy companies’ share price doubles in price.
A large Enron-like fraud is uncovered (and shocks the markets).
In takeover activity:
Amazon acquires Kohl’s (KSS) .
Berkshire (BRK.A) (BRK.B) acquires FedEx (FDX) (see Surprise #7 below).
Jack Dorsey decides to live full time in Africa: In an attempt to improve its position in payments and social media, Google acquires both Square (SQ) and Twitter (TWTR) (beating out Salesforce (CRM) in the process).
Volkswagen (VLKAF) acquires Ford (F) (see upcoming Surprise #4).
Surprise #8 Goldman Sachs Acquires The Vanguard Group (with over $5.3 trillion of assets under management)
In an attempt to expand its retail presence.
Surprise #7 Berkshire Hathaway and Warren Buffett Surprise the Markets – On Several Fronts
Berkshire Hathaway, with over $130 billion of cash, acquires FedEx (for $55 billion) in a spirited bidding contest against Walmart (WMT) . There are several important catalysts to the transaction – Buffett understands FDX’s business and the deal would expand his scale in transportation – where he already enjoys a stronghold in rails with subsidiary Burlington Northern. Moreover, despite the recent Amazon issue, FedEx has a wide business moat with a vast distribution presence and a large fleet of vehicles. Finally, FedEx’ shares have been pummeled (-20%) because of a difficulty in adopting to digital commerce and the company could be purchased on the cheap at under 20x earnings.
Berkshire makes two more large acquisitions – reducing its cash position by $100 billion to $30 billion.
Fires in California grow entirely out of control, shutting down much of the power grid in California – and hobbling the state’s economy. President Trump does not come to the aid of the state until too much damage is done. But Buffett helps and provides bankruptcy financing by Pacific Gas and Electric (PCG) . While it is normally impossible to buy a regulated utility, at the request of regulators Berkshire ultimately takes control of the company.
Contrary to being a “forever holding,” Berkshire unloads a portion of its Apple (AAPL) long investment after the stock becomes too large a percentage of its portfolio.
At the May, 2020 Berkshire Hathaway annual meeting in Omaha, Nebraska, Warren Buffett surprises his shareholders and announces that Ajit Jain will be his successor .
The Oracle of Omaha invites me back to the 2021 Berkshire Hathaway Annual Meeting to ply him and Charlie Munger with tough questions.
Surprise #6 Despite Weakening Economic and Profit Growth the Federal Reserve Does Not Lower Interest Rates This Year
Instead of waiting until the end of Q2 as they currently have planned, the Fed ends the expansion in their balance sheet by February or March. The liquidity spark helping stocks thus ends early.
Foreigners lose their appetite for U.S. corporate debt and government securities and, despite disappointing U.S. economic growth, the 10 year U.S. note yield climbs to over 2.50%.
Surprise #5 With Draghi Gone, ECB Monetary Policy Abruptly Changes and Interest Rates Are Increased
With no more Draghi, the ECB figures out negative rates are a hindrance to growth and has gutted the European banking industry – it normalizes policy. While long term positive, it ends up creating a major disruption in the global bond markets and yields around the world spike. Most European government debt returns to a positive yield. European equity markets rise +20% (compared to a -20% drop in the U.S. indices)
European bank stocks rise by +30% to +40%.
Surprise #4 Watch Out Below! Automobile Industry Sales Plummet and Threaten the Domestic and Global Economies… Ford Is Bailed Out
“Peak Autos” remains in place and the problems facing the industry reverberate in 2020.
At every level there is a ton of automobile loan and securitized debt leverage. A record share of trade-ins last year were upside down on their loans – representing a mirror image of mortgages that existed in 2007.
Retail sales of new vehicles were down by -7% in December, 2019, leading to a retail SAAR of only 14.3 million cars (down from 15 million a year ago and from November, 2019’s 14.8 million rate).
The auto industry falls into a tailspin in 2020 – fueled by burgeoning inventories, record cars going off lease (and entering the used car market), record new car prices (according to J.D. Power and LMC Automotive, the average new care price is now over $35,000), a decline in used car prices, growing and record purchase incentives (of nearly $4,600/unit, a +12% increase from last year), and rising auto loan delinquencies (which hit an all-time high in 3Q2019) causes a substantial amount of damage to the sub-prime auto asset backed securities market in 2020).
The automobile’s sizable role in the domestic economy causes collateral damage to U.S. consumer confidence and spending.
Late in the year, Ford Motor (F) company teeters operationally and financially and the shares fall to under $5/share. The loss-ridden manufacturer is acquired by Volkswagen (VLKAF) .
Surprise #3 The China Trade Deal Falls Apart, China’s Patience With Hong Kong Runs Out and There Is a Global Shortage of Protein
China doesn’t comply with “Phase One” of the trade deal which offers little more than purchasing needed agriculture products and fails to protect U.S. intellectual property.
China’s patience in Hong Kong runs out and it takes action that sets off both a geopolitical and stock market crisis. China’s aggression ends any chance for a “Phase Two” trade deal.
The trade war is reignited and tariffs are reimposed on China.
Capital spending, consumer and business confidence falters.
Speaking of China, the effects of African Swine Fever Virus cause a global shortage of protein. The immediate impact a year ago was wholesale slaughtering, which created a short term surplus. But, now there aren’t enough pigs. Pork prices soar with beef, chicken and fish prices rising in sympathy.
Surprise #2 Disappointing Global Growth, Weakening Corporate Profits, a Fed Pivot and Political and Geopolitcal Instability Produce a “Garden Variety” Bear Market in 2020
As we entered 2020 the almost universal view is that liquidity and the central banks’ put, at the very least, provides a market floor and at the best, will contribute to the next speculative leg of the decade old Bull Market as the market train is supported by the Fed trestle.
As I finished My 15 Surprises for 2020 over the weekend and reviewed the extraordinary nature of the 2019 market — I marvel at the Bull Market in Complacency that seems almost at the polar opposite of the doom and gloom that existed on December 26, 2018, a bit more than 12 months ago. As an example, the CNN Fear and Greed Index was around 2 (!) a year ago compared to 91 (!) this morning. The same applies to the flip flop in AAII sentiment (from very bearish to very bullish – and with the gap between the two moving to over 40).
I would be less concerned with the outlook if the market’s 2019 advance was earnings derived. It was not – like in 2013 it was entirely based on a reset of higher valuations (from a PE of 14.5x at year-end 2018 to approximately 19.0x at year-end 2019). Indeed, consensus 2019 S&P EPS forecasts stood at about $178/share 12 months ago – they are likely to fall in the $163-$164/share level range. As to the 2020 S&P EPS consensus estimates, they, not surprisingly, stand at the same $178/share today! They will likely miss (by an unusually) wide mark, again.
And I would be far less concerned if a changing market structure (the proliferation and popularity of ETFs and the dominance of risk parity and quant products and strategies) coupled with the death of active investing had not served to exaggerate upside price momentum – foiling the natural price discovery many of us “old timers” yearn for.
Meanwhile, as the year concludes, precious metals have made a very “quiet” stealth rally – just look at (GLD) ‘s chart over the last seven weeks. (What are the gold traders seeing that we are not?)
The majority of “talking heads” who hated stocks a year ago are uber bullish on equities this year. (Didn’t we learn from the wrong-footed consensus interest rate forecasts of last December, that self confidently called for a 3.5%+ 10 year U.S. note yield at 2019 year-end?)
Am I concerned? Should investors be concerned? You are damn right. Nevertheless, the consensus remains positive – and the consensus projections shine today with their typical +8% to +10% advance anticipated for the S&P Index.
My view is that next year’s surprise will be a year of mean reversion, but unlike most, I make this surprise without forecast certainty as I recognize that central bankers have lost their collective minds. And so may have many traders and investors.
In 2020, the surprise would be that the “everything bubble” (in which every asset class advanced) is pierced and the notion of mean reversion of returns finally surfaces (just when no one is looking).
Though the third year of the Presidential cycle (2019) was a good one – not so much for the last year of the Presidential cycle (2020).
Despite easing money and an abundance of global liquidity, the rate of growth of the U.S. economy fails to accelerate this year – “The Fed Is Pushing On A String.” Domestic GDP growth slows to under +1% in real terms. Core inflation sits at 2% (but headline inflation is much higher due to rising energy prices). Company share buybacks are sharply diminished as corporate profits disappoint and corporations begin to balk at high stock prices (another surprise)
Though economic growth is slow, interest rates begin to rise in 2020 as the growing U.S. debt load begins to matter. The bond vigilantes slowly return out of hibernation. Higher rates trips up levered corporations and levered consumers. Foreign buyers of credit and Treasuries lose interest in the U.S. debt markets and start selling.
The Fed is stuck and, not wanting to be political, ends its balance sheet expansion and makes no move on interest rates until after the election.
Higher wages and other input costs pressure corporate profits in a backdrop of slowing revenues and domestic growth.
The consensus expectation for 2020 S&P EPS of about $178/share is, for the second year in a row, way off mark as EPS growth falls for the second year in a row because of a continued decline in profit margins that +3% revenue growth can’t overcome. 2020 S&P EPS per share falls to modestly below the $163-$165/share recorded in 2019.
Investors, realizing that corporate profits have essentially been flat since 2014, begin to panic at the “new normal” of subpar economic growth. Another year in which earnings growth fails to recover reverses the valuation upwards reset (so conspicuous last year) as market participants grow increasingly concerned about the real economy’s secular growth prospects.
Much of the more than +25% 2019 reset (higher) of valuations is reversed in 2020 – as price earnings multiples decline by about -15%, producing a modestly larger full year decline (-17%) in the S&P Index. 2020’s market drop is the worst since 2002’s fall of -23%.
The S&P Index closed at 3265 on Friday. The year’s high is made in the first month of the year (at under 3350), the 2020 low in the S&P Index is 2550, and the close is about 2700.
Besides the failure of corporate profits to revive the equity market is burdened by a number of other factors outlined in My 15 Surprises For 2020.
Surprise #1 Trump Popularity Falters Badly, the Progressive Wing of the Democratic Party Fails to Catalyze Voters, Biden Easily Wins the Presidency and Democrats Have a Clean Election Sweep (As Women and Millennials Show Up in Droves)
According to PredictIt and most of the other polls, the general expectation is that President Trump will narrowly win the November election, the Republicans will retain control of the Senate and the Democrats will keep control of the House.
As in 2016, the (political) consensus proves to be mistaken in 2020.
To summarize, several trends become apparent early in the year, leading to Senator Biden eventually being named the Democratic party’s Presidential nominee. Biden’s lead in the polls climbs and Trump trails by a surprisingly large percentage by early summer. In another surprising election result (much like four years ago) – its a clean sweep for the Democrats – Biden easily wins the November election, Democrats narrowly regain control of the Senate and the Democrats maintain control of the House.
Here is how this and the other surprising political events leading up and into the November election could go down:
Democratic Progressive Presidential Hopefuls Fail and Fall Early – Biden Is The Nominee
Advertising money proves to be a major force in producing candidate support and votes. Both Bloomberg and Steyer climb into the top five Democratic candidates in the national polling as Senator Warren’s popularity wanes.
In the belief that only a centrist candidate can defeat President Trump in November, a surprisingly high number of Democratic voters move to the center (and to the support of non-progressive candidates) during the multiple state primaries on March 3rd.
The progressive left of the Democratic Party moves much lower in the polls and the electability of Senators Sanders and Warren comes into question. Sanders’ “hard ceiling” becomes reality as he finishes in only a weak second or third position in the early February Iowa and New Hampshire primaries. By the end of February, a surging Mayor Pete Buttigieg moves into a virtual tie for second with Sanders (and behind Senator Biden) in the national polls. Warren, seen as talking from both sides of the mouth on campaign financing, after releasing what many consider to be poorly constructed tax recommendations and following modification of some other extreme positions, falters and falls out of the top five behind Biden, Sanders, Buttigieg, Bloomberg and Steyer.
Warren, fearful of a further fall (out of contention), approaches Sanders (who essentially shares the same positions that drags down the Senator from Massachusetts – both are fighting a “rigged system”, “Medicare for all”, tax the wealthy, etc.). She proposes a “prepackaged” progressive ticket and political contract (with Sanders as President and Warren as Vice Presidential candidates – with some shared “Presidential” duties). U.S. stocks briefly tank in response to the possibility of a progressive Democratic Presidential nominee. Sanders initially considers Warren’s offer but rejects it and the contract unravels. Warren, with little money left in her campaign till, falls back further in the polls into seventh place (behind Andrew Yang) and drops out of the race. Surprisingly, many of Warren’s supporters fail to lean towards Sanders and move to the other, more centrist candidates.
Biden never falls behind and maintains his front running status throughout all of the primaries and into the Democratic convention.
Late in the race, Bloomberg and Steyer, recognizing the value of a unified Democratic party against Trump transcend their own personal interests and throw their support towards Biden. Stocks start a steady descent lower as investors view the rising probability of a Democratic President as market unfriendly.
Bloomberg (who is worth $58 billion and is the sixth wealthiest person in the U.S. and 14th in the world) commits “whatever it takes” to help Senator Biden defeat President Trump. In total, Bloomberg eventually spends over $2.5 billion on his Presidential run and later on Senator Biden’s campaign and on the key Senate election contests.
In an uncontested convention Biden is named the Democratic nominee. He selects Amy Klobuchar over Stacey Abrams as his Vice Presidential running mate.
Stacey Abrams delivers a riveting keynote convention address and Pete Buttigieg introduces Senator Biden on the convention’s final day.
The day after his nomination, Republican Senator Mitt Romney endorses Senator Joe Biden .
Trump’s Popularity Slumps Under the Weight of Impeachment and Revelations
In the first half of 2020, just as the impeachment hearings percolate, a New York Times investigation uncovers that President Trump directed the purchase of stock futures by the Fed, the Treasury and other parties (over a lengthy period of months) to buoy the U.S. stock markets and with the stated intent (later disclosed in emails) to improve the chances of his reelection. The discovery and publicity associated with stock futures buying policy (which began to be implemented in late summer, 2019) causes an uproar politically (as leaders of both parties are critical) and Congressional hearings are scheduled – sending markets abruptly lower as there was apparently less to the bull market run than meets the eye.
Though Republicans have a 53-47 majority in the Senate, Senator Susan Collins and four other Republican Senators demand the appearance of witnesses and more than 51 Senators vote to call witnesses in the impeachment hearings despite the threat of Executive Privilege by President Trump. The heated impeachment hearings (which includes Bolton’s explosive testimony which is recounted vividly in his NY Times best selling book), are extended all the way into March, hurting Trump’s popularity.
President Trump avoids being removed from office by impeachment by only one vote in the Senate
Consternation as to the President’s rationale regarding the Iraq military base attack intensifies – further dampening the President’s popularity. Over the past weekend in an interview on “Face The Nation”, the Secretary of the Defense Mike Esper seemed to contradict the President’s statement that there was an imminent threat to four American embassies, saying the justification for killing Soleimani was that it was “probably my expectation” that an attack was imminent. No wonder Republican Senator Mike Lee said Esper’s briefing to Congress was insulting. Pushback that the Administration called for the killing of a foreign leader because it is “probably my expectation” draws increased alarm of both Democrats and Republicans and the voting electorate. Based on testimony and uncovered emails, the evidence mounts that the President’s motivation for the attack was to distract attention from the impeachment trial and because some of the (Republican Senator) jurors in that trial pressured him to do so. (h/t Robert Hubbell) As written in a recent Wall Street Journal column, which chronicles the events leading up to the Iraq attack, the lede is buried deep (30 paragraphs into the analysis). “Mr. Trump, after the strike, told associates he was under pressure to deal with Gen. Soleimani from GOP senators he views as important supporters in his coming impeachment trial in the Senate, associates said.”
The Supreme Court reviews Trump’s assertion that the Supremacy Clause of the Constitution means he doesn’t have to reveal his tax returns. After oral arguments are heard in March, the Court rejects the petition for a writ of certiorari and orders the release of the President’s tax returns. The release of his tax returns clearly shows “questionable” transfers and a significant Russian involvement in his financial affairs (and in those of Jared Kushner and Ivanka Trump).
Jared Kushner and Ivanka Trump return to private life in New York City.
A Washington Post report discloses that Melania Trump and the President have essentially lived in separate quarters since late 2018. The Trumps separate.
Meanwhile, a slowing domestic economy and weakening stock market continue to adversely influence Trump’s polling against the Democratic opponent.
Under the weight of the pressure of running for reelection, a hectic travelling schedule and poor eating habits, President Trump’s health catches up to him. A significant health problem is disclosed in the spring forcing the President to curtail his political appearances for more than a month.
Faced with a unified and financially fortified Democratic Party, extended impeachment hearings, the release of Trump’s tax returns, the stock futures controversy, Russian business disclosures (providing a large amount of loans to Trump and buying inflated homes and condominiums from The Trump Organization), health and marital problems, a weakening stock market and slowing domestic economy – Trump continues to suffer badly in the polls.
Attracted to her recent pro-Trump support which culminated last Monday in a charge that “leading Democrats were mourning the loss of Soleimani” (See Peggy Noonan’s Wall Street Journal story this past weekend and desperate to revive his popularity, Trump dumps Vice President Michael Pence for former ambassador to the United Nations Nikki Haley. (PredictIt has a 90% probability that Pence will be Trump’s running mate).
Voter Turnout Rises Dramatically and Biden Easily Wins the Presidential Election and the Democratic Party Sweeps the Congressional Elections
Voter Turnout rises by over +6% (from 2016) – most of the incremental change is captured by Biden who wins 50.7% of the popular vote compared with 46.3% for Trump – a plurality of over 6 million votes. (That compares to 48% for Secretary Clinton and 46% for President Trump in 2016 – a difference of 2.9 million votes).
Senator Biden also wins a surprisingly large majority in the electoral college (304 to 234).
Though the Republican Party was a huge favorite to retain control of the Senate – the Democrats regain control of the Senate on the coattails of Senator Biden and the widening voter turnout.
Upon winning in November, Biden makes first move and nominates Kamala Harris to the Supreme Court to replace Justice Ruth Bader Ginsberg (who agrees to step down). Stacey Abrams is enlisted to become Attorney General . Pete Buttigieg becomes Secretary of Veteran Affairs. Michael Bloomberg is named Secretary of the Treasury. And, in a move of bipartisanship, Senator Mitt Romney is nominated to the post of Secretary of State.
After the election, there are violent demonstrations around the country by Trump supporters in mid- to late- November. Trump does little to squash or calm down the protests and instead holds a number of rallies against Democrats and the election results.
In December, 2020, President Trump announces his plans to launch Trump TV. Sean Hannity leaves Fox News – assuming a duel role as CEO of Trump TV as well as the station’s chief commentator. Rush Limbaugh and several Fox News commentators join Trump TV.