Just one month ago, BofA's excited head equity strategist Savita Subramanian told Barron's that storm clouds would disperse and that the S&P would close out 2016 at 2,200, incidentally the same level as her year ago forecast for where 2015 would close. Fast forward to today and things are far less euphoric.
This is what Savita writes in a note released overnight:
Correction or bear market? The S&P 500 is in correction territory, the Russell 2000 and almost 80% of regional stock indices are in bear markets. The average S&P 500 stock is in a bear market - down more than 25% from its 52-week high. Stocks are down a lot. Let’s move on.
Ok moving on.
Let's focus just on energy, where things are a disaster: "Energy is in a profits recession but Energy stock prices have fallen by more than the market falls during a recession (-44% vs. -40%), the Energy recession has lasted twice as long as a typical recession, and Energy earnings have seen 2x the cut that the S&P 500 typically sees (-65% vs. -29%)."
What about the economy?
Same story for the economy: should we care whether or not the NBER will one day deem this slowdown an official recession, if PMIs suggest that manufacturing sectors have been in a recession in the three biggest economies (China, US, India) and Energy has been in a profit recession that has lasted twice as long as a typical economic recession.
Yes, we probably should care, because it takes us to the next question Savita tries to answer: "Are we at a bottom?" Her answer: "Near-term model suggests caution"
The earnings revision ratio, which has historically been a predictor of market returns over the next 1-2 months, has been falling since July and currently sits at a nine-month low. Short term investors might want to wait for signs of stabilization in this framework.
Subramanian then points out what we showed yesterday, namely that sentiment right now is about as bearish as it has been in the past decade, with the least number of AAII bulls since 2005. She confirms this, saying "sentiment is already bearish"
Global investors are significantly underweight US equities (Exhibit 1) according to our BofAML Global Fund Manager Survey. The most recent survey (in December) also suggests cash levels were raised to 5.2% ahead of the recent sell-off, in “Buy” territory according to their trading rule (Exhibit 2). And our Sell Side Indicator suggests that strategists are as bearish today as they were in March of 2009, recommending investors allocate just 53% to equities, below the long-term benchmark weighting of 60-65%, and at the threshold of a contrarian “Buy” signal (Chart 4). And short interest, another measure of positioning, despite declining in the last three months, remains at its highest levels since 2009.
In theory, as an otherwise dour JPM said yesterday, and virtually all chartists agree, this means a rebound is imminent. However, a bigger question beyond merely the technicals is whather we are now entering a bear market, which would blow up all technical models. Savita's answer:
Are we entering a bear market? Bear markets in context
The S&P identifies 13 bear markets since 1928, of which 10 have coincided with US recessions (Chart 5). The exceptions were 1961, 1966 and 1987, which precisely because they did not occur alongside recessions, were relatively short-lived and followed by swift recoveries. The market declined ~30% on average during these three bear markets, vs. ~40% on average during the remaining bear markets which coincided with recessions. S&P EPS has historically fallen 30% on average during recessions since 1929 or 20% on average during recessions since 1960.
The general rule of thumb is that the stock market leads the economy by 1-2 quarters, and on average, the market peak has historically peaked 7-8 months before a recession. But the range has been remarkably wide, from the peak of the market coinciding with the start of the recession to as early as 2.5 years before the start of the recession (1948).
Curiously, a bear market without a recession may offer little solace, because as BofA calculates, "in bear markets without recessions (1961, 1966, 1987), returns in the subsequent twelve months after the market peak were -12%. If we assume the S&P 500 peaked at May 2015 highs, this would imply today’s levels for May 2016."
What do markets imply are recession odds? According to the S&P the odds have soared to 50%, but accordint to rates the probability is "only" 18%:
Of course, whether and when the NBER will acknowledge the US has entered into a recession, only time will tell.
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Which brings us to the core topic of this post: BofA's response to "What To Own In An Equity Death Spiral"?
According to BofA, first pick large, high quality, cash-rich companies:
Large caps over small caps
Leverage for large cap stocks remains below average, while small-cap leverage is at all-time highs (and also above-average even when excluding Energy and Materials).
Second, pick "liquidity over leverage"
S&P 500 companies with high yield debt have traded at a premium to those with investment grade debt for over two decades, but this has recently begun to reverse, with investment grade stocks trading at a slight premium for the first time since 1994. Cash-rich companies have also traded at a discount to levered companies post-crisis, but we expect them to re-rate as credit sensitivity is penalized and cash becomes a positive as opposed to a drag on earnings.
Finally, choose "High quality over low quality"
Volatility may be here to stay, and high quality stocks typically outperform low quality stocks in volatile environments. And high quality stocks have traded at a discount to low quality stocks—which have been buoyed by fiscal and monetary stimulus—since the Tech Bubble, but are starting to re-rate. We expect this normalization in multiples to continue, and believe high quality stocks will eventually trade at a premium.
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Putting all this together, here is the answer: BofA screens for companies that fufill the following criteria:
- Market cap > $10bn
- S&P quality rank of B+ or better
- Net Debt (Cash) to Market Cap < index median of 16%
- Total Cash to Market Cap > index median of 5%
- S&P Long-Term Credit Rating is Investment Grade
- Underowned by active managers (relative weight <1.0 in latest fund holdings)
The result: