CIO explains why the bear market was the shortest ever and looks forward to an uptick in renewed M&A activity
Much of the humility investors displayed in March has been lost after the shortest bear market in history, according to one portfolio manager.
Felix Narhi, CIO at Penderfund Capital, said the market’s recovery has been “breathtaking” although misleading, with a handful of big winners but many more losers. He is, however, excited by the resurgence of M&A activity, which he believes can be a significant catalyst for his firm’s small-cap strategies.
While there are reasons for optimism, COVID-19 is expected to lead to the deepest global recession in decades, with baselines projecting a 5.2% contraction in global growth this year. Narhi pointed out that, ironically, the only major global economy expected to grow this year is China, the epicentre of the pandemic.
But despite the headlines about high unemployment, bankruptcies and other pandemic related issues, there are interrelated reasons why markets have made a recovery, despite worrisome issues.
Narhi said: “The unprecedented speed and scale of the global fiscal stimulus and central bank action broke the momentum in the market’s negative feedback loop. Beyond restoring market confidence as buyer of last resort, central bank actions have led to even lower interest rates, which usually equates to higher business values.
“While there will be unintended second and third order effects, the ‘shock & awe’ actions from central authorities bought us more time to deal with the real issue – the mortality and morbidity issues from COVID-19.”
Narhi described the progress as “astounding”, with so many of the world’s top scientists and researchers working towards a vaccine, and advances in therapeutics and vaccines taking place at a breathtaking pace.
He said: “Consumer behaviour could change quickly if an effective vaccine becomes available in mass quantities. This would likely lead to a resurgence of economic activity. This pandemic, like others before it, will eventually end. The question is how long and how much damage will be caused in the meantime. Which brings us to the long-term versus the short-term perspective.”
Narratives driven by investor psychology and structural factors are much more powerful determinants of near-term price action. But fundamentals matter over the long haul.
Narhi said: “The longer you hold onto your stocks, the more your returns will reflect the economics of the underlying businesses. The truth is that earnings over the near term only have a minor impact on the economic value of a company.”
He added: “Currently, consensus estimates are projecting a full earnings recovery by late 2021. At this point, it appears the worst is behind us from an earnings perspective.”
Timing and magnitude
Narhi explained: “Timing is clearly one issue. But the magnitude of the change is another, where the connection between the 'real economy' and the 'stock market' is not as strong as commonly believed. During the 2008 Financial Crisis, stock markets around the world plummeted approximately 30-60%, but of course the real economy did not fall by a similar amount. The following bull market saw the S&P500 rise five-fold to the next peak in early 2020, which is also not reflective of real GDP growth.”
Digital Giants vs the Rest of the World
There are hundreds of thousands of small businesses that had to shut down or were severely impaired but were not publicly listed. Then there is Amazon.com, already one of the world’s largest online retailers which became an even greater necessity in a lockdown.
Narhi said: “In a sense, an increased share of the industry profit pools that formerly resided with small private businesses all over the globe have shifted to Amazon.com, a U.S.-listed security. At the margin, public investors in Amazon benefited while private investors in the real economy lost share. Thus, the real economy could be hit over the short term, but because the Amazon’s, Microsoft’s and Apple’s of the world are experiencing heightened demand from their customers and already account for a large portion of the S&P500, overall markets could be surprisingly resilient, or even go up. That dynamic is even more visible in the more concentrated and tech-centric NASDAQ.”
He added: “Many of the most battered industries do not matter much because of the way stock indexes are structured. Some of the worst hit and highly visible industries like department stores, airlines and oil and gas equipment services are only a very small part of the S&P500. They are more than offset by the tailwinds experienced by the giant tech beneficiaries.”
Meanwhile, since the March crash, Narhi said he has been pleased with a much stronger recovery than anyone could have imagined. He is particularly excited about some potential upcoming catalysts, which could further boost momentum. M&A activity was brought to a virtual standstill, which was a big headwind for Pender because part of its strategy requires normal deal-making activity. That headwind seems to be reversing.
He said: “As ‘animal spirits’ return to the markets, and potential acquirers can conduct their due diligence once again, enthusiasm for deals is quickly ramping up again. In aggregate, we believe many of our small and microcaps represent ‘juicy’ takeout targets because their valuations are still relatively attractive, especially compared to the larger caps that have already run up.
“We believe investment bankers and deal-hungry executives are scrambling to make up for lost time. This heighted buyout activity could provide a strong tailwind for us over the next few quarters.”