Click HERE to access the FSInsight COVID-19 Daily Chartbook.
STRATEGY: While markets await Election day, signs of operating leverage in 3Q2020
Taking stock of 2020 so far, in my opinion, COVID-19 is the most important macro story and in some ways, more important than fiscal stimulus and in some aspects, more important than the Fed (Fed can’t cure COVID). What has been lost in the past few weeks (into 2020 Presidential elections) is that 3Q2020 earnings have been pretty good. One thing that stands out to us is the growing evidence of operating leverage in the epicenter groups.
It has been a rough run for “epicenter” stocks for the past few weeks. The surge in COVID-19 cases coupled with the delay in fiscal stimulus has weighed heavily. But we still remain constructive on these stocks, even as the past few weeks have been awful. Mainly, we see US economic momentum strengthening in 2021, even with COVID-19 still surging in the US (less deadly and lockdowns are not needed here). And we see additional reasons Cyclicals, aka epicenter, could see surprisingly strong EPS in 2021:
– restricted topline environment forces these companies to slash operating costs ala 2008
– demand recovery from either stimulus or vaccine = operating leverage
– P/E can expand because they have proven to be “unkillable” surviving the biggest contraction in modern history
As shown below, looking at 3Q2020 EPS so far (~30% the way done), we see numerous instances where EBITDA growth outstrips revenue growth. There are 23 industries where this has happened so for in 3Q2020 EPS season. We discuss this more fully down in Point #3.
Source: Fundstrat
Europe’s second wave is very different because it is the same cities seeing a resurgence…
Earlier in the pandemic, Europe implemented strict lockdown measures and experienced very little COVID-19 spread throughout the summer. But this all changed in September, as Europe experienced a second wave. Those same cities which saw barely any cases over the summer are now seeing daily cases soaring to levels never seen in the US — Milan’s daily cases per 1mm is >1,600, or 4X NYC in its worst days in April.
Source: Various country data and Fundstrat
This has resulted in Europe potentially turning to drastic measures. This is the dreaded Stage 5 we referenced yesterday, new lockdown measures. In fact, this headline, shared by Gabe below, shows the French government potentially proposing a full one-month lockdown. Wow. This is not only a drastic step, but this might also be a huge policy error.
– After all, France had a strict lockdown earlier in 2020, and it did not prevent a massive new wave of cases
US surge does not warrant lockdowns (stage 5 risk) as this wave 3 is not seeing “new wave” in states behind wave 1 and 2
With the US seeing a new all-time high in cases, why do we think the US wave 3 differs from Europe? The key difference is the US wave 3 involves states that did not have outbreaks during wave 1 and wave 2. And similarly, those states at the center of wave 1 and wave 2 are not seeing a resurgence that matches Europe. The chart below details state-level data of daily cases (per 1mm). We color coded the states involved in the prior waves:
– wave 1 was NY tristate +MA +RI and since then, only RI has seen a resurgence
– wave 2 was FL, CA, AZ, TX and since then, no state has seen a resurgence
In other words, Wave 3 is essentially a new set of states seeing the havoc of COVID-19 in the US. And it is much less prior states seeing a resurgence. Cases are up in NY tristate and in F-CAT, but to a far lesser extent. This is actually a reason our alarm is mitigated. After all, this is not like Paris, where this second wave is causing a far greater number of cases. The wave 3 in the US is the expansion of COVID-19 into states previously unscathed.
Source: COVID-19 Tracking Project and Fundstrat
The cooler weather is weakening our immune systems, and we get less sunlight, which is less Vitamin D. So I do hope everyone remains vigilant and continues to practice mitigation measures — masks, wash hands, etc.
Fed will intervene on a contested election — more reason to be thinking risk-on even as we enter the final days into the election
High frequency polls and betting markets are favoring a “Blue wave” but this is actually a binary event. Either Trump is re-elected or Biden wins. This winner takes all is difficult to create equilibrium in stocks and betting markets only show probabilities. (FYI, this is also why the electoral college makes sense to me. The White House is a “winner takes all”. And to achieve this, every state should be treated as “winner takes all” and the White House needs to win enough states. This is the electoral college.)
And today, there are so many hedging and risk mitigation options available for investors, from futures, derivatives, to delta-one to options, etc. so our clients have access to the tools to hedge against event risk like election day. In fact, the inversion of the VIX curve shows this.
– Spot VIX 33.35
– VIX 1M forward 31.95
– VIX 4M forward 29.20
Even VIX is saying the peak of expected market movements is within the next 30 days. This is a long-winded way of saying that with just a few days into the election, we do not believe any active manager is suddenly deciding to “de-risk” — Monday’s sell-off could be logically attributed to the “stimulus capitulation.”
Investors are reluctant to add risk because they do not know who will prevail on Election day. And also, they are concerned about a contested election. And if one was concerned, they could be long volatility. Would a contested election change the 2020 economic outlook materially?
There is one scenario. The US economy badly needs action on fiscal stimulus. So, if the contested election raises the risk of delaying a stimulus bill until after the new President is sworn in, we could see a delay in the badly needed “financial bridge.”
But if this happened, we believe the Fed would intervene.
In other scenarios, we see fiscal stimulus moving forward and with the same Fed backstop. So, the odds heavily favor a rally post-election. In short, while people are sitting on the sidelines into 11/3, we see a rally taking root thereafter.
POINT 1: Daily cases 70,937, up 13,661 vs 7D ago — still more linear than parabolic
The latest COVID-19 daily cases came in at 70,937, up +13,661 vs 7D ago. Daily cases already hit a new all-time high a few days ago of 81,944, so we are seeing a surge in cases. Last week, we spoke of the likelihood that daily cases would move past 70,000 and we are already past that level.
– Because the spread is primarily in 11 states, we might be nearing peak velocity in those states (daily cases per 1mm >500 trigger policy response)
– states involved in wave 1 and wave 2 (except RI) are not seeing a surge in cases in this wave 3
– Hospitalizations are more important, in our view, and while hospitalizations are rising, the levels are still quite low
–
Source: COVID-19 Tracking Project and Fundstrat
US daily cases 7D delta is up but not exponential…
Again, the daily change vs 7D ago, in our view, is the leading indicator as it is what influences the 7D moving average.
– Daily cases are rising vs 7D ago, but the rate of increase is been constant.
– It does not seem to be accelerating (becoming exponential), which is key
– there was 1 day where daily cases surged 23,000 (exponential-like) but it was a 1-day surge
Source: COVID-19 Tracking and Fundstrat
Source: COVID-19 Tracking and Fundstrat
POINT 2: States at the center of wave 1 + wave 2 not seeing the same resurgence in wave 3
What has been lost in the surge in US cases, is the fact that the prior “epicenter” of cases, wave 1 and wave 2, are not seeing a new wave of cases. That is, the surge in US cases is largely a result of new areas of the US seeing a massive spread of cases. These states, 20-22 in total, but really 8 with severe outbreaks, have one or several of these characteristics:
– previously had low prevalence –> large pool of “uninfected”
– they missed out on wave 1 and wave 2, were less prepared (or scared) –> sitting ducks
– might find mitigation measures like limiting group size or masks as impositions –> sitting ducks
The chart below details state-level data of daily cases (per 1mm). We color coded the states involved in the prior waves:
– wave 1 was NY tristate +MA +RI and since then, only RI has seen a resurgence
– wave 2 was FL, CA, AZ, TX and since then, no state has seen a resurgence
In other words, Wave 3 is essentially a new set of states seeing the havoc of COVID-19 in the US. And it is much less prior states seeing a resurgence. Cases are up in NY tristate and in F-CAT, but to a far lesser extent.
Source: COVID-19 Tracking Project and Fundstrat
The risk of a lockdown and even parabolic spread is lower if this is “new areas” not previous areas seeing a resurgence…
The fact that this is a new set of states is an important distinction. Several reasons stand out, but the most relevant is the needed policy response. There is no need for lockdowns in areas which are not getting affected.
Think of it this way, for anyone in NYC or the NY tristate area, COVID-19 swept through the region in Feb-April. And while there was wave 2 of cases in the US, NY tristate was largely unchanged. And nobody needed to take new measures (everyone was already using masks, etc.). In this current wave, while there are more cases in the NY area, the rise is nowhere near what we saw in April. Thus, there is no need to introduce new lockdown measures.
On the other hand, if someone was in South Dakota, COVID-19 was mostly a story in the “headlines” throughout most of 2020. And until the most recent months, when it began to dramatically sweep through these states.
Hospitalizations are showing a similar story…
While there are some media stories of hospitals running out of capacity, this hard to see at the state level data. Below is hospitalizations per 1mm residents and the magnitude of hospitalization use was lower in wave 2 than wave 1 and wave 3, so far, is not surpassing wave 2.
– A few states have high hospitalizations, such as SD,ND and MT.
– But these states did not experience the surges seen in wave 1 and wave 2, so the citizens in these states were essentially caught off guard.
Source: COVID-19 Tracking Project and Fundstrat
Europe might be proof that “containment” doesn’t work Europe is experiencing something entirely different. The same cities that were hit very hard in the first wave are seeing a major second wave. The daily cases per 1mm residents for 5 major European cities are shown below. And as you can see, these daily cases per 1mm residents are soaring.
– Milan has 1,600 daily cases per 1mm residents, 4X NYC on its worst days
– Paris is reaching 800, or 2X NYC
Source: Various country data and Fundstrat
The NYC and Boston daily cases per 1mm are shown below for comparison. And you can see, while both NYC and Boston are seeing a rise in cases, it is nowhere near the levels these cities experienced at the heights of wave 1. So, this remains one of the reasons we can take some comfort.
Source: Various country data and Fundstrat
We also need to keep in mind that the case prevalence in Europe overall is lower than in the US. As shown below, only France and Spain have >12,500 cases per 1mm residents. So much of Europe is vulnerable to an outbreak, because case prevalence is simply low.
Source: Various country data and Fundstrat
POINT 3: 3Q2020 is showing operating leverage of cyclical stocks
The table below compares 3Q2020 EBITDA growth vs revenue growth. And if EBITDA growth > revs growth, these groups have operating leverage. Looking at 3Q2020 EPS so far (~30% the way done), we see numerous instances where EBITDA growth outstrips revenue growth. There are 23 industries where this has happened so for in 3Q2020 EPS season.
Source: Fundstrat
Harley Davidson (HOG) is an example of a company where operating leverage is evident in 3Q2020 results. The company reported revenues down 8% YoY (~10% for motorcycles) and yet, both operating income and EPS were higher:
– EPS is up 41% YoY, or significantly above the -8% revs growth.
This even as the company has managed to have many of its workers work from home and the company suspended a lot of discretionary spending. Again, for a company with revenues down 8%, they posted 41% EPS growth.
Source: Harley Davidson
The stock rose sharply on Tuesday, on the heels of a strong 3Q2020 report, and as shown below, the stock is now pushing up against its long-term downtrend. And this move above $35, and holding and closing above this level, is a good step towards repairing the technical picture.
Source: Bloomberg
And even as the stock has struggled in 2020, HOG bonds have held up well. The 2045 bonds, 25-year duration, are trading at 106. That is pretty incredible. But it is a sign that investors feel considerably better about holding HOG bonds than equity investors feel about HOG equity.
Source: Bloomberg
Another example of this is Boyd Gaming, BYD. The company reported results Monday and again, we are seeing how massive cost cutting has reset the operating leverage bar for these companies.
– BYD saw revenues plunge 20% YoY in 3Q2020
– EBITDA surged to a record $213mm, up 13% YoY
So even with a collapse in sales, costs fell faster and allowed the company to grow EBITDA. This is exactly why epicenter groups, those cyclical sectors hardest hit by this pandemic, should surprise investors in 2021 with this anticipated operating leverage.
Source: Boyd Gaming
Similarly, while gaming stocks have been weak overall, BYD bonds have traded at basically par for most of the last few months. The message is that if US cases do not surge to the point requiring lockdowns, we think stocks are very well positioned.
Source: Bloomberg
