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Executive Summary

As a quick follow up to last week’s missive, the déjà vu continued this Monday with another COVID-19 vaccine headline.  Markets jumped on headlines, not financial data. While the S&P 500 Index is comprised of the 500 largest U.S. public companies, the Russell 2000 Index represents roughly 2,000 small publicly owned companies. Many of these are in the service industries and have been hit hard by COVID-19.  When reporting price-to-earnings (p/e) ratios for the Russell 2000 Index, the financial media exclude “negative” earnings or companies reporting losses.  This is extremely misleading for the public.  However, Siblis Research reported the trailing twelve-month p/e ratio for the Russell 2000 was 46.9 as of June 30 of this year, and they included negative earnings.  Please see the third graph below for the indescribable disconnect.   Below, I also include two graphs related to companies at risk for filing bankruptcy.  Investors need to understand the risks. 

Please proceed to The Details for a more in depth understanding.

“Capitalism without bankruptcy is like Christianity without hell.”
–Frank Borman

The Details

First a quick follow-up from last week’s missive in which I discussed having déjà vu.  It was the second Monday in a row where stock markets were boosted by an announcement of a potentially successful vaccine candidate.  I stated at the end, “There are two more companies with vaccines in development, so do not be surprised if you once again experience déjà vu.” Well I guess the third time’s the charm.  This is now the third consecutive Monday with a vaccine announcement, and yes, the market jumped.

However, it has been stated that widespread distribution will likely not occur until around April 2021.  And, as economist David Rosenburg Tweeted today, “Today is a key test for the markets.  A doubling in the case count and hospitalizations in a month, the renewed curbs, no fiscal stimulus and forecasts of a Q1 GDP contraction.  Investors don’t care.  It’s all about vaccines and a perceived return to normal.”  Investors have been tricked into believing with a vaccine everything will bounce back to pre-COVID levels.  What many don’t remember is the economy began its downturn in the fourth quarter of 2018, prior to the pandemic.

The chart below illustrates the historic levels of the Financial Conditions Index as compared to the S&P 500 Index.  Julien Bittel, CFA, Tweeted the following:

“US financial conditions just fell to their lowest lvl on record at 97.9.

<99 is already rare.

But add to this:

-Record equity valuations

-Risk-averse mkt conds.

-Narrow stock breadth

Only 6% of the time over 25 yrs.

Nov ‘98-June ‘99

Dec ‘99-June ‘00

Oct ‘07

July ‘20-Present”

Each prior similar condition preceded a significant market correction.

The S&P 500 Index is comprised of the 500 largest U.S. public companies.  There is another index which represents companies even more affected by the pandemic.  I am referencing the Russell 2000 Index, an index of roughly 2,000 small publicly owned companies.  Small companies, many in the service industries, have been hit hard by COVID-19.  A few months back, I provided the following graph to highlight the number of “zombie” companies existing at the time.  Approximately 15% of all U.S. public corporations were classified as “zombies” meaning they were not generating enough income to pay the interest on their outstanding debt.

When isolated to the Russell 2000 companies, I have read where the number of zombies in the index could now be approaching 40%.  The financial media, including print media, play a little trickery with the Russell 2000 financial numbers.  Almost all earnings and price-to-earnings (p/e) ratios reported for the Russell 2000 Index exclude “negative” earnings or companies reporting losses.  This has a material impact on p/e’s and is extremely misleading for the public.

When analyzing an “index,” it is necessary to include all earnings and losses reported by companies.  Excluding companies with losses gives the false impression that in the aggregate, earnings are better than the reality and provides a p/e lower than what should be reported.  Doing so can lure investors into the index without realizing a large portion of companies are not even generating profits.  And that is what is currently happening as the Russell 2000 has jumped at the same time its earnings have plummeted.

Siblis Research has published information including negative earnings.  As of June 30, of this year, Siblis reported the trailing twelve-month p/e ratio for the Russell 2000 was 46.9.  This compared to the S&P 500 p/e on June 30 of 31.2 – still near an all-time high.  The third quarter year-over-year (yoy) earnings for the Russell 2000 fell 14.4% which would push the p/e even higher.  The S&P 500 p/e for the yoy period ending September 30, 2020, rose to 34.2.  Yet with near record high p/e ratios, a surging pandemic, high unemployment, and no planned stimulus to assist zombie companies, investors continue to dive in.

The graph below, prepared by Michael Carr in a post in Money & Markets, compares the p/e ratios using expected earnings for the S&P 500 (green line) to the Russell 2000 (orange line).  While the graph is a little hard to read, the extreme Russell 2000 overvaluation should be obvious.  Note that even the S&P 500 is near record high valuation levels, so the orange line is indescribable.

Zombie companies lead to bankrupt companies, and the number is soaring.  See the chart of U.S. bankruptcies from Statista below.

Investors are now taking on more risk in the equity markets than ever before.  Nothing seems to matter:  not falling earnings, a weakening economy, a contested election, nor lack of an identifiable impetus for rising stock prices, yet the delusion continues.  There is no way to predict how long the disconnect continues, but it is currently safe to say that one of the most dangerous places is the Russell 2000 Index.

Someday, the disconnect becomes re-connected.  Investors should understand what that entails.

The S&P 500 Index closed at 3,558, down 0.8% for the week.  The yield on the 10-year Treasury Note fell to 0.83%.  Oil prices increased to $42 per barrel, and the national average price of gasoline according to AAA fell to $2.11 per gallon.


© 2020. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.

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