Yes I’m stating the obvious, there’s a bear market coming. However I’ve only seen technical analysis theories for a downturn in the near future, but I haven’t seen facts based on financial statements. As a value investor and up until recently, a public auditor at a big 4 accounting firm, here’s why I think we’ll be seeing a 40-50% downturn from our pre-pandemic highs in the S&P. The factors I list below I highly doubt are priced in, at the exception of #4.
Disclaimer: I am not making predictions for tomorrow, next week or next month, but more towards the medium-term (next few quarters). The post is intended to educate people on accounting losses that aren’t obvious to the average retail trader.
- A vaccine will be released in 12-18 months
- Even as the count of daily new cases decreases, we won’t be eating in restaurants, traveling, or doing other leisure activities until there’s a vaccine. Seriously, ask yourself if your going to eat at a restaurant, board a plane or go into any large gatherings until a vaccine is released. I know I won’t be.
Financial Statement Impacts in Q1 and Q2 2020:
- Goodwill and Asset Impairment. In simplified terms, when a company A purchases company B at a price above it’s book value, the difference is recorded as an asset called goodwill. Many of these acquisitions’ goodwill value will need to be lowered, thus impaired. The loss is booked to net income and subsequently destroys equity. This can wipe out several years of net income. Be careful of “strong” balance sheets just because they have a lot of equity, check how much of that equity is in goodwill, inventory, joint ventures and equipment.
- Large market cap companies are releasing financials beginning in 2 weeks, starting with banks. I know what your thinking, Q1 won’t be so bad! The damage is in Q2. Yes, however when a material subsequent event occurs (a worldwide pandemic that brought revenues to 0$ for many businesses), the company is required to disclose, to the best of their ability, the financial impact on Q1 figures. This means we might already start to see estimates for provisions of goodwill impairments, accounts receivable write-offs and property/equipment/inventory devaluations. Again, these can wipe-out multiple years of profits. Forward guidance should also shed some light on how badly companies will be bleeding.
- Severe dilution of EPS. How does a public company get large of amounts of quick cash for free? Issue more shares (give up ownership in exchange for cash)! Remember when Carnival Cruise Lines lost 30% in one day, just a few days ago? That’s because they diluted the shit out of EPS by issuing a large chunk of stock in exchange for cash. That definitely wasn’t priced in. Investors now have a smaller claim of future earnings, even when the economy comes back to normal. We haven’t seen this as much because were only about 3-4 weeks into this pandemic, so many companies can still tap cash reserves, short term investments and credit lines. Once those are exhausted, take a guess where they’ll go to get the cash. Bonds at 10%+ interest rates or stock issuance?
- Earnings of tech companies. Large tech companies hold a huge weight on the S&P, and are probably responsible for avoiding a 50%+ collapse of the index. I’ll assume these companies will remain profitable, but much less as they’re advertising revenue plummets. The pure website-based tech companies (Facebook, Google, Amazon) should only have declines in revenues and remain profitable. I don’t expect 50%+ declines in these great businesses. However, a large chunk of smaller tech companies, that combined, form a large weight on the index, have revenues dependent on businesses and consumers running they’re day-to-day operations and are going get hit hard on the income statement. For example, IT consulting (IBM, Accenture, Oracle), consumer tech (Apple), business software subscriptions (Adobe, Salesforce) worry me. I don’t think we’ll see balance sheet write offs in these, but the income statement will get hit hard.
I see people stating that stocks are forward-looking and that’s why the market has been going up. Why should a business lose half it’s value for only being shut a few months? Your partially right. However this pandemic might only last a few months, but the losses incurred in these can wipe-out years worth of net income, especially in stocks with low-margins and high fixed costs. Airlines, hotels and cruises are extreme cases where 10+ years of equity is getting eliminated in a few months, but many other businesses are in the same situation in the coming months.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.