What Bear Market? Why the More Solid Stocks May Be on the Upswing

While more overall market misery likely is in store, this bunch should be headed higher, SunTrust’s Lerner says.

The market could well resume its downward spiral, but we may have reached a little-seen pivot point that culls out the best performers, which no longer keep falling and indeed will rise. That’s the take from SunTrust Advisory Services.

The concept here is called an “internal low,” according to Keith Lerner, the unit’s chief market strategist. This means that, after the initial market crash that took down almost everything starting in February, certain strong players start to show their mettle.

This phenomenon “occurs when the intensity of the selling pressure as well as fear and indiscriminate selling reach a crescendo,” he wrote in a research note. “While the overall market index may continue to decline, the movement of stocks within the index become less synchronized.”

And at such a stage, the sturdier stocks pull away. “Once the internal low is passed, there tends to be greater differentiation among stocks within the market,” he explained. “Investors start to separate the wheat from the chaff.” From here, he wrote, “We now expect more of a two-way market, as we move past the peak of indiscriminate selling.”

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To be sure, no mathematical precision is attached to this observation. Still, he went on, “Longer-term investors should not be waiting for an all clear or a bell to ring at the market bottom. The question is, will longer-term investors be rewarded at current levels? We believe the probabilities suggest the answer is yes.”

A couple of examples cement the idea of an internal low. Last week, the S&P 500 slid 2.1%—a big improvement from the wipeout that began February 19, when all seemed lost, and ended March 23, with huge rescues from Congress and the Federal Reserve in place.

But at the same time, last week featured solid performances from companies known for their enduring business models, robust cash flows, and strong balance sheets. Although Lerner didn’t cite them, these included cut-rate retailer Dollar General (up 14.8%), food maker General Mills (9.8%), and wireless titan Verizon Communications (3.3%).

Certainly, no one can say that the broad market has reached its low point. And the anguishing weeks expected ahead, of more coronavirus cases and more deaths, suggest that stock investors haven’t fully priced in all the horrible news.

But Lerner argued that reaching an internal low is a precursor to the overall market’s eventual nadir, which is not always near at hand. One instance of that, he declared, was the popping of the dot-com bubble. Back then, he wrote, “the internal low in the market occurred in July 2002.” Yet the rock-bottom for the market in that cycle was three months later, in October.

By the same token, he continued, the internal low during the global financial crisis came in October 2008, just one month after the collapse of Lehman Brothers, the inciting incident for the crash. The market as a whole, though, didn’t hit its lowest level until March 2009. And, Lerner added, “there were plenty of good buying opportunities in individual stocks before that.”

For those worrying that we are in for a prolonged market plummet, as happened after the 1929 crash, this all is reassuring. “Following an internal low,” Lerner said, “many individual stocks will have already bottomed ahead of the overall market as investors sought out the winners and losers.”

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Coronavirus a Boon for 2018/2019 Private Equity Vintage Funds

New funds will acquire portfolio companies at bottom of price curve.

While the economic effects of the coronavirus pandemic have been devastating to most investors, the timing is fortuitous for private equity funds that are finishing up their fundraising and looking to deploy capital.

Before the pandemic hit, forecasts suggested that 2018/19 vintage funds would likely struggle to make decent returns this year as they faced record high asset pricing and intense competition. But once the markets settle down from the current volatility, vintage funds will be ideally placed to acquire portfolio companies at the bottom of the pricing curve, according to research from financial data and information provider Preqin and risk management consulting firm FRG.

At the same time, the firms said funds with vintage years 2012 through 2017 are likely to see their returns hurt by the pandemic.

“Those funds looking to make exits in the next 12 to 24 months will be facing a lower pricing environment,” Preqin said in a release, “while vehicles currently operating their portfolios will see disruption to their holdings’ industries.”

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The  2016/17 vintage funds are likely to be most affected, having bought at the pricing peak and may face being unable to recoup their investments through exits. Collectively, vintage years 2012 through 2017 hold 77% of the unrealized capital invested in private equity, according to Preqin.

“In the coming months, investors will have to look at the disruption in financial markets and ask if they are ideally positioned to achieve their investment goals,” Dmitri Sedov, Preqin’s chief product and marketing officer, said in a statement. “Many have looked to private equity to help provide returns through good times and bad, and so the need to accurately predict their cash flows in this area is critical.”

The research also found that market upheaval will reduce capital calls and distributions in 2020 as fund managers delay making acquisitions or exits. Preqin and FRG analyzed the impact of a pandemic-triggered recession on capital calls, distributions, and net cash flows.

To model the impact, FRG created a “pandemic scenario,” which assumes a 25% contraction in US real gross domestic product (GDP) in the second quarter of this year, followed by a sharp rebound through the rest of 2020. The firms focused their analysis on 2017-2019 vintage funds, which represent 72% of the $2.63 trillion in callable dry powder that the private capital industry has raised since 2000.

The research said that for the 12 months ending June 2021, 2017-2019 vintage funds will likely reduce capital calls by 38% and reduce distributions by 19%.

“This is because we expect deal activity to be muted and distributions delayed as GPs [general partners] looking to buy wait for valuations to fall and greater economic certainty,” Jonathon Furer, Preqin’s head of strategy, wrote in a blog post. “At the same time, GPs that would otherwise look for an exit hold onto their assets to avoid selling in a downturn.”

Furer noted a sharp reduction in capital calls for funds with the highest amounts of dry powder, saying this should offer some relief to limited partners who will need to figure out how to meet their obligations in a more challenging environment. He said investors should plan for how they will meet outsized capital calls in 2021, as fund managers ramp up capital calls to capitalize on the lower asset prices.

“Since the global financial crisis, fund managers have had to contend with rising prices and increased competition as they try to make outsized returns for their investors,” Furer said. “While a recession certainly poses material risk to portfolio companies and exits today, it also represents a record opportunity for fund managers to buy at low prices after the longest bull market in history.”

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