Investors are in a frenzy to understand what is going on with the coronavirus and its impact on the markets. There are two main camps. The optimistic camp thinks this will be over in two months and it’s back to the races. They believe this is a good buying opportunity. The pessimistic camp believes the correction is far from over, and that sitting on your hands and being patient is key. To help us decide, which camp is most likely correct, let’s look at some of the facts.
Fact: The biggest moves have occurred in bear markets
A friend of mine sent me the above. It was on Jim Bianco’s Twitter account. This was a few days before the massive -12% day we had 2 days ago. Note that all these massive moves occurred in bear markets…
Fact: The market has dropped fast
This month we witnessed the quickest 20% decline in the Dow and the S&P 500 in history. According to Ritholtz Wealth Management, a historically 20% decline from the index’s peak took on average 255 days (median: 156). The 2nd fastest decline was during the 1929 crash. Below we see that the S&P 500 also had its fastest 10% correction.
I’d interpret this quickness as bearish. Investors are running for the exits and can’t get out quick enough. And it’s not only because of systematic trading or ETFs. It’s also the leverage in place. There are rumors of margin calls and huge hits at large funds (eg. Bridgewater -20%). This is important because not only will the decline reduce leveraged funds equity (investments worth – borrowing) but redemptions will act as a multiplier effect. Here is an example. Let’s say you’re a high yield bond fund. You are invested in some B rated credits with a yield of 5%. You borrow at 3% and use the leverage to buy more bonds. You have twice the amount of bonds (perhaps even more) and are yielding 7%+. You look like a god. But market collapses and the fund’s equity drops (remember that borrowings are constant while investments worth fluctuates). You get a margin call and to make matters worse redemptions roll-in. But the pain doesn’t stop there. A lot of high yield bond funds don’t just hold B credits but also CCCs. If these bonds are maturing and the companies don’t have enough cash, how easy will it for them to refinance? (To issue new debt to pay off the old). Over the last 3 weeks I’ve noticed the liquidity has disappeared across BBB – B credits. So assume in CCCs it’s event worse. Expect funds to start gating (which means they don’t immediately give the investors their money back but with a delay or some type of schedule) and for some to close.
Fact: VIX at 2nd highest point ever
The VIX is a measure of the expected market volatility. It hit almost 85 with 89.53 being the highest ever recorded. That occurred in October 2008 – 5 months before the market bottomed…
Fact: Credit Markets signaling trouble ahead
The Fed launched its commercial paper funding facility which was in place during the Global Financial Crisis (GFC) of 2008. The commercial paper market is where highly rated companies raise money for up to 270 days. Under this facility the Fed will purchase 3-month paper until March 2021. Basically, what is going on is that strong companies are either facing difficulties raising money short-term and/or need to pay much higher rates than they are used to. As the chart from Bloomberg shows, the spread (between AA and 3-month swap) hasn’t been this high since 2008.
Corporate bonds are quoted at higher yields currently, regardless of fundamentals. An opportunity? It’s hard to say at this point in time, but possibly in industries that are not cyclical (eg. Telecoms). My view is that it is currently best to sell issues where there may be a risk of default. Better to lose 10% today than 100% in six months. The market worry in high yield credit can be see in the Bloomberg chart below. You can follow from home via a similar stat from the St. Lewis Fed (link). The spread again hasn’t been this high since the GFC. At least in equities, you actual have trading and can always sell at the bid. In bonds the situation is different, there are days where there are actually ZERO bids in investment grade bonds! That means no buyers at all!
Fact: Government printing may not necessarily be good
Packages worth trillions are being announced by governments and central banks globally. Treasury Secretary Steven Mnuchin told senators that unemployment could reach 20% if a stimulus is not put in place. I agree that a stimulus is needed but not the type of stimulus that involves direct payments and bailouts. The developed world needs stimulus that will bring about GDP growth. Investment in infrastructure, education and health care. Bill Gates warned the world in his 2015 TED talk (see here) but no one listened.
Now where are all these trillions that governments are promising going to come from? More debt and money printing that doesn’t bring about constructive long term economic growth can lead to inflation. This results in more pain down the road. It’s not unlikely that we see a combo of inflation and unemployment and absolutely no tools to combat it (won’t be able to either cut rates or do more spending). Even if there isn’t higher inflation, there is at a minimum a rise in risk premium as there is more leverage. In simple terms, the more you borrow, the more riskier you are, the higher the return that is demanded by lenders. So as you understand a higher risk premium hits all financial assets. Finance 101. Higher discount rate = lower present value of future cash flows.
Take a look at how sovereign yields reacted to the various packages announced…
Fact: Companies rushing to tap backup lines of credit.
Companies (either of their own initiative or from advisors) are rushing to access as much cash as possible. Companies have various credit facilities which their banks offer them. They draw on them now so that they are ready to face a potential crisis. This puts pressure on banks. The banks may have to reduce their own activities, and if companies default the problem is magnified.
Fact: The fantasy island of relative pricing
Up until the coronavirus, the logic for buying equities was simple: “Look at all the other assets classes. Bonds are at negative yields! Compared to bonds, equities are cheap! A 25 P/E means a 4% earnings yield!”. When you frame it like that, sure they look cheap, but both professional and retail investors forget that an asset is worth the present value of future cash flows. A lot of companies were trading at valuations that could not be justified. The growth that would have to be achieved was not realistic. So even though a stock may look relatively cheap (one asset compared to another), an absolute valuation (based on cash flows) indicated that many stocks were expensive. Keep in mind that stocks don’t drop because they are expensive, nor do they go up because they are cheap. They need a catalyst and the coronavirus was the catalyst that ruined the party. If the coronavirus happened when stocks were cheap (in an absolute sense) then the effect would not have been so great.
Fact: The coronavirus is a real threat and the math says social distancing works.
The truth is that many of us initially dismissed the coronavirus and didn’t take it seriously. If you are to read only 1 article on the coronavirus then read this. The potential exponential growth of this virus is scary. The potential to overwhelm the health care system is very real. What this means is that people suffering from the virus will not be treated and die. But it doesn’t stop there. It also means that all the other people suffering from other health problems won’t be treated. So not only do coronavirus infected people die but also others that would normally survive. What social distancing does is slow the growth and allow the system to take care of the patients. See this article from the Washington Post that includes a simulator that proves how social distancing flattens the curve. Basically slows the growth and allows treatment.
The problem is that restricting people’s freedom of movement results in a serious decline in demand for goods and services. In addition, we have a hit to supply as well. Unfortunately, I’ve heard people express the view that we need to let nature do its thing. Survival of the fittest. These people believe we will get through this quicker, develop herd immunity and get on with our lives without a hit to the economy. Firstly, do these people have no friends or family? I certainly would not want to see a loved one die from this. Secondly, what do you think would happen if 10-20% of the global population dropped dead? There would still be a global recession. Demand for products and services would decline permanently. Someone may say I’m exaggerating as the deaths would most likely be 1-3%. Really? If hospitals are overwhelmed, then the percentage will be significantly higher.
I believe that a global recession is a given. The question mark is how big. This time multiple QE programs will be difficult to pull off or be effective. The dotcom bubble was followed by an approximate 50% decline, while the global financial crisis of 2008 saw stocks decline even more (around 57%). We are still at around -30% currently. First week of March, I sold half of my own personal portfolio. It was a hard decision to make. I kept everything I wouldn’t mind holding for the next 10 years. Companies I believe will still be around no matter what. Three managers I know actually bought puts. I’m not that smart. But that’s ok. What I am doing now is building a grocery list. There are stocks I’ve wanted to own but just looked too expensive to me. For example, Disney (DIS). The house of the mouse will be around for as long as there are children and imagination. There is no need to rush. This isn’t over and personally am waiting. Of course, no one can pick the bottom and the market will start reversing when we are still discussing gloom and doom. But is there a vaccine? No. Has the virus peaked? No. Is the situation under control? No. Is there still high growth in cases? Yes. Have we seen any major defaults? No, but I expect we will see some. So, for any investors reading this, I’d say that you should work on your own grocery list and be patient.
In the meantime, take good care of yourselves. Be safe!
