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Today's Thoughts

Our combined experience to help guide you through the markets

MARCH 27, 2020

Stay Invested, Keep Cash Ready 

Staying Invested and Keeping Your Sanity

In last Friday’s blog we showed an overvalued equity market relative to U.S. GDP which has now reverted to the long-term mean and has potentially opened up possibilities to selectively get back into the market. 


Certain companies in the healthcare/biotech, consumer stables and utilities sectors have been disproportionately sold off relative to the economic impact to their business and now present very attractive entry points.  

However, the long-term outlook for the broader market remains vastly negative.  Initial unemployment claims jumped in March to ~3.2 million from ~220 thousand, the biggest rate of change in US history and practically ensures we are going to have a consumption recession that could last anywhere from 3-12 months. 

Initial Claims.png

Growth and inflation are both slowing at the same time, and the Federal Reserve Bank can’t directly control it in the short term with lots of its levers already used. 

Additionally, the corporate credit bubble is beginning to come undone.  Companies like Subway, the Cheesecake factory, H&M (and many more to come) have announced that they can no longer pay their rent, and Tapestry pulled their $700 million credit line and suspended their dividend.  Retail and service companies will struggle in this environment as will anyone with weak balance sheets.  

The probability that the US economy will shrink for two consecutive quarters is certainly possible, and the broader market indexes could retreat 15% - 20% from here; or 50% from the February peak.  Weaker companies will go out of business or be acquired, and many industries will see a reshuffling. However, from an investment perspective, there are plenty of opportunities. Well-capitalized companies with clear competitive advantages will emerge in even stronger positions from this, even if their share price decreases in the short-term.  Other companies, especially in healthcare, will thrive and use this environment to establish themselves as essential businesses for years to come.

Is This The Bottom?

We won’t attempt to call a bottom or a top in the markets.  Especially now, we simply don;t have enough clarity on what comes next.  However, the market predictably trades within a certain range of resistance at both to and bottom based on its recent history.  Recessions, especially deep ones with abnormal demand shocks can break the market’s bottom support, usually while investors are waiting for full clarity on what is happening and how the Fed and the Federal government is approaching the crisis.   

In 2008, the normal support for the S&P 500 was ~1000.  However, in October of 2008, it broke that support and proceeded to fall another 20% to ~800 in early 2009.  The news was still grim at that time, but the Fed and government actions were clear and investors could see a long-term path through.   


Our current market’s normal range of support is around 2600 for the S&P 500.  However, we have broken through that already and this looks eerily similar to 2008/2009.  Each situation is different, but the Federal reserve and Government actions mirror previous actions and we will reach a point where we get enough clarity of stimulus packages and their impact as well as a better timeline for getting the virus under control, at which time investors will have enough confidence that the worst is over. 


Assuming we break normal support by 20% similar to the great financial recession, we could see the S&P 500 go as low as 2100.  Again, we are not calling a bottom, but highlighting a range where we think the market will fluctuate. As more information about both the virus and the economic stimulus becomes available, this range will be calibrated, but this is consistent with most technical analysis using stochastic differential and other tools. 


Depending on your expectations, that may or may not be positive news, but once we understand how far we possibly have to still fall, we can act accordingly and alibrate our investment approach. 


What Are We Doing?

We see tremendous opportunity in an environment that is full of risk and uncertainty.  The way to navigate this environment is to have cash that’s ready to deploy on a moment's notice, upgrade portfolios from high risk to high quality, select companies carefully within industries that are likely to lead us out of the chaos, and make buys at deep discounts.  

This is the time to be ready to invest, not a time to retreat.

As a fund, we continue to operate according to two guiding principles, and encourage everyone to do the same:

  1. Focus current investments on individual companies that can withstand or even benefit from a recession rather than hold broad baskets of companies (buy stocks not indexes);

  2. Preserve cash and be patient.  Investments made over the next 3-6 months will set investors up for far greater returns than previously available.  We will continue to share investment recommendations and timing on both our blog and through specific company reports.  


Stay safe!  Stay healthy!  Stay invested!

MARCH 20, 2020

Put Some Cash To Work & Save Some For Later

When is it safe to go back in the water?

With a 30% drop in equity markets, the question for investors now is whether there is more to come or whether it is time to get back into the market?   No one will ever call a market bottom correctly, but with a lot of the froth gone, prices are now quite attractive and this is a time for investors to keep a long-term perspective and start to conservatively buy back into the indexes and more aggressively buy individual companies that have been disproportionately sold off without its outlook materially changed.  


In the middle of the chaos and carnage where every day is a new low, it’s often hard to see how things will ever get better.  However, we will get through this.


So what happened?

Any way you measure it, absolute U.S. equity valuations have been historically high for some time, which obviously set them up for a correction.  However, valuations have been elevated for some time, and simply continued to march higher, in what has become the longest economic expansion in U.S. history.   This has conditioned many investors to assume that whenever stock valuations become stretched, it’s safe to assume that they can become stretched even more.

The CAPE ratio and Q ratio all indicated the market was frothy, but looking at the ratio of the Wilshire 5000 index over GDP through January 2020, is probably the easiest way to see that valuations were well-ahead of the mean (orange perforated line). 


From 2016 on, valuations kept expanding beyond the mean, fueled mostly by extra liquidity from the Fed.  That the unemployment was at an all-time low and economic indicators were all flashing green gave investors confidence.  Commission free trades for retail investors simply added to the froth. We would probably have had a softer landing were it not for two adverse simultaneous shocks to the system - the COVID-19 pandemic and oil prices dropping below $35 per barrel; which is the result of Russia and OPEC being locked in a price war.  These events elevated fear and accelerated the selloff, which mirrors the selloff we saw in the Great Recession after the Lehman Brothers bankruptcy (see figure 1 below)


Table 1.


However, while it may feel like it, this is not 2008 all over again.  The virus’s impact will likely be large and sharp, but the economy is on more solid footing and, importantly, the financial system is much more robust than it was going into the crisis of 2008.

So is this the bottom?

With the current drop, valuations are now back to the mean.  The froth is gone and markets are even pricing in a two-quarter recession.   


While the official backward-looking announcement will not come until Q4, we are likely in a recession already.  With much of the world operating in 2nd or 3rd gear due to the pandemic, the economic impact will definitely be material.  The spread of the virus in the US is expected to continue ramping up, and from a health and economic perspective, the worst is definitely ahead of us.  However, the stock market is forward-looking and this is now priced into the current valuations. There is an outside chance that the recession will be deeper and stretch well into 2021, but this seems unlikely.  


All governments and central banks around the world are taking swift and imminent action.  The virus should lessen with warmer weather and natural immunity while we await a vaccine.  This leaves only oil as a major global economic risk. However, current oil prices are not sustainable for either OPEC or Russia in the long run, and will eventually rise.  We will likely experience a second wave of the virus next winter if a commercial vaccine is still not available. We hope that with better testing and wisdom acquired this year, the world will be far better prepared.  


From an investor’s perspective, the pendulum always swings too far in either direction, and markets most often overshoot the bull case when both liquidity and investor confidence are high.  Now that valuations are correcting, we'll likely overshoot again on the downside, given investors’ shaken confidence and extreme uncertainty around what this virus really means. Technical support for the S&P 500 is (or was) at around the 2550-level.  We are already below that, so indications are that we might already have overdone it.  


Volatility will remain high for some time, but this is a time for investors to keep a long-term perspective.  The ultimate depth and duration of the coronavirus’ economic impact are definitely uncertain, but with all hands on deck globally to combat it,  the shock should be temporary as the outbreak will eventually dissipate and economic activity will normalize for investors with a 6-12 month horizon, all indexes present an attractive risk/reward at these level and can conservatively be bought now.  There are enough individual companies that now offer so much upside that aggressive buying can begin and we recommend that investors put some cash to work. 

MARCH 19, 2020

What Can You Trust?


What Can You Trust?

Right now, the list of things you distrust is probably a lot longer than the things you do trust.  The markets haven’t just been choppy or turbulent, they’re downright volatile.  Can you trust the stock market?  Your 401K or IRA are looking pretty scary.  Can you trust your financial advisor? On every news station all we hear about are death rates and pleas for government help.  Can you trust the government?   With our normal trust shaken, these are trying times, but also manageable if we just focus on what we can control.


What’s Within Our Control?

We need to make these choices; worry about everything, or just focus on the things we can manage.  As investors, we’re choosing the latter.  We can choose to panic over the testing, the emergency response, the inconveniences, and the tragic loss of life; but realistically we can’t effect any change on any of those things.  As investors we have no advantage in trying to predict the extent of this viral outbreak.  Our advantage lies in our ability to analyze companies and the price points where they represent great value.  


Where’s The Bottom?

We’re going to hear this question a lot; but don’t think that anyone really knows.  We can use technical tools to make educated guesses, but ultimately, we know that there is no calling a bottom.  We know that our advantage is in selecting individual stocks, so that’s where we’ll apply ourselves.  The overall market is still above fair value, but there are names where the pendulum has swung too far, and the stock prices have become attractive again.  Some names still have further to fall.  As an investment firm we’ve slowly started legging back into the market, buying high quality and high conviction names at deeply reduced prices.

MARCH 18, 2020

COVID-19 And The Markets


On a day when the US President and Treasury Secretary came out with important announcements, we saw the market rally.  As we write this there is news of a possible vaccine and a rapid deployment of testing nationwide in the US.  The situation is serious, but we also see a way through this. 


What we have to fear is fear itself – So let’s get objective

The situation is scary, and without a historical precedent, the worst-case scenario becomes whatever people can think up in their mind.  For many, that is a health and economic market apocalypse.  As such, it’s important to stay very grounded in reality as much as we can.  


Some of the data we’ve been looking at to date estimates that a large part of the global population will be affected by COVID-19, perhaps double that of the common cold, or half the population. However, this is based on models incorporating exponential growth for a sustained period of time.   However, exponential growth models assume that new people can be infected every day since infected people keep meeting new people.  In reality, though, most people meet and interact with the same people every day and after some time most of these will either be infected or immune, and the spread will slow or stop altogether.  When you consider the Diamond Princess cruise ship, it represents the worst-case scenario, as the close confines of the ship offered optimal conditions for the virus to be passed among those aboard. Despite this, infection rate was closer to 20%, more in line with the common flu. 


The best information we have says that ‘Peak-Virus’ is expected in about 8-weeks in mid-to-late May.  People affected by the virus will experience varying degrees of symptoms from being asymptomatic, having mild symptoms, and unfortunately death.  Death will be more likely for people with comorbidity issues like respiratory illnesses and immune system diseases.  

Covid-19 Mortality Rate.png

The mortality rate varies by age group, as seen below, but when you factor in everyone expected to become infected and consider that many will either already be immune or not exhibit any real symptoms, the mortality rate will come down significantly from early estimates; likely closer to 0.15% per the Cold Spring Harbor Laboratory at Yale’s latest estimates.  That is still double the regular flu and not to be taken lightly. 


Assuming a 20% global infection rate and overall mortality rate of 0.15%, this means up to 2 million people globally will “die” from COVID-19 (7 billion x 30% x 0.5%).  To put that in context. approximately 50 million people died from the Spanish flu at a time when modern medicine was a fraction of what it was today. Far more people die of heart disease each year, and sepsis and cancer each claim the same number of victims.


Few Incremental deaths from COVID-19

However, what’s important to keep in mind is that globally, about 43 million people die each year due to age-related diseases.  There will be significant overlap between this group and people dying from COVID-19, and the 2 million potential deaths attributed to the virus won’t likely be incremental deaths, but rather elderly people who were already sick dying sooner due to infection and respiratory issues.  That may sound like good news (if 10 million people dying can be contextualized as “good news”).  However, the acceleration of deaths will definitely stress the healthcare system significantly and have cascading effects on others in the system, albeit not deadly. 


The other good news is that this is likely not a permanent killer.  Even if the virus recurs seasonally, most people will build up immunity and the mortality rate will plummet in future years.  When put in this context, the virus becomes less of an unknown killer where worst-case scenarios are only limited to people’s wildest imagination. 


Life will get back to normal 

We have models that can, with some level of confidence, estimate the virus’ duration and begin to model when our self-imposed quarantine will end and re-ignite demand.  We can also model the return of the supply chain, and when we will be ready to resume our normal busy lives.  All signs point to a 2H 2020 waning and economic recovery.


Fear may linger and changing human behavior remain the wildcards

However, what we can’t model is how this has seared our DNA.  We can’t yet measure the fear that this has instilled in people and how that has spilled into human behavior and investment decisions.  Unlike the last major economic recessions, we now live in a world where, for better or for worse, social media dominates daily human information flow and people are informed more quickly about the ills of the pandemic, often without professional curation and context.  One month ago, the idea of shutting down entire US cities seemed unfathomable, yet here we are.  If that is on the table, what other scenarios do investors now deem within reason to include in their risk premium?  Social distancing may stay with us for more than a few weeks and will in many ways change our way of life.  When the virus is gone, will air travel resume as normal or will we start driving more?  Will people dine out less and cook more at home?  Will friends and family gatherings decrease or increase with more virtual gatherings online?  The impact to the service industry might take some time to emerge.  We have no precedent for modeling this kind of psychological impact, so any projections at this point are a dice roll.


For now, it’s important to stay grounded and let facts and data dictate our next steps.  

MARCH 16, 2020

The Fed Acted, But It Wasn't Enough

Markets are responding to significant uncertainty around coronavirus and the impacts on business in the US and globally.  The Federal Reserve’s actions cutting rates to zero was clearly not enough as investors realize that lever is now gone. The Fed then added another $500 billion in liquidity through Repo-Operations.  In the context of a large portion of the economy materially slowing down for at least a quarter, this is a beginning stimulus, but not enough. The Feds next step needs to be a guarantee on commercial paper so that longer dated notes can keep rolling over. Powell also needs to tell Treasury they can overdraft. That allows congress to instruct treasury to send out checks. Ultimately, it's possible The Fed will look to backstop industries instead of specific companies to avoid a financial crisis. The method they can use most effectively is to buy sector ETFs. Instead of helping specific companies as the government did during the financial crisis, they can now support a whole sector and use the open market to eventually get back the investment.  

Let's put all this in perspective; we are having a healthcare crisis, not a financial crisis.  Companies that were significantly over-valued are now coming into ranges where we can buy shares based on their actual fundamentals instead of market sentiment.  As a fund, we have held a great deal of cash in preparation for some event where stocks reprice.  For many companies in the portfolio and on our watch list, we never thought we’d get a chance at these prices, but here we are.  With the DOW down 30% from its highs, we have to begin buying, carefully.   We are probably only beginning to understand the full ramifications of COVID-19 and it’s hard to identify the bottom of the equities market.  The medical community will ramp up testing and we will eventually see treatments and a vaccine. Society as a whole will begin to develop herd immunity, and the financial community and federal government will work to provide stimulus for economic activities.  It’s hard to see an end to the chaos when you are in the middle of the storm, but we will make it through this.  One foot in front of the other.

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