What I'm Reading (2020-03-30)

I wrote last night that two essential developments are needed if we want to see a U bottom.

• Antivirals/therapeutics and a vaccine
• Antibody testing, in order to get people back to work safely.

There actually has been some significant developments.  Most notably Abbot Lab's 5 (ABT) min test, and J&J's (JNJ) large scale vaccine that could be available early next year.  Additionally, Henry Schein (HSIC) is releasing Covid-19 antibody tests.

• The US can bring people back to work safely if it follows these steps

• J&J and Abbott announce potential vaccine and rapid test

• How Covid-19 immunity testing can help people get back to work

I make particular note of these developments because while I believe the most probably scenario remains the L recession, part of being a successful investor is to remain flexible in thinking.  And these developments are unequivocal market positives.

L is for Lower for Longer

There have been three broad scenarios that is being debated by the market.  The V bottom (which i don't believe is even remotely realistic), characterized by a immediate recover.  A U bottom (recession & recovery), which is a longer and more persistent decline which ultimately recovers, and an L recession (global recession) which depicts a bear market, potentially taking months to complete and years to recover.

We are currently in the relief rally phase which I think will take some time to play out.  This phase should end with a decline in volatility.

U Bottom vs L Recession

It's worth analyzing the factors that support the U vs L scenarios.  Personally, I believe the odds of the L scenario (global recession) outweighs the U scenario 2:1 (or about 67% favouring a L scenario).  While I can make the case for both, I find the L scenario more plausible.

U Bottom

QE/2T+ stimulus:  It would seem that authorities have learned a lot from the credit crisis and have leapfrogged ahead of the curve with massive stimulus.  Don't fight the Fed.
Antivirals and Vaccines:  With global efforts of really smart people working to combat the pandemic, it is possible that antivirals/antibody therapies capable of treating Covid-19 are discovered.
Antibody testing:  This isn't the usual test that is being talked about, but we have to start to get a handle on people that have already had Covid-19 and have developed antibodies.  This could allow more people get back to work, but I have yet to hear any significant progress in deploying this at scale.


L Recession

Rolling infection waves: While individual regions are able to somewhat predict when they will have peak Covid-19 cases, they have yet to address how to contain Covid-19 afterwards (safely sending people back to work).  As one area becomes contained, breakouts occur elsewhere which ultimately result in a continuous flow of outbreaks.  China itself, admits to having challenges now dealing with imported cases.  Worse yet, there STILL seems to be regions that are not taking the pandemic seriously.  I believe this is human nature - that the majority of the population will not respond until it directly affects them.  If this is true, then every major city (and country) needs to have its "New York" or "Italy" moment.

Demand destruction due to fear:  Assuming we can deal with the above, getting people back out to spend will prove to be a challenge unless there are effective treatments and a vaccine.   Even with QE/2T+, there's no amount of money sufficient to get the population to wade back into murky waters with a hungry Covid crocodile still on the hunt.

Vaccine 12-18 months out:  A vaccine is sorely needed.  However, by the industries best/optimistic estimates, it is still at least a year out.  This includes testing for efficacy, safety, manufacturing and distribution.

Re-Pricing of Risk:  I think this one is particularly important for the markets, but rarely discussed.  The outcome of the 08 recession was a repricing of credit and safeguards placed on the banking system.  The result of the Covid-19 recession, will cause a repricing of supply chains, placing safeguards on the manufacturing of critical supplies.  This includes very basic commodity products (aspirin, masks, components parts).  This inherently adds cost into the system and furthers the breakdown in globalization.

Regarding these two scenarios, it's important not to get too rigid into one particular belief.  Remain open to new information as its presented.  With respect to investing, use the current relief rally to exit any stocks directly in the Covid-19 blast zone.

I'm still thinking through a longer term investment thesis, but there are four broad themes I'm confident in today.

High Yield: (Be careful with dividends - assume cuts and changing consumer behaviours)
Growth Mega-cap: (Scale matters, and Mega cap stocks will inevitably take share)
Leap of Faith stocks: (looking through the Covid-19 valley, life resumes.  Humans are social creatures of habit.  We eat, shop and seek entertainment.  Some stocks offer tremendous value if you have faith that life goes on)
Gold: (massive stimulus isn't unique to the US)

Risk Manager Jeff

Subscribe to receive by Email

Trading & Investing in the Relief Rally

In my last article, I outlined 3 phases and its clear that we are in the phase 2 relief rally.  In this article, I want to spend a little time on the chart technicals.  These relief rallies often retrace about 50% of the decline which is at $280 for the SPY (S&P 500 ETF).  Additionally, we can easily draw a few overhead resistance lines, essentially all of which are within the black box I've drawn.  

I would expect 2 different paths into this range, ultimately targeting 275.  Either we charge right into that area (as it seems like we have for the past 3 days), or my more preferred case (as depicted with the black arrows), we pause below (where we are today) before breaking out into the box above.

At 275, the market would have sufficiently 

• worked off oversold conditions
• made typical bear market re-tracement
• run up against horizontal resistances lines 
• run up against the downtrend starting back on late February at the market top
• run up against major falling moving averages

In the last article, I also characterized this relief rally to be lead by momentum traders buying, ultimately countered by fundamental sellers.  I'm just going to use Carnival Cruise Lines (CCL) as an example, but there are many to choose from that offer similar characteristics.  These are the companies most impacted by Covid-19 (cruises, airlines) and have rallied the hardest from the bottom.  CCL reversed from $8 to $18 in the past 3 days - a prime example of aggressive momentum traders.  As we approach the top of the relief rally, we should see 

• sellers stop the rally (lack of buyers) in these most beaten down sectors
• a rotation once again into more defensive names (utilities, healthcare, large cap secular growth)
• a rotation into value names - i.e. financials

I believe this is where we are now, observing that utilities and healthcare outperformed today.  The market may also be front running the necessary bond/equity rebalancing at the end of March for Q1.

Personally, I would use this opportunity to sell any remaining positions that are directly affected by Covid-19 to raise cash.  If you're an investor, you shouldn't have any.  And if you're a trader, its time to take profits.

On a pullback, I would be looking to add to still damaged stocks, but names that offer value when looking out 5 years from now.  This includes many of the big tech names, and certain quality blue chip companies.  I would also look at high yielding companies that perhaps have been caught up in the broad market decline that have yet to recover.  These could augment the cashflow portion of a portfolio for many years to come.

In my next article, I will outline my longer term thesis in a "Post Corona World" and specific stocks that should benefit from secular trends.

Subscribe to RiskManagerJeff by Email

Risk Manager Jeff

The Other Side of the Covid-19 Curve

We all know we are heading into the teeth of this outbreak over the next few weeks and a lot of what happens next hinges on how governments and society have responded.  I do believe that the social and government responses are taking effect in varying efficacies, albeit less than I would have preferred.  Todays article isn't about the responses to Covid-19, but rather the market afterwards.  We will get to the other side of the Covid-19 curve as surely as time passes.

By examining the '08, '01, and crash of '29; we can see that these market declines can be characterized in the 3 broad phases.  At this point, there's no reason not to use this as a guide to how this decline will unfold.

Phase 1:  The Panic (short and violent)
This is where we are now.  As I wrote last week, I don't believe the market can find firm footing until main street is flushed with a US Dollar cash infusion.  As it stands today, the stimulus bill was not passes.  (reminiscent of TARP in 08 which did not pass on the first attempt)

Phase 2:  The Relief Rally (2 or 3x the duration of the panic)
Once we get to the other side of the Covid-19 curve, we should see a sharp snapback rally.  This will be fuelled on the thesis of low rates, stimulus money flooding the system and ultimately boosting stocks as again - being the only game in town.  Most importantly, technical and momentum traders will push it up high and fast.  (an over shoot to the upside)  Typically, this is a

Phase 3:  Reality Sets In (months or longer, depending on the damage to the economy)
In this last phase, fundamental investors will slowly gain clarity on earnings.  A new "lower - for longer - earnings" could easily develop as we enter into a period of containment of Covid-19.  That is, many of the social distancing practices which impaired the economy will stay in place.  Travel and leisure will not rebound for a long period of time as we "flatten the curve" and require a longer than expected period of containment protocols.  It is at this phase, where fundamental sellers will act as a counter force to the bullish traders in phase 2.  We should see a another leg down to test the lows as earnings estimates begin to reflect the new reality.  Depending on the damage to the economy and the effectiveness of the stimulus, we could see beginnings of a recovery ('01 or '08 scenarios), or worse yet - a slow decline into a longer lasting global recession ('29 scenario).  A catalyst for a global recession (vs a recovery) potentially could be a shifting societal demand to correct the imbalances between capital and labour - likely in the form of various taxes (a topic for another day).

Over the next few days/weeks, I will outline my thesis on the sectors, themes and individual companies that I believe will outperform in the months and years ahead.

Subscribe in the top right box to receive these updates in your email.

We will get through this and because of that truth, we must plan for it.
Risk Manager Jeff

US Govt Bonds are not legal tender

The 10 year US Treasury yield is back over 1% again.  The TLT (20+ year long term Treasury Bond ETF) has fallen 20% from its peak at $180 to its close today at $144.  

Aren't US bonds a safe haven?  Not always. 

You can't pay your employees, buy groceries and pay your internet bill with US Treasury.  You need cash.  And you need to exchange (sell) them for US Dollars.

As soon as North America began to respond to Covid-19 by shutting down the economy, this immediately put a halt to the movement of cash, and the rush for US dollars began.  On top of the usual causes for a rush to dollars (hedge fund liquidiations, risk parity gone arwy), I believe there are two other important structural issues that are magnifying the demand for cash which are particularly relevant today.

Govt Bonds went parabolic in a rush to safety, and has crashed in a rush to the USD.

First, society (households and businesses) have become 'cashflow' based as opposed to 'balance sheet' based.  Decade ago, it was common to save up a large amount of equity to purchases assets.  These would sit on your balance sheet.  Today, its much more common finance businesses (and even house holds which live paycheque to paycheque!) without the need of much equity (or savings for households).  While this leads to very high return on equity (because there is so little equity), it results vastly more cashflow risk!

The second reason is indexing and low interest rates.  I believe that a lot of small businesses use their business also as their retirement savings.  Low interest rates have forced them to invest in risky assets (stocks, bonds; not cash).  Now, as the economy shuts down and the cashflow they are accustomed to disappears overnight, they are require to sell their stocks and bonds to pay their employees, bills, rent, etc.  This might explain why the selling seems to have been a somewhat steady 4-5% per down day.  As cash needs arise, people are forced to sell to raise cash to save their business.

What does this mean for markets?

I don't think markets (both stock, bonds, and all other asset classes) can gain stable footing until the latest round of proposed stimulus ($1 Trillion in the US) actually puts CASH into bank accounts (or at least close enough combined with raised capital to make it to the next payment cycle).  The expectation certainly helps, but you still can't pay your bills with expectations.

Here's the latest $1T proposal.  The cash won't arrive for another couple weeks so expect periods of forced selling to continue.

• Two $250B cash infusions to individuals (first starting Apr 6, second in mid-May), potentially in the form of $1000 cheques.
• $300B for "small business interruption loans"
• $200B for other loans and bailouts

Risk Manager Jeff

Not only the Bad and the Ugly

There's no need for me to tell you all the bad and the ugly out there in the market, economy and day to day life.  It's been my experience that it behooves one to neither get too bullish nor too bearish.

So let me tell you about The Good with all the bad and the ugly already out there:

Valuation:  when stocks fall, they (usually) do get cheaper.

Historically speaking, forward PEs above 20 are expensive.   I always prefer to flip the PE (Price divided by Earnings) on its head, into Earnings Yield (Earnings / price).  This puts a 20PE at 1/20 = 5% earnings yield at a time when the 10 year gov bond was traded at 2%.  This means you're getting 5% - 2% = 3% to take on market risk.

That was 1 month ago.  How about today?

Today, the market is about 14.5 PE, and flipping that on its head, implies about a 7% earnings yield when the 10 year bond trades sub 1%.  This means you're now getting 7% - 1% = 6% to take on market risk.  The market is now affording you twice the amount of return for taking on market risk.  I'll let you decide if the market risk was higher a month ago (with stocks standing 33% higher - with that much more height to fall; versus today, at a far lower price)

For context, at a 13 PE, I would start to consider to be getting pretty cheap.  This implies (on a reduced $165 forward earnings) that the S&P would be cheap at 13x$165 = 2145, or about 10% lower from here.  Hey, thats just merely one more day like today;)

What is my point?  Right now, the market has fallen about 30% from its highs.  Ask yourself, in 1-2 years, will the economy (and earnings) be 30% LESS than what it was 1 month ago at the highs?

If you answered 'No', then you cant continue to be more and more bearish as the market falls.  Even if the PE stays at 14.5, and earnings make there way back up to more recent estimates of $177, then we are taking about the S&P at (14.5 x $177 = 2566) in a year or so.  From todays S&P close of 2386, thats a 7.5% return.  If the market falls another 10% in panic first, then its more like a 17.5% return!

My point has little to do with the math above, and everything to do with accepting that as prices fall, sometimes...  stocks do indeed get cheaper.

Don't get too bearish.



Peaking Italian infection:  Could it be?

At some point it's going to happen if theres no mobility within the country.  Italy has been in lockdown for over a week, which has now passed the average incubation period for symptoms to show.  Mathematically, new cases should start to slow... just about now....

My theory is that society and governments would continue to ramp responses to Covid-19 until it is contained.  Going into lockdown is pretty much what the Chinese did in Wuhan, so I would expect a total freeze of the Italian population to have a similar chilling effect on the virus.

If I squint, maybe I can maybe see a deceleration just beginning to show....
I'm not entirely sure how accurate and up to date this data is, but judge for yourself below.  Is it maybe peaking?

https://www.worldometers.info/coronavirus/country/italy/

And try comparing the above with South Korea's daily new cases which have long since peaked.

Could Italy be near peak new daily cases?  Perhaps Italy somewhere equivalent to March 1 in South Korea.  If Italy can make it through the valley, than surely we will be able to as well.  And if the market can see through the valley - that's very bullish indeed.

So it's not only the Bad and Ugly out there.

Don't get too bearish.

Risk Manager Jeff

Economic pain is the Covid-19 Antidote

March 15 2020

To recap, last weekend i wrote to look for some milestones that we'll need to cross:

• Total reported infections outside of china to exceed the total in China (just happened today)
• North America infected to reach 10k in 3 weeks (inevitable within days now)
• A major North American city goes into lockdown 

Here are my thoughts this week:

A week ago, i would not have graded any of the social/government responses to Covid-19 anything close to passing grades.  

But things got real.  And that is an improvement.

Government response - Check (reluctantly)

After the declaration of Nation Emergency by Trump, which directs a combined public/private focus to directly combat covid-19, I have to say that government response has kicked into high gear.  This is clearly a positive.  I hope that effective execution follows.  

Corporate response - Check (reluctantly)

I see quite a of bit of bifurcation.  One one hand, a lot of corporations have already executed pandemic response plans - primarily requiring work at home protocols where possible.  I understand thats not possible for a lot of companies however.  

On the other hand, can we please have the Travel and Tourism related companies stop offering incentives to increase social gathering?  Tempting the public with cheap vacations is NOT helping combat covid-19.  Ultimately, I come down on giving this a check at the moment, because of large gathering event cancellations - everything from sporting events to SXSW, and an array of other conferences.

Public response - still lacking

This is a judgement call, but I still don't believe society as a whole is taking this seriously.  It seemed to be only when sporting events were cancelled, did the public wake up - that perhaps something is wrong; that is, it became (more) real for them.  But is that sufficient for them to enact changes in their own day to day life?

Why?  - Fear and a failure to understand non linearity.

Let's start with the latter using an example:  Non-linearity

Suppose there's a lily pad in a pond that grows only in march.  It's planted on March 1st.  Each day, it doubles the number of pads.  

On day 1 it has 1 pad.

On day 2, it has 2.  

On day 3, it has 4.

On day 4, it has 8; and so forth...  

By March 31st, it has covered the entire pond.  

On what day was the pond half covered?

If the lily pad was planted merely 1 day later, how much of the pond would not be covered on the 31st?

Most people in society aren't going to truly grasp that small actions taken today, lead to MASSIVE differences many steps down the road.

The best way to deal with Covid-19, is a full strength response today, not tomorrow.  We need to go for the head.

The second reason is Fear,

Or more precisely - a lack of courage.

Some level of fear is entirely rational.  However, courage is action in the face of fear.  As long as our leadership (and media) does not focus on the actions needed, and instead focus on eye catching / click enticing headlines, people aren't going to change their ways.  Courage and cowardice are both contagious so do your part and act, so that others can follow your example.  We'll know that the public is responding, when the media that holds their attention leads by example.  I'm not sure we are there yet.

The markets being volatile is an understatement  

First, understand that the market price (S&P) is a proxy for the mean value after adjusting for risks (both positive and negative).

I think the best way to look at what the various efforts to combat the virus and the economic fallout, is to look at it as if it was a battlefront.

Monetary actions (Fed rate cuts, 1.5T liquidity) all focus on the fallout and collateral damage.  You have to remember that companies swap US dollars for their goods (not treasury or stocks), so a constant supply if USD is needed.  By attempting to flood the system by buying (thereby injecting US dollars) into the system, the goal is to tide over corporate credit and the supply chain of physical goods.  The last thing we need, is a breakdown of the banking system and a full on credit crisis (08 style) on top of Covid-19.

Fiscal stimulus is best thought of the rebuilding forces, needed after the Covid battle is won.  Additionally, fiscal stimulus that is effective now, is counterproductive to the goverment/corporate/society responses to Covid-19.  We do NOT need any more incentive to go out and gather together right now!  So its not surprising that fiscal news does little to calm markets.

We saw the market rally friday, on the declaration of National Emergency, a public/private partnership to combat Covid-19, a series of corporate cancelations of events and some response by society.  These are all direct counters to Covid-19, which is the primary battle front.  We need positive news in this area to rally the markets.  

As you can see, nearly all of the government actions taken to date (prior to friday) does not directly combat Covid-19 - the root cause of the market malaise.

As I wrote last week, government and societal responses will continue to accelerate as long as Covid-19 is not contained.  At some point, the responses is sufficient to contain Covid-19 and infection rates will plateau and decline.  This is unfortunately a necessary part of the process.

Email me at riskmanagerjeff@gmail.com to let me know if you want updates as events unfold in this crisis.

And stay at home.

If you found this useful, the fee for this email is to share it with someone you know.

RiskManagerJeff

PS - Since writing this early on sunday, the Fed has cut rates to near 0, and is purchasing another 700B of treasury to further inject USD into the system.  Swap lines to other central banks are being established to provide USD to other countries as well.  As I wrote above - these monetary actions do not directly impact the primary battle front (Covid-19), but is necessary to avoid a credit crisis on top of the biological crisis.

A Roadmap to a Covid-19 Market Bottom

Sunday March 8, 2020

If a massive liquidity injection was the antidote to the crisis of '08, then a massive targeted response to halt the contagion of Covid-19 is the antidote we have to wait for today.  

What I expect to happen

1)  infection and deaths will continue to rise as long as its unimpeded; however it will not be unimpeded due to a reflexive response by governments and society.  

2)  as infections and deaths continue to increase, governments will respond more and more aggressively (enforcing lockdowns and quarantines, testing)

3)  as infections and deaths continue to increase, society will implement their own personal protection protocols.  (washing hands, social distancing)

4)  Both governments and society will become more and more draconian in their response until the virus is halted - and will not slow (the teal line) until it is halted.  (this appears to have happened in China)  

What does this imply?

1)  The virus is ultimately halted (at some unknown point in the future - peak of red line)

2)  In hindsight when looking back, the point of max infection panic will likely coincide with a market panic.  This also implies that infection rates would have declined ahead of this event due to the 2 week infectious incubation period - although it would not be observable in the data at the time.

3)  When the market believes that the virus can be contained, it can rally.  This would occur by observing the first large region that has determined sufficient government and social response to contain the virus (in a democratic country)

What can we expect?

1)  Watch the European country infection rates to slow before North America.  Since they are 3 weeks ahead of North America, we can expect European governments and society farther along in their reflexive response to the virus, relative to North America.  What we see in Europe, we should expect to see in North America.

2)  Expect that a point of sufficient government and personal containment protocols will occur (intersect of the red and teal times) while North America is at its max panic being 3 weeks behind.  (when North America is just beginning to put in sufficient measures to halt the virus)  

What am I watching

1)  The North American infection rates to assess where we are currently

2)  The eurozone rates to assess where North America will be in 3 weeks 

3)  The Chinese numbers to gauge the measures needed to contain the virus, as North America and Europe head towards similar measures

When to put money back to work

1)  Wait for Eurozone infection rates / acceleration to slow - which will allow markets to bottom

2)  This likely coincides with accelerating social and government responses here, to match those in the areas in Europe that have slowing rates of infections.

3)  This likely also coincides with max market panic here, as we institute these responses to peak infection risks, and represents a point in time to begin investing again.

Ultimately the market needs to see that both governments and society are mounting a sufficient response to halt the virus.  

Email me at riskmanagerjeff@gmail.com to let me know if you want updates as events unfold in this crisis.

If you found this useful, the fee for this email is to share it with someone you know.

RiskManagerJeff

PS - the oil market is going into free-fall tonight, impacting both energy, currency and credit markets.  I believe most of the move today, is due to risks of a liquidity/credit event due to the linkage to emerging market economies with USD debt, and weakened balance sheets in US energy companies - ultimately affecting financial markets at a time when demand destruction is in full swing, and liquidity is already strained.  Yes, its that convoluted.  However, this is a man-made problem which can be walked/talked back.