The Bear Market

Good Morning

Another day, another 3% + move in the markets.  This is starting to feel normal. After falling into a bear market faster than any time in history, the market just posted one of its strongest weekly rebounds ever. The questions I began receiving yesterday afternoon can be summarized in one short line "is the Bear Market over?" In my view the answer is "not yet."  History, fundamentals, and that very dangerous emotion known as "feelings" are on my side.

The history of bear markets suggest that a quick resolution of the bear is extremely rare, if ever. Bear market rallies can be powerful, as we saw this week. In my view, the goal of the bear market is to break the spirit of investors, both long and short. These powerful rallies tend to squeeze out the short sellers, providing fuel to the upward move, then breaks their hearts as it returns to the downtrend. We only need to look at 2008 for an example of this action. The fuzzy chart below shows three robust rallies of 24%, 19%, and 27% in October, November, and from Thanksgiving to Christmas of 2008. The market ultimately bottomed three months later, which felt like an eternity.

While markets tend to trade ahead of changes in the fundamentals, we are just at the beginning of the slowdown. We have virtually zero idea what the impact on earnings will be from these quarantines, so any earnings estimate is nothing more than a guess. Yesterday we saw the first snippet of bad news as the unemployment report jumped by 3 million, a record. Given 12 million people work in the food services industry and 17 million in the hospitality services industry, I expect those unemployment numbers continue to spike. It does appear the fiscal stimulus package could pass as early as today, but the question then becomes "how long will it take to get into consumer hands" and "what type of impact will it have."  The answer to the first question is "never soon enough," while the answer to the second question is "it depends." What does it depend upon?  The length and infection rate of this virus and how long the shut-in-place response lasts.

The last reason I doubt the bear is over is my "feeling," which is ironic given that just yesterday, in an interview with Reuters, I gave this quote: "The most dangerous three phrases in our business are  'this time is different'  'I feel as though…' and  'I hope' .  It's never different, your feelings are wrong, and hope isn't an investment strategy."  The consensus seems to be we haven't yet seen the bottom, which makes me immediately concerned as I try to avoid being in the consensus, however, this time I FEEL as though the consensus may be correct, although I HOPE they are not.

I have been through a number of bear markets and will posit that we will do some things right, and will definitely do some things wrong during this period. It's part of the business at all times, unfortunately the errors get magnified during a bear market. Everyone is smart in a bull market, everyone is dumb in a bear market. The most important part of navigating a bear market is not to dwell on the mistakes-NO ONE navigates through this perfectly. Perfection is the enemy of success in a bear market. Regret minimization is the key to mental stability and successfully coming out of a bear market. Don't dwell on the mistakes, it will keep you from executing your plan.

This too shall end. 

Have a great weekend

Ned

Every Note is About Corona Virus

This morning I was fortunate to be able to participate in a call with former Homeland Security Chief Michael Chertoff and former Director of Operations for the CIA Chad Sweet.  Their knowledge on pandemic preparation, security, etc, is invaluable.  I want to pass along some of the important pieces of information from that call.  Additionally, I have spoken with many of our managers over the past two days and was on an investment committee call with 12 CIOs and will include anecdotes from those calls as well. 

Needless to say we are in uncharted territory. There has never been a shutdown of the US economy with this breadth. Undoubtedly we will have a monstrously negative 2nd quarter GDP.  That is somewhat priced into markets today. The question is the duration of the slowdown and the speed of recovery.  The pace of the virus will be key to determining these trajectories, Michael and Chad addressed that issue.  The government reaction has been swift and robust. If the virus impact is relatively short, the economy should explode in 2021, the markets sooner.

Chertoff and Sweet:
1. This emergency is similar to a bioterrorism attack. The government has prepped for this type of attack for since 9/11.  The difference is there is no mass evacuation required and no infrastructure rebuild to follow.
2. The key to a successful path through this epidemic is clear directions and people following the prescribed rules. Social distancing, working at home when feasible, etc, will reduce the strain on our medical system.
3. The US has 1 million hospital beds but only 10,000 respirators. If the infection rate gets large, it will overwhelm the healthcare system and doctors will be placed in the unenviable  position of deciding who gets to use the ventilator.  The social limitations should help reduce the number of severe cases, which they feel is more important to the healthcare system than the mortality rate. Long term ill patients consume medical resources for long time periods. Not to sound cold, but dead patients don't consumer resources.
4. Weather should definitely slow this virus down, possibly ending the infection process by mid-summer. The travel ban to China and other actions helped stave off the onset of the virus in the US, which will work to our benefit as we are one-month closer to summer than a country like Italy.
5. Unless there are changes in the overly bureaucratic FDA, it would be 12-18 months for a vaccine. This becomes dangerous if the virus reemerges in September, much like the Spanish Flu of 2018. The majority of deaths from that pandemic occurred in the second season.   The impetus for the FDA to act judiciously has never been higher.
6. Their view is that the mortality rate is only slightly higher than that of the flu. The bigger issue is the percentage of serious cases requiring hospitalization (morbidity rate), which exacerbates the healthcare resource problem discussed earlier. They feel this percentage could be as high as 10%.
7. The media is dropping the ball, contributing excessively to the hysteria by reporting snippets of data such as a 52 year old dying from the virus. This out of context reporting misinforms  the public (but it helps ratings).
8. The Administration's early mistake was not their reaction, but their expectation that the virus could be eradicated and that would be victory. They have now appropriately shifted their expectations that victory is slowing the spread so as not to overwhelm our healthcare resources. Under that scenario, April 15 and May 15 are key dates for measuring the retransmission and growth rates. If the number of cases has stopped doubling by those dates, the virus should "burn itself out"  If we haven't achieved knocking the growth rate below 100% by then, we run the risk of this coming back as a full blown pandemic in the fall.
9. Outside of the early messaging mistakes, the financial and medical response from government has been on track  and for the most part textbook.
10. South Korea's success is due to their 70 years of being in a state of war. They practice and have stockpiled supplies in the event of a chemical or germ warfare attack from the North for the past 70 years.
11. If the number of infections tracks too far up and will overwhelm the number of beds available, the government will have to lower their standard of care and open college dorms, hotels, and parking lots for care centers.
12. The virus won't be rendered  completely gone until either a vaccine or exposure to the virus infects the majority of the population.
13. China's reports of no more cases are BS.  China consistently lies about their activities.  Additionally, people are loathe to self-report this illness because the government will yank them out of their homes, along with their family, and isolate them.

Regarding our portfolio, I have been on calls with our PE managers. Our allocations to distressed managers (XXX and XXX) should benefit from this environment.  Additionally, based upon the investment committee call I was on earlier today, it appears our secondary investments with XXX should also benefit as CIOs are concerned about liquidity and are looking to sell selective PE interests. I have also been on the phone with XXX XXX at XXX-at this time they are flush with dry powder and only have one portfolio company to worry about which means, unlike other managers with larger portfolios, they can focus on using their cash for opportunistic purchases versus shoring up existing portfolio companies.

For our overall portfolio we have quite a bit of cash and will use it strategically but patiently as this situation will not be resolved in the next two weeks. We should be thinking in terms of months, with a mid-late June time frame being realistic and a success.

Have a great day

Corona-Virus Economic Impact

I typically like to write on Fridays, however, given how rapidly the economic conditions are deteriorating (along with the markets) as the hysteria spikes, this morning seems like a good time to send out some thoughts.

First, the virus. According to the CDC, 80% of people will experience cold or flu-like symptoms if they contract the virus. The remaining 10-14% will experience more severe symptoms and of those, 10-14% will experience critical symptoms. For those not following the math, 1-2% of those contracting the virus will experience critical symptoms. The United States has 1233 cases of Covid-19 as of this morning and 37 deaths. To put these figures in perspective, H1N1 in 2009 killed 280,000  and this year’s flu has killed 45,000. If you are older than 65 or have underlying health issues, especially lung related, you are in the higher risk group.

The NBA has postponed the remainder of their season. The NCAA has announced March Madness is now cancelled. Conferences and travel have been cancelled or dramatically curtailed. Major banks, Google, Twitter, and scores of other companies are having their employees work from home. Universities, including Ole Miss where my son attends, have cancelled ground classes and are moving online (BTW-my son gets an extra week of spring break while they figure this out, he's quite excited). Costco is out of toilet paper (I love that one and don’t quite get it). Without proper perspective and guidance, organizations are taking draconian measures and it’s having a major effect on the economy.   

Why is this occurring? Fear and misinformation. This is the first epidemic to occur during the social media age. The majority of Gen Z and Millennials do not subscribe to cable television. Most of their news comes from social media-Facebook, Twitter, Instagram, etc. As Abraham Lincoln once said “The problem with stealing quotes off the internet is you never know if they are genuine.” I have friends on Facebook who were constitutional scholars in January during the impeachment and are now global virologists. The point being, too many people are taking their cues from social media, and given the vacuum of leadership from the White House, the reaction has taken on a life of its own.

Although the virus has not made significant progress in the United States so far, the reaction is having a severe impact on the economy. Two weeks ago my recession probability jumped to 60%, today it’s at 90%. The impact on the hospitality, travel and entertainment business is breathtaking and this alone will have a ripple effect through the rest of the economy as these workers become either underemployed or unemployed. Retail is being impacted as shoppers avoid malls, yet crowd into Wal Mart and Costco to stock up on staples.

I’m anticipating a weak set of earnings for the first quarter, with significantly lower guidance (or no guidance) from companies for the second quarter and the remainder of 2020. A few companies may benefit during this period-some healthcare companies, Amazon (when you’re shut in, someone needs to deliver), Facebook/Google/Twitter/Netflix (as people stay home, they need something to do), Apple (device sales will be soft, but the higher margin services business should benefit), Zoom and WebEx (video conferencing), Grand Canyon (online education), etc. The majority of companies will suffer, especially those which are consumer facing.

Given our large cash position coming into February (17%), we are looking for a spot to put capital back to work. Given the speed at which the economy is deteriorating, and the market along with it, we are being cautious  but systematic. The fear factor is high in the market as evidenced by the VIX, which has spiked to 67 this morning, not far from a record high. Given the 25% correction in the stock market, this isn’t a horrible time to add to equities. The question is whether this will be a 4-6 week economic shutdown or a 4-6 month shutdown. If the former, the market has probably seen it’s worst moments. If the latter, we have another 10-15% to fall. For those looking for spots, legging into the markets makes sense and if you haven’t already done so, your first tranche should be now.

The federal government is discussing a number of ideas on the fiscal front to help stimulate the economy. In my view their efforts won’t be helpful in the short run without creating confidence that the virus is under control.  What could create a quick turnaround in the economy?  A government sponsored, mass testing program for the virus would be significant. Those with the virus could self-quarantine, those without could go back to their regular routine.

The Fed is active and will become more active as certain credit markets become impaired. (in fact, after I wrote this, the Fed added $500 billion in asset purchases) With a few exceptions, the markets have been functioning smoothly in spite of the mass selling. High yield spreads have spiked, BBB credit has collapsed, and treasuries have rallied-all normal responses for a slowing economy.

I’m happy to answer any questions. This is a fluid situation that we are monitoring closely. As an example, I have been reading hourly updates from the CDC to keep up with their latest thinking on the progress of the virus-now I’m a global virologist 😊

Have a great day and weekend.

Ned