The future is always uncertain. Investing relies heavily on the past to predict what will happen going forward. Generally the past is a good indication of what we can expect. Nevertheless, there are always moments in time when things are more uncertain than others and the recent past cannot really help us to forecast future earnings for companies. This would be one of them. It took a virus to bring the longest bull market on record to a screeching halt. But that is not all that it has done. On top of increased mortality, what Covid 19 has achieved is to provide a view of a different world going forward for the next 12 to 18 months. Even if these changes ultimately end up being marginal, they will have an economic impact that will last for generations to come.
Ultimately in investing it is well known that it is impossible to catch the top, or the bottom. Nobody really knows when the time to buy or sell is exactly so you have to do both in a measured and disciplined way. What is true for both is that it hurts. It hurts to sell when things are still going up, leaving money on the table. It really hurts to buy when everybody is scared and in a panic and things never looked worse because most likely things will keep going down for a while a longer until the last panicked investor is out. We are officially in a bear market and it is important to remember that the last two bear markets lasted 21-24 months from peak to trough. These two bear markets also provided rallies of 12-25% along the way before the final trough was reached. Everyone wants to go back to the glory days pre-February of 2020 but that is just not how economies and markets work. There will be several downturns and wonderful rallies in between before this is all over. No need to feel anxious or in a panic about either getting in or out of anything.
The simplest mantra to follow is to buy when things never looked worse but the story is getting better, and to sell when things never looked better but the story is getting worse. We started the year with a very cautious approach (defined by higher than average cash weightings) because markets were valued to reflect only good news. At this point nobody would argue that in February things never looked better. However the story was getting worse as a pandemic was on the way. That was the time to sell. Indeed the market then had the fastest fall in the shortest period of time in history as it dropped 34%, from the peak on February 19th to the trough on March 23rd.
For the moment, the story is unfolding, and we would argue it continues to get worse as the impact of the virus and the economic shutdown has barely begun.
The market usually corrects this much by retracing over months not over one month. So market pundits will argue it is all over. The stocks already reflect all the bad news, so time to pile back in. We would argue that unlike other economic slowdowns, this one cannot really be fixed with money. It can only be fixed with medical solutions that take time. Do you really think you will be fighting to get that last middle seat on a plane any time soon? Do you believe the majority would be keen to go to a concert or a sporting event unless this menace was clearly behind us? Also, how do you value what has never been valued before given the economic drop (travel and leisure were a very big part of our economy) will be larger than anything we have seen in the last 100 years? Furthermore, this virus has shown some very weak links in the supply chain that will undoubtedly have to be fixed. How do you value that when nobody yet has a good handle on what that is? Lastly, the Saudis and the Russians have chosen the middle of a crisis to start a price war on oil, that can only result in the ultimate destruction of a lot of North American supply. Given the highest leverage was in the energy sector that now has no way of paying back those loans, can you really say what these companies will be worth until the price of oil stabilizes?
All this to say that in order to place a value on the overall market today, you have to assume everything returns exactly back to how it was up until February of 2020. We would argue that is highly unlikely. Economic disruptions of this magnitude have everlasting consequences. Subsequent rallies to the March 23rd low reflect a reality that may not be possible for many months, possibly years, to come. Just like the past two bear markets in 2007/09 and 2000/2002. We will return back to normal. It just will not be overnight. There is no V recovery here under any scenario.
Some have argued that when the curve flattens, i.e. the number of reported cases does not grow, then we are past the worst of it and it is time to pile back into the stock markets. We disagree. Flattening the curve is about allowing the health system to cope with the number of hospitalizations so that everyone that needs a ventilator can get one, and therefore hopefully survive. That is all.
Others have argued about the trillions of dollars that the central banks have thrown at the problem to tide people over. This has indeed been very good news because it was achieved with great speed, and primarily because it has kept an over leveraged credit system from going into default, potentially creating a worse financial crisis than that of 2008. But we must not lose sight of the fact that this is simply a band-aid. It is a short term solution to provide much needed liquidity to the markets so they can continue to function. Ultimately however, the businesses that should never have been in business will have to be allowed to default and the good businesses will carry on. That is the way capital markets work. Unfortunately, that means pain. Recessionary pain, because too many of these businesses were never really viable but they were allowed to flourish on cheap debt thrown at them for the past decade. Saving the zombies at the tax payers expense would not be a solution. It would just mean greater pain for tax payers in the future.
That brings us to the second problem presented by all the massive liquidity provided by central banks that were over levered to begin with. We had the greatest bull market in history for the last ten years, with economies that were growing, albeit at lower rates than in previous decades, yet not one country thought it appropriate to start saving for a rainy day. The rainy day has come and we are yet again fixing the problem of too much debt, with more debt. How does this end?
Today’ s problem is medical. From where we stand, the story will stop getting worse when we have the ability to test on a massive scale so that those that have the virus can be isolated and treated, those that had the virus can go back to work, and those that have not had it can take extra precautions to not all get it at the same time. Eventually only when 60% of the population has had it, will herd immunity protect the rest of us. The only other options are either to come out with drugs that can be given to people to avoid dying from this virus or a vaccine to avoid getting it. Both of which are unlikely to be available to the population at large, in a safely approved manner, until 2021. Sadly, to date, tests are not widely available, and when they are, they are not yet testing with all these goals mentioned above necessarily in mind.
That does not mean we need to sit on our hands in the meantime. Not losing sight of the fact that our first and foremost priority is to protect capital, we are also in the business of maximizing returns, on a risk adjusted basis. This leads us always to valuations. Notwithstanding the fact that many businesses today cannot be appropriately valued given there will be changes in how business is conducted in the future, there are many businesses that will be fine and can in fact be assumed that some day normal times will return. These are the ones with strong balance sheets, with strong competitive advantages from providing a unique product or service that people must have and are willing to pay up for. Unsurprisingly, these businesses even with the recent market drop, still do not look particularly cheap.
We need to wait until earnings seasons reports come out, analysts are forced to downgrade their estimates (few have done so to date), investors are forced to accept a new reality for many industries, and a revaluation will need to take place. This will likely be accompanied by more capitulation on the overall market (not unlike March 23rd, but hopefully with more gusto) which will take all the names down, the good and the bad. When this happens the companies we want to own will get sold too. Index investing is all about throwing the baby out with the bath water and the largest amount of money today is invested passively in this manner. That is when we get excited and step in to buy those names that we know will get through this virus, recession, or even depression, just fine. There is never a right time to buy. Because the best time to buy is always when it feels the worst. Things will have never looked worse. But from a valuation standpoint, we will know that things are actually getting better. That day is still not today.
Stay healthy and be safe. This too will pass.
The Summerhill Team