more on coronavirus and the stock market

In an earlier post, I outlined what I saw then as differences between SARS in 2002 and the new COVID-19 in 2019.

Updating:

–it appears China has mishandled COVID-19 in the same way it bungled SARS, surpressing information about the disease, allowing it to become more widespread than I might have hoped.  Not a plus, nor a good look for Xi.

–if press reports are correct, the administration in Washington is ignoring the advice of the Center for Disease Control and approaching COVID-19 in the same (hare-brained) way it is dealing with the economy–potentially making a bad situation worse

 

I think COVID-19 will be in the rear view mirror by July–as SARS was in 2003–but the road to get there will be bumpier than I would have guessed.

 

–the way the stock market has reacted to the new coronavirus  gives some insight, I think, into the differences between how AI discounts news vs. when human analysts were in charge.

when humans ruled 

Pre-AI, analysts like me would look to past examples of similar situations–in this case, SARS.

Immediate points of difference:  COVID-19 is not a unique occurrence–it’s the latest coronavirus from China but not the first so the fact of a new coronavirus should not be as shocking as the first was.  COVID-19 carriers are contagious before they exhibit symptoms, so quarantine is more difficult–i.e., transmission is harder to stop.  On the other hand, the death rate appears to be significantly lower than from SARS.

Two other factors:  the first half of 2003 was the time of greatest medical risk; generally speaking, the stock market back then rose during that period (because the world was just entering recovery from the popping of the stock market internet bubble in early 2000;  given that we’re in year 11 of recovery from the financial crisis, gains shouldn’t be anywhere top of the list of possibilities).

Obvious investment areas to avoid would be operations physically located in China or with large sales to/in China; anything travel- or vacation-related, like airlines, hotels, cruise ships, amusement parks, tourist destinations.

It’s harder for me to think of areas that would prosper during a time like this, mostly because I’m not a big fan of healthcare stocks.  Arguably anything operating totally outside China and not dependent on inputs from China; highly-automated capital-intensive operations rather than labor-intensive,   Public utility-like stocks.

Portfolio reorientation–becoming defensive and raising cash–would have started in early February.

the AI world

What I find interesting is that the thought process/behavior I just described only started happening, as far as I can see, about a week ago. That’s when news headlines began to emphasize that COVID-19 was spreading to areas outside China.  Put another way, the selloff came maybe three weeks later than it would were traditional investment professionals running the show.  In the in-between time, speculative tech stocks shot up like rockets.  The ensuing selloff has hit those high-fliers at least as badly as stocks that are directly affected.

In sum:

–late reaction

–violent, December 2018-like selloff

–recent outperformers targeted, whether fundamentals affected or not.

what to do

Better said, what I’m doing.

The two questions about every market selloff are:  how long and how far down.  On the first front, it seems likely that COVID-19 will be a continuing topic of concern through the first half.  The second is harder to gauge.  There was a one-month selloff in December 2018 that came out of nowhere and pushed stocks down by about 10%.  Today’s situation is probably worse, but that’s purely a guess.

I’ve found that even professional investors tend to not want to confront the ugliness of falling markets, and tend to do nothing.  However, in a downdraft stocks that have been clunkers don’t go down as much as former outperformers.  Nothing esoteric here.  It’s simply because they haven’t gone up in the first place.

A market like the one we’re in now almost always gives us the chance to get rid of clunkers and reposition into long-term winners at a more favorable relative price than we could in an up market.  My experience is that this is what we all should be doing now.  As I wrote above, my hunch is that we don’t need to be in a big hurry, but there’s no reason (especially in a zero commission world) not to get started.

 

 

 

Keeping Score for January 2020

I’ve just updated myKeeping Score page for January.   weaker world economy = interest rates lower for longer = more buoyancy in stock markets

Hong Kong riots

a brief-ish history

During the first part of the 19th century the UK’s stores of gold and silver were being depleted (in effect contracting the country’s money supply) to pay for tea imported from China.  London suggested to Beijing that they barter opium from the British colony India instead.  Beijing sensibly refused.  So in 1841 the British army invaded China to force the change.  The UK seized Hong Kong to use as a staging area and kept it once China submitted to its demands.  During a second Opium War (1856-60), launched when China again balked at the mass shipment of narcotics into its territory, the UK seized more land.

In 1898, China granted the UK a 99-year lease over the area it occupied.  This legalized the status of Hong Kong, which remained under the practical control of the “hongs,” a newer form of the old British opium companies, for much of the 20th century.

In the late 1970s Deng Xiaoping made it clear that the lease would not be renewed but that Hong Kong would remain a Special Administrative Region, with substantial autonomy, for fifty years after its return to China on June 30, 1997.  (For its part, the UK parliament decided Hong Kongers would find the climate of the British Isles inhospitable.  So these soon-to-be-former British subjects would be issued identity cards but no other legal protections–citizenship, for example–within the Commonwealth on the handover.  This is a whole other story.)

Hong Kong’s importance today…

The conventional wisdom at that time was that while Hong Kong China’s main goal in triggering the return was to set the stage for the eventual reintegration of (much larger) Taiwan, where the armies of Chiang Kaishek fled after their defeat by Mao.

Today Hong Kong is much more important, in my view, than it was in the 1980s.  Due, ironically, to the sound, and well-understood worldwide, legal framework imposed by the UK, Hong Kong has become the main jumping-off point for multinationals investing in China.  It’s also an international banking center, a transportation hub and a major tourist destination.  Most important for investors, however, is that its equity market not only has greater integrity than Wall Street but is also the easiest venue to buy and sell Chinese stocks (Fidelity’s international brokerage service is the best in the US for online access, I think, even though the prices in my account are invariably a day–sometimes three–old).

…and tomorrow

Mr. Trump has begun to weaponize US-based finance by denying Chinese companies access to US capital markets, US portfolio investors and, ultimately, the dollar-based financial system.  China’s obvious response is accelerate its build up of Hong Kong as a viable alternative in all three areas.  As with the tariff wars, Trump’s ill thought out strategy will most likely galvanize these efforts.

the riots…

Hong Kong has 27 years left to go as an SAR.  For some reason, however, Xi seems to have decided earlier in 2019 to begin to exert mainland control today rather than adhering to the return agreement.  His trial balloon was legislation under which political protesters in Hong Kong whose statements/actions are legal there, but crimes elsewhere in China, could be arrested and extradited to the mainland for prosecution.  This sparked the rioting.  These protests do have deeper underlying causes which are similar to those affecting many areas in the US.

…continue to be an issue

The recent change in Hong Kong’s stock listing rules (to allow companies whose owners have special, super voting power shares) and the subsequent fund raising by Alibaba seem to me to show that Beijing wants Hong Kong to become the center for international capital-raising by Chinese companies.  From this perspective, Xi’s failure to minimize disruptive protests by withdrawing the extradition legislation quickly is hard to understand.

One might argue that Xi, like Trump, is trying to reestablish an older order, purely for the political advantage it gives.  In China’s case it entails reviving the Communist Party’s traditional power base, the dysfunctional state-owned enterprises that Deng began to marginalize in the late 1970s with his move toward a market-based economy (i.e., “Socialism with Chinese Characteristics”).   I find it hard to believe that Beijing is as impractical and dysfunctional as Washington, but who knows.

My bottom line:  I think the Hong Kong situation is worth monitoring carefully as a gauge of how aggressively China is going to exploit the opening Trump policies have haplessly given it to replace the US as the center of world commerce–sooner than anyone might have dreamed in 2016.

 

 

 

 

 

 

 

 

 

 

 

 

 

public utilities and California wildfires

public utilities

The idea behind public utilities is that society is far worse off if a municipality has, say, ten companies vying to provide essential services like power and water to citizens, tearing up streets to install infrastructure and then maybe going out of business because they can’t get enough customers.  Better to give one (or some other small number) a monopoly on providing service, with government supervising and regulating what the utility can charge.

The general idea of this government price-setting is to permit a maximum annual profit return, say 5% per year, on the utility company’s net investment in plant and equipment (net meaning after accumulated depreciation).  The precise language and formula used to translate this into unit prices will vary from place to place.

The ideal situation for a public utility is one where the population of the service area is expanding and new capacity is continually needed.  If so, regulators are happy to authorize a generous return on plant, to make it easier for the utility to raise money for expansion in bond and stock markets.

mature service areas

Once the service area matures, which is the case in most of the US, the situation changes significantly.  Customers are no longer clamoring to get more electric power or water.  They have them already.  What they want now is lower rates.  At the same time, premium returns are no longer needed to raise new money in the capital markets.  The result is that public service commissions begin to reduce the allowable return on plant–downward pressure that there’s no obvious reason to stop.

In turn, utility company managements typically respond in two ways:  invest cash flow in higher-potential return non-utility areas, and/or reduce operating costs.  In fact, doing the second can generate extra money to do the first.

How does a utility reduce costs?

One way is to merge with a utility in another area, to cut administrative expenses–the combined entity only needs one chairman, for example, one president, one personnel department…

Also, if each utility has a hundred employees on call to respond to emergencies, arguably the combined utility only needs one hundred, not two.    In the New York area, where I live, let’s say a hundred maintenance people come from Ohio during a blackout and another hundred from Pennsylvania to join a hundred local maintenance workers in New York.  Heroic-sounding, and for the workers in question heroic in fact.  But a generation ago each utility would each have employed three hundred maintenance workers locally, most of whom have since been laid off in cost-cutting drives.

Of course, this also means fewer workers available to do routine maintenance, like making sure power lines won’t get tangles up in trees.

the California example

I don’t know all the details, but the bare bones of the situation are what I’ve described above:

–the political imperative shifts from making it easier for the utility to raise new funds (i.e., allowing a generous return on plant) to keeping voters’ utility bills from increasing (i.e., lowering the permitted return).

–the utility tries to maintain profits by spending less, including on repair and maintenance

The utility sees no use in complaining about the lower return; the utility commission sees no advantage in pointing out that maintenance spending is declining (since a major cause is the commission lowering the allowable return).   So both sides ignore the worry that repair and maintenance will eventually be reduced to a level where there’s a significant risk of power failure–or in California’s case, of fires.  When a costly failure does occur, neither side has any incentive to reveal the political bargain that has brought it on.

utilities as an investment

In the old days, it was almost enough to look at the dividend yield of a given utility, on the assumption that all but the highest would be relatively stable.  So utilities were viewed more or less as bond proxies.  Because of the character of mature utilities, no longer.

In addition, in today’s world a lot more is happening in this once-staid industry, virtually all of it, as I see things, to the disadvantage of the traditional utility.  Renewables like wind and solar are now in the picture and made competitive with traditional power through government subsidies.  Utilities are being broken up into separate transmission and generation companies, with transmission firms compelled to allow independent power generators to use their lines to deliver output to customers.

While the California experience may be a once-in-a-lifetime extreme, to my mind utilities are no longer the boring, but safe bond proxies they were a generation or more ago.

Quite the opposite.

 

 

 

 

 

 

 

the best of all possible worlds/the invisible hand/modern portfolio theory …and stupid stuff

Leibniz

Scientific thinkers of the seventeenth- and eighteenth centuries in Europe described the universe as being like a gigantic, complex, smoothly-functioning watch.  This implies, they argued, that the cosmos must have been made by the supreme watchmaker = God.

G W Leibniz, the inventor of calculus, offered the idea (later lampooned by Voltaire in Candide) that ours is also the best of all possible worlds.  What about war, famine, disease, poverty…?  Leibniz’ view is that though we can imagine a world like ours, only better, that thought-experiment world is not possible.  Put a different way, Leibniz thought that behind the scenes God uses a calculus-like maximizing function for his creation.  The total amount of goodness in the world is the highest it can be.  Were we to make one existing bad thing better, other things would worsen enough that the sum total of good would be reduced.

Adam Smith

Around the same time Adam Smith introduced into economics basically the same idea, the “invisible hand” that directs individuals, all following their own self-interest, in a way that also somehow ends up serving the public interest.  This idea, still a staple of economics and finance, has the same, ultimately theological, roots–that behind the scenes a benificent God is working to create the best possible outcome.

since then

The scientific world has moved on since Leibniz and Smith, thanks to Hegel/Marx (social evolution), Schopenhauer (collective unconscious), Darwin (natural evolution), Kierkegaard (God of religion vs. god of science), Nietzsche (change without progress) and Freud (individual unconscious).

Twentieth-century physicists, starting with Einstein, have suggested that the universe is in fact messier and more unruly than Newton thought.

Nevertheless, the laissez faire assumption of the invisible hand that makes everything ok remains a key element of economic and financial theorizing.

Modern Portfolio Theory

Invented by academics over fifty years ago, MPT is what every MBA student learns in business school.  Its main conclusion is that the highest value portfolio (i.e., the best of all possible portfolios) is the market index.  A cynic might argue that the main attraction of a theory that says practical knowledge or experience in financial markets is useless is that it suits the interests of professors who possess neither.

However, the conclusion is not just convenient for the educational establishment.  It also fits squarely into the 18th century European Enlightenment view of the “invisible hand” guiding the market.

MPT requires a bunch of counter-intuitive assumptions, summed up in the efficient markets hypothesis, including that:

–everyone acts rationally

–everyone has the same information

–everyone has the same investment objectives

–everyone has the same investment time frame

–everyone has the same risk tolerances

–there are no dominant, market-moving players.

Granted all this, one can argue that any portfolio that differs from the market will be worse than the market.

The standard criticism of MPT is that it ignores the bouts of greed and fear that periodically take control of markets.  In fact, even while MPT was being formulated, markets were being roiled by the conglomerate mania of the late Sixties, the Nifty Fifty mania of the early Seventies and the wicked bear panic of 1974, when stocks were ultimately trading below net cash on the balance sheet and still went down every day.

Arguably anyone looking out an ivory tower window should have noticed that MPT had no way of talking about the crazy stuff that was roiling Wall Street almost constantly during that period–and which showed its assumptions were loony.  Nevertheless, theology trumped the facts.

today

In a way, MPT suits me fine.  The fewer people looking for undervalued companies the easier it is for the rest of us to find them.

However, one basic high-level assumption that even professional investors still make is that the economic/political system in the US functions relatively prudently and therefore the economy remains more or less stable.  But in essence this is only a different way of saying the “invisible hand” guides self-interest-seeking individuals in politics toward a socially beneficial result.

I’m not sure that’s true anymore, if it ever was.  For one thing, Washington has relied almost exclusively on monetary policy to fine-tune the US economy over the past generation–encouraging all sorts of unhealthy financial speculation and intensifying social inequality.  Washington has also done less than the ruling body of any other developed country to help citizens cope with dramatic structural economic changes over the past twenty years.  Resulting dissatisfaction has caused the rise to power of newcomers like Donald Trump who have pledged to address these issues but whose racism, venality and stunning incompetence appear to me to be doing large-scale economic and political damage to the country.

This development presents a significant issue for laissez faire theorists in the way deep emotionally-driven market declines do for the efficient markets hypothesis.  As a practical matter, though, the situation is far worse than that:  recent events in the US and UK illustrate, populating the halls of economic and political power with self-serving incompetents can do extraordinary amounts of damage.  Left unchecked, at some point this has to have a negative effect on stock returns.

 

 

 

 

 

 

 

 

 

 

what to do on a rebound day

It doesn’t appear to me that the economic or political situation in the US has changed in any significant way overnight.  Yet stocks of most stripes are rising sharply.

What to do?   …or if you prefer, what am I doing?

Watching and analyzing.

A day like today contains lots of information, both about the tone of the market and about every portfolio’s holdings.  Over the past month, through 2:30 pm est today, the S&P is down by 4.8%.  The small-cap Russell 2000 has lost 7.7%, NASDAQ 7.8%.   All three important indices are up significantly so far today—NASDAQ +2.2%, Russell 2000 +1.9%, S&P 500 +1.8%.  So this is a general advance.  Everything is up by more or less the same amount, meaning investors aren’t homing in on size or foreign/domestic as indicators for their trading.

What we should all be looking for, I think, is what issues that should be going up–either because they’re high beta or have been beaten up recently–are shooting through the roof and which are lagging.  (“Lagging” means underperforming other similar companies or underperforming the overall market.)  The first category are probably keepers.  The poor price action for the latter says they should be subjects for further analysis to figure out why the market doesn’t appreciate their merits.  Maybe there aren’t any.  

We should also note defensive stocks that are at least keeping up with the S&P.  That’s better than they should be doing.  They may well be true defensives, meaning they stay with the market (more or less) on the way up and outperform on the way down.  This is a rare, and valuable, breed in today’s world, in my view, and can be a way to hedge downside risk.

 

 

Another topic:  Over the past few days, I’ve been in rural Pennsylvania filming my art school thesis project–yes, I’ve gone from stills to video–so I haven’t kept up with the news.  I’m surprised to see that the UK, which still remembers the enormous price it paid a generation ago resisting fascism, has done an abrupt about-face and allowed Mr. Trump to make a state visit.  The anticipated consequences of Brexit must be far more dire than the consensus expects.