a bear market in time? sort of…

In the middle of a garden-variety bear market–i.e., one orchestrated by the Fed to stop the economy from running too hot–I remember a prominent strategist saying she thought the market had fallen far enough to be already discounting the slowdown in profits but that the signs of recovery were yet to be seen.  So, she said, we were in a bear market in time.

We’re in a different situation today, though:

–most importantly, we don’t know for sure how much damage the coronavirus will do, only that it’s bad and we unfortunately have someone of frightening incompetence at the helm  (think:  the Knicks on steroids) who continues to make the situation worse (while claiming we’re in the playoffs)

–with most of the seasoned investment professionals fired in the aftermath of the financial crisis, and replaced by AI and talking heads, it’s hard to gauge what’s driving day-to-day market moves

–if we assume that the US economy is 70% consumption and that this drops by 20% in the June quarter, then COVID-19 will reduce GDP by 14% for those three months.  This is a far steeper and deeper drop than most of us have ever seen before

–on the other hand, I think it’s reasonable to guess that the worst of the pandemic will be behind us by mid-year and that people released from quarantine will go back to living the same lives they did before they locked themselves up.

 

It seems to me, the key question for  us as investors is how to navigate the next three months.  In a pre-2008 market what would happen would be that in, say, six or eight weeks, companies would be seeing the first signs that the worst was past.  That might come with more foot traffic in stores or the hectic pace of online orders for basic necessities beginning to slow.

Astute analysts would detect these little signs, write reports and savvy portfolio managers reading them would begin to become more aggressive in their portfolio composition and in the prices they were willing to pay for stocks.

 

How the market will play out in today’s world is an open question.  AI seem to act much more dramatically and erratically than humans, but to wait for newsfeeds for stop/go signals.  (My guess is that the bottom for the market ends up lower than history would predict and comes closer to June.  At the same time as the market starts to rise again, it will rotate toward the sectors that have been hurt the worst.  Am I willing to act on this?   –on the first part, no; on the second part, looking at hotels, restaurants…when the time comes, yes)

A wild card:  Mr. Trump now seems to be indicating he will end quarantine earlier than medical experts say is safe.  At the very least, this will likely bring him into conflict with the governors of states, like NY, NJ and CA, who have been leading efforts to fight the pandemic.  At the worst, it will prolong and intensify the virus effects in areas that follow his direction.  Scary.

 

 

 

the morning after

As I’m writing this, US futures are indicating about a 4% rise in the domestic stock market   …after about a 7 1/2% fall yesterday.

I was particularly struck by the weak performance of energy stocks on Monday.  Despite yielding 6%+, Exxon (XOM) was down by 12.2% and ended the day yielding 10x the 10-year Treasury.  Shale oil-related issues like Occidental (OXY)  at -52%, with a 9.6% yield, or WPX Energy (WPX) at -45% were hit very hard.  The sector as a whole dropped by 20%.

In the premarket, XOM is +8%, OXY +23%, WPX +14%.

I mention this not because I’m a fan of oil–it’s the new tobacco, in my view, which is not a good thing (this is much more evident in Europe than here).  It’s because daily moves like this are real headscratchers.  It’s either total panic by humans or AI run amok.  I don’t know which.  But the company fundamentals certainly haven’t yo-yoed like this in two days.  If I were convinced real people were either panicking or being caught out by margin calls I’d be much more comfortable buying.

 

Buying or not, from a tactical viewpoint I do think it’s important for investors to look carefully at the price action from yesterday as well as what today brings, assuming there’s follow through to the upside.  Prices during times like this are chock full of information.  The ideal combination would be outperformance yesterday and outperformance today.   The reverse, underperformance both days, is to me a clear danger signal.

As to the market overall, I think time is the main issue we’re facing.  It will likely be hard for stocks to go up until the domestic incidence of new COVID-19 cases begins to decline.  Midyear?  A narrower question, but still important, is when the “stay at home” stocks will run out of steam.  My guess is sooner than later.  Another hunch–I haven’t done any work) is that highly operationally leverages transport stock (meaning all of them?) are riskier than they appear.  After all, we’ve already seen one small EU airline go under.  And the shine may be off cruise lines for a long time.  I continue to find the administration’s efforts to prevent testing and otherwise obstruct treatment of COVID-19 hard to fathom and very scary.  With my portfolio manager hat on, however, the real impending disaster is the Trump fiscal and trade policy.

 

A point of basic arithmetic:  a stock starts at 100.  It falls by 50% on day one and rises by 50% on day two.  It’s now at 75.  That’s nowhere close to breakeven.  Apply that to OXY.

 

 

Keeping Score for February 2020

I’ve just updated my Keeping Score page for February and year-to-date.  What a strange time!

margin calls

When I looked at my Fidelity account this morning I saw two odd things:  a simplified interface, and a message sent to everyone with a margin account (my wife and my joint account with Fidelity is a margin account, although we don’t trade on margin).  The message was essentially a warning to be on the alert for potential margin calls.

I’ve never seen this before.  A caveat:  until I retired at the end of 2006 all the family money was in the mutual funds I was managing, in whatever vehicle my employer required.  Still, I didn’t see this in 2008-09.

Two conclusions:

–Fidelity is anticipating/seeing volume increases that are testing the limits of its software (probably mostly an issue of private-company-esque aversion to spending on software infrastructure)

–more interesting, aggregate equity in the accounts of its margin customers must be dangerously (for the customers) low.  Margin-driven selloffs are typically ugly–and very often mark a market bottom.  Here’s why:

margin trading

In its simplest form, a market participant establishes a margin portfolio by investing some of his own money and borrowing the rest from his broker.  He pays interest on the margin loan (Fidelity charges 5% – 9%+, depending on the amount) but all of the gains/losses from the stocks go to him.  The client does relinquish some control over the account to the broker.  In particular, the broker has the right to liquidate some/all of the portfolio, and use the proceeds to repay the loan, if the portfolio value minus the loan value falls below specified levels.

Before liquidating, the broker tells the client what is going to happen and gives him a short period of time to put enough new money (securities or cash) into the account to get the equity above the minimum amount.  This is a margin call.

If the client doesn’t meet the call, the broker begins to sell.  The broker has only one aim–not to get the best price for the client but to convert securities to cash as fast as possible.  Of course, potential buyers quickly figure out what’s going on and withdraw their bids.  Carnage ensues.

That’s what Fidelity was saying we’re on the cusp of this morning.

There are some very shrewd and successful margin traders.  Around the world, though, retail margin traders are regarded as the ultimate dumb money.  That’s why seeing forced selling from these portfolios is typically seen as a very positive sign for stocks.

 

 

 

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.

 

 

 

more on the new coronavirus

SARS

SARS emerged in China in November 2002.  Local authorities, later removed from office in disgrace, initially failed to sound an alarm about the new disease, apparently thinking reporting it would reflect badly on them and hoping it would just go away if ignored.

The world first became aware of SARS as a public health threat in February 2003.  The disease was declared under control in July 2003.  By that time there had been 8000+ reported cases and about 800 deaths.  The overwhelming majority of the fatalities were in China.  The elderly and the very young were the age groups hardest hit.

the new virus

As of yesterday, there had been 2700+ cases of the new coronavirus reported and 80+ deaths.

There are four differences I see between the SARS epidemic and this year’s outbreak:

–faster reporting and more aggressive quarantining today (the disease is passed through contact with an infected person’s bodily fluids.  There’s no medicine that works against it, so isolating victims is the only “cure”)

–symptoms emerge on average about ten days after infection, pretty much the same as with SARS.   But unlike the case with SARS, where carriers only became infectious after they showed symptoms, carriers of the new virus appear to be infectious from day one, long before they become visibly ill

–China is a much larger part of the world economy today than it was back then.  While the US has grown by 80% (using conventional GDP) since 2003, China is 12x the size it was then.  So the slowdown in global economic activity that will result from quarantine measures in China today will be greater than it was for SARS.  If SARS is a good indicator–and it’s the only one we have, so it is in a sense our best guide–the current outbreak will be well past the worst by mid-year

–SARS happened just as the world was beginning to recover from the recession caused by the internet bubble collapse of early 2000.  The new virus comes during year 11 of recovery from the downturn caused by the near-collapse of the US banking system from losses that piled up during years of wildly speculative lending and securities trading.  In other words, SARS happened when profits were beginning to boom and stocks really wanted to go up; in contrast, this virus is happening when profits are plateauing and stocks want to go sideways mostly because interest rates are crazy low.

investment thoughts

During the SARS outbreak business travel came to a screeching halt because people feared becoming sick/being quarantined in a foreign country. If it’s correct that the new virus can be passed on even before the carrier shows symptoms, the risk in using public transport is substantially greater.  So too the possibility that one’s home country will temporarily bar returnees from virus-infected areas.

Securities markets in China are currently closed for the New Year holiday.  It isn’t clear that they will reopen on schedule.  In the meantime, China-related selling pressure will likely be redirected to markets like New York.  Alibaba (BABA) shares (which I hold), for example, are down about 6% in pre-market trading.  At some point, assuming as I do that the SARS analogy will be a good indicator, there’ll be a buying opportunity.  For me, it’s not today, although if I weren’t a BABA holder I’d probably buy a little.

It will be interesting to see how AI handles trading today.

 

 

WeWork (WE) and Wall Street: my take

I’ll start out by underlining that I don’t know enough about WE to have a usable investment opinion about the offering’s merits.  I do have opinions, though.  It’s just that they’re more like my thoughts about the Mets than a way to make money.  Anyway, here goes:

in general

–the WE structure isn’t new.  Think: a savings and loan, or a hotel chain, or an airline or an offshore drilling company, or a container ship firm–or, for that matter, a cement plant or a coal mine.  All these involve owning expensive long-lived assets which are typically debt financed and whose use is sold bit by bit.   Although there may be attempts at branding, with varying degrees of success, in the final analysis these are commodity businesses.

–in good times, this is a favorable structure for a company to have.  Costs remain relatively constant as selling prices rise, so most of the increase drops down to the pre-tax line.  Rental/purchase contracts may limit annual price increases, but investors typically factor in anticipated rises relatively quickly

–in bad times, it’s not great.  Customers may stop purchasing with little notice, sometimes walking away from contracts or renegotiating them sharply downward (using the threat of termination as leverage).  Offshore drilling rigs are an extreme example of feast/famine cyclicality

–because of cyclicality, PE multiples for mature firms with this structure tend to be low.  When such companies come to market, they tend to try to ride a wave of energy generated by previously successful IPOs–meaning that simply the appearance of their offering documents is a sign of potential overheating

WE

–in the case of WE, investor perception appears to be frosty.  This is partly because of what I’ve just written.  Also, from what I’ve heard and read, the 350+-page prospectus is not particularly illuminating (I’ve flicked through it but haven’t analyzed it myself)

 

investment implications

The arrival of the WE prospectus coincides with a sharp selloff in the shares of recent tech-related IPOs.

Two possible reasons:

Wall Street thinks that the marketing campaign for WE heralds the end of the line for the current IPO frenzy, on the argument that the underwriters would be presenting a higher quality offering if they had one.  This is what I think is going on.

The other possibility I see is the week-long, humorous but kind of scary Alabama weather discussion, an episode I think makes anyone question the mental stability of Mssrs. Trump and Ross.

In any event, given that some newly-listed tech names have fallen by a quarter or more over the past week or so, I think it’s time to sift through the ashes.

 

Having said that, I do suspect that a significant rotation away from these former market darlings, triggered by WE but based on valuation, is now underway. This will only mark a fundamentally new direction for the stock market if the tariff wars go away completely.  I don’t think this will happen.  So I’d buy a partial position now and hope to pick up more on further weakness.  Remember, too, that this is a highly speculative corner of the market, so it’s not everyone’s cup of tea.