“Basically, the stupider you are, the smarter you think you are and vice versa."
- Richard Feynman
Finally! All of those people on the Doomsday Preppers TV show don’t look so ridiculous now! Ok, let’s get some disclosures out of the way. I'm not a doctor. I'm not a scientist. I used to be a volunteer CPR and First Aid instructor for the American Red Cross, but that was quite a few years back. I’ve long lost any competence I once had with Resusci Annie or Andy or however he/she/it identifies these days. I can apply band-aids and administer Children’s Tylenol, and I’m semi-skilled in the art of “shake it off” when it comes to most falls and bumps. So, I’ll leave the detailed scientific analysis of the coronavirus to the YouTube virology/investing/makeup/gaming experts out there, who seem to be spreading faster than the virus itself.
Prior to this week, the markets were largely complacent and dismissive of the coronavirus. The collective “wisdom” seemed to be that it would play out like others in recent memory - a quick flare up with a rapid response followed by a speedy retreat into the recesses of our collective memory. If that wasn’t reassuring enough, the market seemed to take comfort in the omnipotence of our monetary and fiscal overlords, secure in the belief that any economic hiccup, stock market dip, rise in ocean levels, alien invasion, or pesky bug will be readily dismissed with a simple counter-clockwise turn of the golden spigot of stimulus. I mean, nothing bad seems to have mattered for a decade now, so why should this?
The markets finally came to their senses this week as it became clear that there may be some economic impact from quarantining millions of people. If factories are closed and people aren’t working, traveling, or retailing, there’s going to be an impact. If companies can’t get parts for their products in this just-in-time inventory world, there’s going to be an impact. To make matters worse, the world has gone on a massive debt binge this last decade, led by China, and that debt needs to be paid or rolled over. So, yeah, there’s going to be an impact in this debt-soaked world that was already hugging the flat line before this virus surfaced.
The coronavirus is a nasty little thing, and it’s going to be made the scapegoat for every poor economic report and earnings miss we see in the coming quarters. One of my bathroom fans died on me two days ago, and I immediately blamed it on the virus. The reality is that global economic activity was slowing well before this virus erupted. Activity in China was weakening, and Japan and Germany were teetering on the edge of recession. Car sales were down, bad debt was climbing, and industrial metals were weak. Despite the growing evidence of economic weakness, the U.S. stock market had recently erupted into the mania phase of the bubble. The only thing keeping this ridiculous charade running was heavy deficit spending, central bank stimulus, and the madness of crowds. The fragility of the entire system has been increasing for years. The coronavirus didn’t cause our problems. It’s only helping to reveal some of them, like this grossly overvalued stock market.
In the span of a week, this grossly overvalued stock market has dropped 11% (before Friday). That’s about as quick a 10% drop as the market has ever experienced, and the airwaves are predictably full of headlines screaming “panic”, “crash”, and “plunge”. After listening to me drone on about this bubble for a while now, none of us should be surprised by this pullback, but let’s add some more perspective on this latest downdraft. The chart below shows the S&P 500 going back 5 years. This recent pullback has taken the stock market all the way back to where the big 20% pullback of late 2018 BEGAN. We haven’t seen any real earnings growth in the past year, so the rise in the market has been driven almost entirely by multiple expansion. This pullback has simply unwound the run-up in equities that occurred after the Fed started expanding its balance sheet again last fall. This recent pullback may feel dramatic, but it hasn’t done anything to improve the attractiveness of equities in general. Remember, the last two bear markets saw declines of 50-60%. The S&P 500 would have to fall another 44% just to hit the low end of that range.
I thought and tentatively claimed that the market was running on fumes in early 2018. That looked prescient until the Fed started pumping again this past fall, but the market is now back near those early 2018 levels. This all continues to feel like the large, drawn-out topping process we’ve been discussing. There are many potential paths for the coming bear market to follow, and I have no strong view of which will prevail. We can’t even be certain that this recent decline will continue in the coming weeks. Nevertheless, it will all implode at some point, and the coronavirus may well be the pin. The positive feedback loops of stock buybacks, algorithmic trading, and passive investment flows will reverse. I’ve believed that Trump was certain to be reelected barring a recession. If he bungles the handling of this virus (which he has so far), the economy slips into recession (very likely), and the stock market drops into a bear market (we’re half-way there), the Democrats will have a much better chance in November. Regardless of your politics, the market is not pricing in a Democratic win. This could add to the negative feedback loop.
I do expect we’ll hear from the Federal Reserve soon, but if they were smart, they’d let the air come out of stocks and just blame it on the virus. This is a terrific “Get Out Of Jail Free” card for the Fed. It’s not like they have much room to cut interest rates at this point, with the Federal Funds rate at a paltry 1.55%. Despite the strategic intelligence of sitting still, I suspect Powell and the Fed will succumb to the pressure to “DO SOMETHING!!!” I’m not smart enough to figure out how cutting low interest rates or expanding QE will actually help with the virus, but St. Louis Fed President Jim Bullard tried to clear it up a few days ago on CNBC. When asked how a quarter-point rate cut would help with the flu, Jim sputtered about an interest rate cut helping because maybe you drink more orange juice than usual if you get sick. Ummmm…ok. If Americans are so bad off that they need to get a personal or home equity loan to buy more orange juice any time they get the sniffles, we’re in more trouble than I thought. This is the thinking of the geniuses who control our nation’s monetary policy. This is a nice example of why we own gold.
We may make some modest changes in the days ahead, and we’ll look to take advantage of any short-term panic, but I’m comfortable with the structure of our portfolios. We have different buckets within our portfolios that serve different roles. The sizeable cash, safe yield, short, and put option positions aren’t terribly helpful when the market is ripping higher, but they sure have been nice to own this week. The active positions that we do own each have a very solid underpinning that isn’t dependent on strong economic growth or a continuing equity bubble. Precious metals will continue to benefit from excessive monetary policy response in the years ahead. Our other two active bets are focused on two small niche industries with essential products, incredibly undervalued shares, and strong supply/demand imbalances in the years ahead. They are not well-followed or particularly liquid, so it isn’t surprising to see them get hit (with most everything else) in a panic. If anything, we’ll look to take advantage of this. If the drop continues, we’ll start unwinding our shorts and puts, and we’ll start adding to any of our favorite names that get unduly punished. Our process and methodology are mundanely methodical, even during a panic.
Remember, in a panic, investors sell everything that isn’t nailed down. There is no rationality. We’ve talked about how a panic phase would likely play out like it did in 2008, with just about everything besides the U.S. dollar and Treasury debt being sold, regardless of investment merit. We’ve seen that this week. We’ve very intentionally avoided the most overvalued, manic, cult stocks, the vastly overvalued mega-caps, the obvious high-flying frauds, the money-losing companies with flawed business models, and irreparably indebted firms. What we don’t want to own are unjustifiably expensive stocks that can get cut in half and still be grossly overvalued. There is ultimately a lot of air beneath those names.
I’ve been doing this for almost 30 years and have been through my share of manias and crashes. I'm seldom surprised and can easily and dispassionately evaluate a bubble as well as a panic. I don’t chase bubbles, and I don’t soil myself during a panic. One of my few talents is being able to keep my head about me while others freak out. I know what we own, I know why we own it, and I know how to value it. If you feel any call to action these days, my advice would be to stock up on non-perishable food items, beer, and a few months of whatever medical supplies and prescriptions you need. Start thinking about how you can limit your contact with others. The coronavirus is here, and there’s a good chance it’s coming to your community. Remember what grocery stores look like a day or two before a hurricane. This could be a hurricane that sticks around a bit longer. If you’re not worried about the virus, you should at least be concerned about how others react. I’ve taken my own advice and stocked up. Yesterday was also my last day at the gym for a while, and I’m actively planning out how to further nourish my inner introvert. I’ve also purchased a Resusci Andy to dress up in Army fatigues and post in a Karate Kid pose on my front lawn.
Ken, CFA, CFP, New Amateur Prepper
The Market Rubbernecker is associated with Aspera Financial, LLC, an investment management and financial planning firm based in the Cary, Raleigh, and Durham area of North Carolina. This and all Market Rubbernecker missives and musings (written, oral, or mimed) are subject to the disclaimers, disavowals, and hindquarter-coverings found at www.asperafinancial.com/aboutrubbernecker.