I must confess that I don’t know what is going to happen in investment markets, or what the impact of coronavirus, economic shutdown, and policy responses will be for the prices of investments. Massive stimulus makes that impossible to predict. What I can do is opine on what are the major long-term risks and opportunities.
We can all agree that quarantining the vast majority of citizens has caused extensive economic damage and has dramatically changed our daily lives. Suffice it to say that we live in challenging times for the modern world. US citizens are not accustomed to being made to stay home.
The focus of this letter is on the economic and market forces underpinning the 1st quarter’s steep market decline and rebound; and to explain our approach for navigating Highgate’s clients through this unsteady time.
As it became increasingly apparent during the 1st quarter that the economic threat from the coronavirus was both real and significant, stock prices (the S&P 500) rolled over and finished down by 20% for the quarter -- the worst quarter since 1938. From peak to trough, the S&P 500 declined 34%. Apart from sparking a humanitarian crisis, the virus came at the top of a Fed-wrought credit bubble that was allowed to expand for eleven years through interest rate suppression, quantitative easing, government deficits, and bailouts. What is rarely acknowledged is that the remedies deployed to combat slow economic growth post-2008, namely cheap credit and deficits, are now the source of fragility in our financial system. The virus simply revealed this.
Once again, over the course of the last eleven years, rising asset prices resulting from ever-increasing borrowing and leverage were mistaken for genius. Company after company borrowed money on the cheap to buy back their own stock. Private equity sponsors flourished as flush institutional investors sought ‘alternative returns’, thereby bidding up prices of everything. Real estate speculators borrowed money to build vacant buildings and to buy more and more properties as prices continued to rise. Conservative investors who saw this and who were reluctant to participate paid for their forbearance by losing clients who feared missing out on those speculative returns.
As if to punctuate the top of this speculative mania, Ray Dalio, the acclaimed billionaire hedge fund manager said, “cash is trash” at the Davos Conference on January 21, 2020 (approximately 21 trading days before the biggest and swiftest drop in stock prices in recorded history). While he was right during a long period of time when Federal Reserve was doing everything possible to devalue cash, he was also wrong. What he probably meant to say was that if you hold cash, you might miss out on the very last of the gains at the top of the 11-year old credit-induced asset bubble. Disregard risk, Ray would advise -- prices are going to the moon.
To take a step back and shorten a very long explanation of what caused the market dysfunction, volatility and 1st quarter decline, in a nutshell this is what has happened: technology, automation, immigration and globalization (the outsourcing of manufacturing) displaced US labor and saw entire industries move their production offshore. As a result, the working and middle classes in the US suffered declining real (meaning after-inflation) household incomes (see Exhibit 1). This trend began in earnest in the late 1990s. Incomes have been flat for 20 years, with a slight uptick in the last three years due to full employment.
To try to mitigate and mask the effect of flat real incomes, the Federal Reserve and Congress felt not only that they should suppress interest rates to cause rising asset prices and to encourage speculation, but they should also run huge peacetime budget deficits for decades. If asset prices rose, people would feel wealthier and spend more. And if markets balked, they would implement numerous ‘bailout’ programs and pledge to “do whatever it takes” (Mary Daly, San Francisco Fed President, March 31, 2020) to keep things going. Since the mid-1990s this resulted in massive recurring credit bubbles (see Exhibit 2).
Emboldened by super cheap credit, professional investors went all in. They often disregarded high valuations because (1) they get paid for returns (not the quality of risks assumed); and (2) it is not their money. These are the hedge funds, pension funds, mutual funds, leveraged ETFs, REITS and product pushers of various stripes. Bubbles form mainly from the career incentives of institutional investors caught up in the performance derby to maximize one’s own compensation for ‘outperformance’. Trying to outperform means taking on more and more risk. The last 25 years have seen a series of speculative manias, built on the backs of savers, retirees and risk-averse investors who have suffered below-inflation interest rates. The most recent is the third credit bubble in 20 years.
As we have mentioned in previous letters, the WeWork debacle in 2019 signaled the likely top of the latest credit bubble. SoftBank (WeWork’s private equity sponsor) has now backed away from a tender offer to bail out WeWork’s existing shareholders, citing significant criminal and civil investigations. WeWork has collapsed into billions of dollars in losses and a morass of lawsuits. None of that should be surprising… it is what usually happens when incompetent self-promoters are given access to too much cash and credit. Still coming are the inevitable consequences of a recession – televised Congressional hearings, new regulations, and "blamesmanship."
The best advice we can offer during stressful times is to turn off CNBC. CNBC only offers a skewed, fantastical version of financial markets. Even worse, it is scripted by the Wall Street promotional machine (watch who the ad sponsors and the guests usually are). CNBC’s sole motivation is to draw in viewers by appealing to individuals’ basest desire to make a quick buck. Apart from occasional guests such as Stan Druckenmiller, Warren Buffett or Jim Grant, it is eye candy for the speculative crowd. One need look no further than Jim Cramer’s comment on Lyft’s first post-IPO trade of $87.24 where he Tweeted “good price Lyft.” The stock now trades at $31.51.
The intent is not to imply that Highgate has all the answers. We don’t. But some investments, such as Lyft, were terrible risks at high prices. Of course, any investment that is priced well and a good risk can also get knocked down due to unforeseen circumstances. I believe strongly that investors will have better results if they simply avoid bad risks in the first place and not play musical chairs with money.
That said, anything can happen in markets. The S&P is only back down to where it was in August 2019, nine months ago. Obviously, this is based on the Fed’s liquidity injections and the prospect of huge amounts of government largesse. The market is therefore pricing a fairly rapid recovery, which may indeed be the case. We shall see.
Given the unknowns, Highgate shifted to a more defensive stance for our clients in early March and purged companies that faced existential risk from economic shutdown. This was not a market timing call. It was simply recognition that the US faces unemployment numbers similar to the Great Depression, consumption behavior significantly changed, whole industries that will restructure, and a deterioration of the government’s creditworthiness. At current levels, those factors are not priced in.
It was difficult to sell the stocks of well-run businesses with great market positions, reasonable prices and real long-term prospects. However, we can’t rely on fundamentals alone in an economy that has nearly stopped. Extended quarantine is a game changer. Since long-bond yields are at microscopic levels, we raised our allocation to cash and plan to keep it until (1) herd immunity is in the cards and economic activity comes back (which will take many months); or (2) we get capitulation/indiscriminate selling of high-quality investments. The overall market trades at very high historical multiples implying low future returns, but that is due to a very heavy weighting of high flying tech stocks that trade at astronomical valuation (see chart below). We avoid the tech high-flyers because they have very low future returns.
To assess price levels of where stocks begin to become super attractive, we can use past crises as a guide. During the panic low in 2009, the S&P 500 traded down to 10.9X forward earnings. Granted, that was a different crisis with different causes. The consensus 2020 forward earnings estimate published on 3/30/2020 for the S&P 500 is $163. Assuming that is accurate (it may in fact be optimistic) and history repeats itself, a panic low of around 1800 on the S&P 500 is possible. This is not a prediction, but rather a view that it is difficult to get too excited about stocks at the current level.
If the crisis abates quickly and we get back to business as usual, we won’t even get close to that low. But the potential for that kind of downside is why we hold more cash than normal, some gold, and more defensive, dividend paying stocks that should survive and thrive on the other side. Stocks get much more interesting below 2000 on the S&P, so for now we will maintain lighter allocations until something changes.
Cash is not easy to hold either because the economy could easily begin to see rising consumer prices due to production shutdowns, broken supply chains, shortages and the government putting out money through Fed and Congressional largesse. Even though we are back to 0% interest rates and hyper-stimulus, the government’s ammunition has limited effectiveness. The economy needs to purge bad businesses that only exist because of subsides of some form. As such, now is still not a time for long-term investors to be aggressive or to speculate in positions that have been the most beloved by hedge funds and leveraged investors for years. Please call us if you have any questions, or if you would like to know more about Highgate and how we might serve you. We are always available by phone, email, or by Zoom and Skype. We work very hard to make high-quality decisions for our clients and to deliver a superior client experience.