March 11, 2020, Comments on Equity Markets

March 11, 2020, Comments on Equity Markets

WHAT IS HAPPENING

There has been significant price volatility this week and indiscriminate selling today as market liquidity (the degree to which an investment can be easily bought or sold) has been drying up.

Why has liquidity been drying up? A confluence of important developments have shocked investors and caused fear. They are mainly 1) Fears about the economic fallout from the coronavirus and social distancing and how long that lasts; 2) The effect that fear has on credit markets, which translates into concern about the equities of companies that have long-term debt on their balance sheets being hit the hardest; and 3) Geopolitical turmoil heating up last weekend with Saudi Arabia declaring that it will pursue a "volume over price" strategy and basically produce crude oil full out.

The Saudis' intent is to force Russia back to the negotiating table in order to make an agreement to curtail production to prop up crude prices, but the real intent is likely to be to finish off the Iranian regime – Iran being Saudi Arabia’s bitter enemy. This upset could go on for a little while but won’t be forever. This news has certainly hit our energy investments.

The ‘why’ is not as important as what it means.

A well-functioning credit market (the willingness and ability of lenders to lend) affects all asset prices, not just stocks. It affects residential and commercial real estate, private equity, commodities, etc. When there are unanticipated adverse developments like the coronavirus, there are reflexive reactions by traders and the public that lead to secondary effects that can be unpredictable and adverse. People’s emotional behavior has real economic and financial impacts. This is an environment where perceptions take on a life of their own and can create negative feedback loops. This is what worries us.

We do believe this will pass. But it’s impossible to predict how everything will play out and the depth and duration of the economic impact. As I write this, authorities in many school districts are considering shutting down public schools, which will certainly have a huge impact on working families and the businesses that employee them. In short, “social distancing” and a shutdown of business across the economy affects everything.

In the spirit of capital preservation, we have liquidated some positions, and we may liquidate more that depend on functioning credit markets. The intent is not to time the market, but to reinvest in businesses that can perform well with things as they are, not as we wish them to be. We also do not want to bet heavily on a return to normalcy in a short period of time. The news is coming so fast it is difficult to evaluate thoroughly, which is why we have been slow to make changes. Also slow to make changes because we want to make sure we are thorough in our reinvestments since we plan to hold them for a long time.

We are not traders. We do not want to react emotionally to significant price changes that imply a deep and prolong recession that no one predicted and may not come to pass. Our overarching goal is to maintain your capital and your net worth in the face of adversity, but also to earn high risk-adjusted, long-term returns. We don’t want to give up upside, but we also want to limit downside. This is why we try to maintain an appropriate balance, to not be rash, and to keep our emotions in check by looking at developments objectively. We will be successful in earning high risk-adjusted returns if we are able to avoid permanent losses in any of our investments and own businesses that are well-managed, well-financed and in stocks well-priced. Despite our best efforts, we won’t get the timing right or pick bottoms or tops in stocks that we buy or sell.

FACTORS IN OUR FAVOR

While it is hard to see positives amidst such consistently negative and alarming news flow, there are some: Two key tailwinds to economic activity are taking hold. The fall in Treasury yields decreases the costs of capital for households, which represent 70% of GDP, and limits the pain inflicted on the corporate sector. Meanwhile, the collapse in oil prices is a drag for the energy sector, but also the equivalent of a tax cut for households and companies that consume energy.

In response to these two market moves, the drags on future economic growth have plunged to their lowest level since the financial crisis. If history is any guide, this combined easing will turbocharge any growth rebound and support stocks on a 12-months basis, once the panic and uncertainty abate.

In the short run, the only sustainable way out of this mess is likely to be a big fiscal package, because the Fed's easing via zero interest rate policy and quantitative easing (the fifth) is already priced in and expected. Communicativeness by government officials to reduce the potential for negative feedback loops is also critical. The market expects the Fed to do
everything it can, but the Fed can’t do it all on its own. Restoring confidence will require a coordinated effort and a rapid one.

With regard to a fiscal package, we believe there will be something similar in magnitude to those rolled out in 2008 in order to stem the equity market hemorrhaging and instill confidence that there is plenty of money available to deal with the fallout of the coronavirus. As I have mentioned in previous articles, we are at a point in time where the direction of the stock market itself is a major factor in US economic activity because it is such a large component of people’s wealth, which in turn affects confidence and, ultimately, their economic behavior.

Please know that we are evaluating relevant news and information as it comes out, and we are keeping our emotions in check. We are totally focused on making the best long-term decisions as we can on your behalf. Nothing is more important to us than the trust you have bestowed on Highgate to do the right thing for you at all times and we will honor that trust.

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