When you buy a stock, you buy its risk. Yesterday I sold 25% of my stocks. I may be sorry I didn’t sell more. My financial adviser gave me ample things to think about before he pulled the trigger for me but in the end I think we are way beyond owning risk, so I held my nose sold into yesterday’s rally.
Phil, my adviser asked me: “So you think that corporate earnings will be permanently impaired going forward?” This is a good question and used to head me off, but the real question is do you think corporate risk (volatility) is going o rise to Lehman brother levels. I think we are at Lehman levels. In 2007 I saw the crash coming. It was absolutely clear but I didn’t know what to do. The right thing to do would have been to get out. IT’S ALWAYS BUY LOW SELL HIGH! The argument is “ya but when do you get back in?” The answer is when risk normalizes.
My reasoning follows
- This is a chart of the S&P 500 going back into the 70’s. I drew something like a long term up sloping trend line which shows market growth over the past 40 or so years i.e a long term trend. I next drew a line that captured the market peak in 2000 and about the time Trump was elected. The chart shows the recent year high of 3397 and the year low of 2480 put in Thursday. I don’t know what the value of the long term trend is, but it seems clear we are still above long term trend. This means from a long term perspective stocks are still not cheap. The laws of large numbers preach mean reversion, I don’t think we have yet reached mean reversion.
- The market has been going up for decades based on boomers saving for retirement. Every month tens of millions of people invest in “the averages” and according to this trend people are not buying low, they are buying high because the trend slopes up. Since that buying pressure has been the case for decades the price of funds does not represent the true value of the underlying shares but the true value plus an upward buying bias due to accumulation. That upward bias is coming to an end as boomers are forced to stop buying. It can be exacerbated if they are forced to sell. An example of forced sales is RMD. Another example is a market crash and no ready cash to live on eg SORR.
- I believe the COVID virus is going to be far worse than we think. Everybody is looking at this like it’s some kind of flu. It is MUCH more disruptive than the flu. The CDC projected a nightmare of 1.7 MILLION deaths. You see that kind of disruption happening in Italy. My wife told me nearly 20% of healthcare workers are infected or dead and this is before the peak. ALL of the ICU beds in the country are over capacity. They are using OR’s for ICU and no surgery is happening. Italians are not genetically different than we are. The Virus will do to us what it’s doing to them. They are just 4 weeks ahead of us. if you want to know the future just go study the Italian experience. We talk about 3% mortality. It maybe as low as 1% mortality, but I think it could be higher once the ICU beds are overwhelmed. There is some idea the old are at risk but not the young. This is not the Italian experience. The old came first, and now the young are coming. It just took longer for the virus to burn through the excess health reserves of youth. Once the aveola are burned out they fill with fluid regardless of age and this is the definition of ARDS. The Hong Kong experience is there is a 20-30% post infection respiratory morbidity in recovered patients. This manifest in no respiratory reserve. Walk fast and you huff and puff like you’re running a sprint. If it’s a 1% death rate and 1.7M die you can expect 170M infections. If 25% of those have morbidity you can expect an additional 42M to have some level of permanent respiratory illness. What does that do to a work force that requires good lungs to be productive? At this point in time the only way to achieve immunity is to get sick. It typically takes 2 years to achieve herd immunity in a pandemic.
- Pensions have no money. They are virtually ALL underwater. This means pensioners are ALL virtually underwater. How does an economy grow when the number of retired is growing and no one has any money?
- Companies have been financially engineering their stock prices since 1990. Corporate debt is being used to buy back shares to raise the price/share. Less shares forces the price to go up to keep the ration the same. Lets say 2 shares has a value of $4. Lets say you buy back a share leaving only 1 share available to trade. To get back to a $4 equivalent valuation the share price must raise to $8. If the company dumped the 1 share of stock it would go back to $4 but that share is being used for collateral on the loan that was taken to buy back the stock. This is called leverage. When the world crashes the debt becomes junk and buybacks cease. Buybacks provide a source of demand and demand raises prices. A crash kills that source of demand and therefore prices must fall because the price was artificially high in the first place. Stock funds encourage companies to use this trick and it works till it doesn’t. Regardless when you buy a stock you pay for its risk and if the price is inflated due to financial engineering you pay too much for your shares.
It turns out there are 2 different classes of 10 year treasuries they are called RUN and NON RUN. Run treasuries are what the FED uses to add liquidity. Non Run are treasuries that live in investment accounts. They price differently. Run treasuries usually price 14 basis points higher than non run bonds. When Lehman crashed the spread was 60 bp. A couple days ago the spread reached 50bp. This show the instability of the economies foundation AKA 3x normal risk. In addition the FED is allowing all terms as collateral not just T-Bills aka the entire curve. This I believe was called a twist. This is QE4 period! This means we are deep in instability IMHO
7. The VIX hit 76. Only 3 times in history did the VIX hit 76. 1987, 2008 and this week. A VIX this high totally distorts the ability to make rational decisions regarding stocks aka risk becomes unknowable. As VIX goes up it becomes more and more like trying to divide by zero from algorithmic perspectives.
8. The supply chains are screwed. Even if they come back online but there is no demand there is no need for supply. The virus will assure demand is screwed. As people loose their jobs, no mon, no fun. Money printing isn’t going to cure that. No mon no fun no corporate profits. No corporate profits? That’s just the question Phil asked me. Why own corporate risk when you can own risk free cash and all the arrows are pointing into the ground?
I think that’s the set up for the next 5 to 10 years. I think we have shot our collective world wide wad. I think there is much more downside likelihood than upside. Even if 25% of my doomsday happens it’s still a relative doomsday. My present allocation is about 35% stocks about 30% bonds, about 10% gold and the rest in cash. I’ll wait to see how the Virus plays out and how much permanent damage is done, and who wins the election. If I am wrong I will loose a little upside. The market isn’t going to double. If I am, right I’m well protected. The market could very easily fall in half or more. That’s my bet. After writing this I may double down. There is something satisfying about owning the risk free asset, until inflation hits.