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.
8 Replies to “The Day The Universe Changed”
Your analysis seems reasonable. What was Phil’s advice? Hold? What would you do if you were accumulating?
We took some risk off the table a while back but still have substantial equity exposure and plan to keep buying on the way down and the way back up again. I’m not sure about alternatives, besides keeping gold and real estate exposure.
Any thoughts on the future of BTC after the crash?
I believe Phil is buying. It’s a relative thing. From a price perspective and based on recency bias that would seem a prudent thing to do. If BRK.B was 220 and today it’s 180 back up the truck. But that presumes the market is not broken. So what are the clues the market is broken? VIX=76, a 905 point drop in the S&P in a week with only a 230 point retrancement. S&P futures as of 30 min ago are down another 31 points aka lower highs. The blowout between Run and non Run treasuries. The sudden need for literally TONS of repo activity. Last Wed I believe 500B of repo was offered and only 79B was taken. This means for the other 421B there was no collateral of sufficient credit worthiness to do the swap. This is like 2008 and 1987. Oil volatility (the oil VIX) went OVER 120 Gold volatility got up to 38 a 20% change. Bond yields went from 55bp to 95bp a 72% change in the wrong direction. To determine the signal you first have to determine the noise aka the background. With all of these things blowing out simultaneously how can you make any decision that BRK.B is worth 180? Maybe it’s worth 150, maybe less and that’s the point.
Consider a multidimensional 4 space. The dimensions are VIX OVX GZV MOVE UUP.
VIX is stock volatility, OVX is oil (commodities) volatility MOVE is bond volatility and UUP measures the strength of the dollar (reserve currency).
The one thing that is safe in a multidimensional blowup (VIX OVX GZV MOVE) is to get out of the matrix aka go to cash. Volatility along 4 dimensions represents out sized risk EVERYWHERE else. If you make the right call on one dimension and the wrong call on the other 3 your just slightly less hosed. Cash is the only place that is risk free, and in fact goes up because people want to denominate in dollars when it hits the fan. In fact I do own UUP and it went up 0.33% Friday implying strengthening as the world sells out of risk and buys dollars. Phil may be exactly right. He may be skiing fresh powder down a predictable hill. That kind of ride has manageable risk and a predictable outcome. It looks to me however like he’s skiing 5 feet in front of an avalanche.
Opinion on BTC is all over the map. I own some and will keep it to the bitter end. It’s the obvious solution to the problem of stuffing cash under the mattress or using cash to perform illegal activity. Every government is working on a crypto solution, so owning it is like owning a permanent call option on the creative destruction it holds in its concept. Chinese Cash in Wuhan became infected and the government had to burn it. Makes BTC look like a pretty good alternative.
Your asset allocation looks reasonably for a 60-year old. I am half your age, and I have a similar allocation now.
Are you implying the inflation will hit at some point during the recovery?
Inflation has already hit. Bubbles are inflation. When your asset prices are 100% above trend without concomitant increase in productivity or stored value, that’s inflation. People don’t like it when bread inflates. People do like it when IBM inflates but in both cases it’s a price distortion. The government promotes inflation as a “good” thing aka brainwashes you, but that’s a lie. At 2% over 50 years the government would like to consume half the value of your property to pay for their debt. The FED has a 2 trillion balance sheet now closer to 4 and going to 10. Smells like inflation to me.
Thanks for sharing your actions and your rationale. Like you I am converting TIRA to Roth IRA and trying to do this while keeping taxes as low as possible. I know from your previous posts that you are in the middle of multiyear partial Roth Conversions.
Are you going to do your 2020 worth of Conversions soon now or wait longer for more of a drop?
What kind of trigger/plan do you have for deciding when to convert in this interesting period?
Hey TM My plan was to move the most volatile assets first like funds and individual stocks. Since in an up market these have the greatest likelihood of appreciation I wanted them out of the TIRA asap like Jan 2. Next I moved lower vol assets. Now I’m at the gold and bond level. This year I moved all the gold early while it was cheap as I figured if there was a crash it would go up and would already be transferred. I’ll wait to move the rest of this year’s aliquot later depending on market gyrations. If markets go down I’ll move the same relative value on a cash basis so if I have 1,000 shares of XYZ to move in 2 chunks say 500 and 500 and the value drops by 20% I’ll move 600 this year and 400 plus something else to equal the same dollar value until I get it all moved. Since SECURE got passed I’m moving a smaller amount for 2 more transfers to cut down on taxes on a per year basis. This way my tax bill is entirely predictable and I know how much cash to have on hand. Since I’ll take SS at 70 but not RMD till 72 I’ll probably drop my transfer amount by the amount equal to SS so I don’t trigger a higher medicare cost. So if I transfer 210K/yr and SS is 30K I’ll drop the transfer to 180K or something like that. The goal is 500K in TIRA at age 72 with a 15/85 equity/bond split, the rest in Roth.
What are your thoughts on some of the downside tail risk financial products such as HDGE,TAIL, etc. There is a cost to having y these”downside insurance products” . Are these meant to be purchased in times of crisis or are they a buy and hold option?
I don’t use these or think much of these. If I did use this it would be for a very specific reason say to change the risk of a always long portfolio without inuring capital gains. There are many hedge kind of strategies you can use to enhance your profit like covered calls and they work in certain volatility environments and become disasters in other volatility environments.
Seems to me purchasing such an instrument is basically trying to add trading to a buy and hold portfolio. The simplest way to reduce risk is to go to cash. So you have to develop a means to measure risk to understand how much risk is too much risk and understand what is wagging, the tail or the dog. If you’re tied to a rail road track and the cow catcher of a million pound freight is barreling down on you at 100mph, wrapping yourself is some bubble wrap isn’t a solution. If you are untied, staying on the tracks because of tax consequence may also not be a solution. So it depends on what you perceive as the threat and whether you think the threat temporary or permanent or some of both.
There are perfectly good measures like VIX MOVE OVX GVZ that can inform you of increasing or decreasing volatility (risk). Right now in this market today these measures of volatility are ALL multiple standard deviation away from a low vol reality. In that kind of environment it become highly undesirable to own any volatility. The problem of staying alive becomes much worse when 6 independent things are trying to simultaneously kill you instead of one thing. When I look at this universe, I don’t see the same universe as yesterdays universe. We went from a universe of low disruption to high disruption almost overnight and I see the disruption as inelastic. The FED 2 weeks ago declared the all time high economy sound sound sound and then proceeded to make 2 emergency rate cuts to save the economy, neither of which will work and will likely do more harm than good. 6 states closed their restaurants by decree. This virus isn’t going to peak for at least 12 weeks maybe twice that if we successfully manage to smash the peak. The peaky curve and the smashed curve have the same volume so if you smash the peak you extend the base like squeezing a balloon. This means 12 weeks become 24 weeks. This means restaurants logically should remain closed for 24 weeks, which means employees that go unemployed for 24 weeks and likely businesses that will cease because they run a marginal operation, so not only no job for 24 weeks no job ever for some people, and a business loss for the business owner. In addition there will be a permanently reduced demand and likely a permanently disrupted supply chain. You can well imagine the ripple effect. 6 states of closure could result in farmers planting less because you don’t want to plant lettuce for the salad if it’s only going to rot because your restaurant lettuce customers are closed by government order. No lettuce sales = no mortgage payment on the farm = no farm = no jobs for farm hands, etc etc. That’s a permanent disruption, and that’s what I see this economy is undergoing. A little tail insurance isn’t going to save your ass (pun intended).