We sent out our last letter only two weeks ago on February 27th, warning that although the market had fallen -12% in a week, valuations were still high, and signs of speculative excess and deteriorating fundamentals were legion.
That seems like a lifetime ago. As of the close yesterday, the S&P 500 had fallen another -16.6% for a total decline of -26.7% from its highs. Yesterday’s plummet of -9.5% was the fifth worst day in the history of the S&P 500, exceeded only by Black Monday in 1987 and three days during the collapse preceding the Great Depression in 1929. Crude oil has fallen over -40%. Treasuries have soared, sending long-term yields deep into uncharted territory. Yesterday, high-yield corporate and municipal bonds collapsed, more than doubling credit spreads. Everything fell in tandem: international equities crashed -11.1%, and even allegedly uncorrelated assets like gold (-3.6%) and bitcoin (-27.2%) declined.
We understand the distress in the marketplace. Markets abhor uncertainty, and the novel coronavirus presents a large and unknown risk. The uncertainty stems partly from the danger from the disease itself, and partly from the distressingly insufficient response from Washington, whose priority thus far has been scoring political points instead of prioritizing public health.
The Federal Reserve instituted an emergency rate cut and a new quantitative easing program. However, monetary policy is not going to be of much help in the case of a simultaneous supply and demand shock. Shuttered factories, disrupted supply chains, and consumers under quarantine will be little affected by lower interest rates.
Fiscal policy would be more helpful. Temporary relief for individuals and businesses is crucial to minimize the economic fallout of what is sure to be a long, drawn-out battle with the virus. Discussions in Washington are frustratingly slow and fraught with political infighting, but proceeding.
The most important measures, clearly, would be a proactive public health response: increasing testing capabilities, building temporary hospitals, training new emergency personnel, etc. Sadly, efforts here seem few and far between.
Expert consensus on coronavirus outbreak in US
We are investors, not epidemiologists. However, we believe there is an emerging consensus among experts regarding the possible path of the pandemic and the proper response. We would be remiss if we didn’t take this opportunity to share our understanding of it with you.
The US had advance warning of this approaching pandemic yet squandered the opportunity to adequately prepare. Any chance for containment has been missed. Community spread is occurring throughout the country. Testing remains woefully scarce: in the US, testing per capita is several orders of magnitude lower than in other countries. Even people in high-risk areas already showing symptoms are finding it hard, if not impossible, to get tested. Given the virus’s long incubation time, many people are already infected (and contagious) but not yet showing symptoms -- and those people are definitely not being tested. Thus, the official numbers massively understate the severity of the problem.
In Hubei, the Chinese province at the epicenter of the outbreak, there were 444 confirmed cases as of 1/22. Further testing and diagnosis eventually backdated the number of cases on 1/22 to an estimated ~12,000. At this point, intensive social distancing was implemented. Wuhan was locked down on 1/23, and fifteen more cities followed on 1/24.
China’s new cases seem to be slowing dramatically; it appears they are peaking at around 80,000 cases. However, we should not be sanguine in the US. China has “only” 80,000 because of the extreme measures taken there.
China’s quarantines were draconian. Cities were totally isolated, with no traffic in or out. All movement other than for grocery shopping and medical care was banned, with checkpoints, security guards and barricades outside some apartment complexes. Volunteers went door-to-door checking people for fevers and sent those they found to quarantine centers. More than 1,800 teams of epidemiologists traced tens of thousands of contacts per day.
Measures like these are unlikely to be contemplated by authorities -- or tolerated by civilians -- in a liberal democracy. This could mean that, despite our superior resources, the West will be unable to contain the spread as well as China did.
As of 3/13, the US has 1,800 confirmed cases, and has implemented very little in terms of social distancing. Compare this with 444 Chinese cases when China began its intensive lockdown. This means that infections are almost certain to spike in the US no matter what is done today.
We do not think COVID-19 is reason to panic. We do not think that civilization itself is threatened by COVID-19. But the worst case is staggering. The CDC estimates that up to 214 million people could be infected, and as many as 1.7 million could die. The nation has less than a million hospital beds, but between 2.4 and 21 million people could require hospitalization. The New York Times developed a great interactive modeling tool to demonstrate the possible severity of the crisis given interventions of varying speed and intensity.
We can -- and will -- avoid that worst-case scenario. But that is conditional on all of us doing our part to minimize the speed and extent of the spread. In order to do that, it is imperative that we “flatten the curve,” i.e., decrease the rate at which the virus spreads. Even if we do not decrease the total number of cases, merely spreading them out over time will prevent our medical system from being overloaded, which will save countless lives.
Italy is an illustrative case. Italy has a well-regarded hospital system, but it has become so overwhelmed that there are insufficient resources to treat all severe cases. Doctors are facing a horrifying real-life trolley problem: who to treat and who to save? Without enough essential resources such as ventilators for everyone who is severely ill, doctors treat only those most likely to survive -- essentially leaving the elderly and infirm to die. The mortality rate among the elderly and those with preexisting conditions are appalling even in countries without overburdened healthcare systems.
We can attempt to avoid Italy’s fate and flatten the curve by increasing social distance. In the past few days, that appears to be happening. Sports leagues and schools have been suspended, businesses are closing or instituting work-from-home policies, and cities are enforcing curfews.
This is not panicking; it is doing your part to minimize the human cost of the pandemic. Fortunately, the young and healthy have low infection and mortality rates. However, even if you are not in an at-risk demographic yourself, by exposing yourself to infection, you risk being a vector for others who are more vulnerable.
If you are looking for advice on social distancing, here is a great resource.
Is the market overreacting to coronavirus? Is now the time to buy?
This is a difficult question, and there is no simple answer. On the one hand, if you just look at the -26.7% drop in the S&P 500 since its high, the decline absolutely looks excessive. When functioning properly, the stock market estimates and discounts the net present value of long-term cash flows from businesses. We do not believe that the economic fallout from COVID-19 will destroy more than a quarter of the value of future cash flows to American businesses. Even if the economy grinds to halt and earnings were a net zero over the next several quarters, in our mind, that would still not justify a -26.7% fall.
On the other hand, if you look at a long-term chart, you’ll see that the S&P 500 is actually trading higher than it was at year-end 2018. Astonishingly, despite its collapse over the last three weeks, the S&P has only given up about a year’s worth of gains. (Contrast this with other countries -- for example, the UK’s benchmark index, the FTSE 100, has gone nowhere since 1997!)
We didn’t find valuations especially compelling at the end of 2018. In fact, back in 4Q17 we were writing about high valuations and the risks embedded in the stock market and economy. Furthermore, the economic backdrop today is clearly much worse today than it was at the end of 2018. In 2020, GDP will be down, corporate earnings will be down, and there will be bankruptcies of highly levered businesses.
We have been positioned conservatively: we’ve carried net cash, and the stocks in our clients' portfolios are value-oriented with strong cash flows and modest leverage. But it has not helped performance as much as we would’ve liked. The selling has been largely indiscriminate. Since the top, investors have found no haven in quality or value stocks as one would expect. Yesterday was no exception with quality stocks losing -9.4% and value losing -11.37%. As the saying goes: in a crash, correlations go to one. That has been our impression thus far.
This has presented us with the opportunity to increase our holdings in resilient, well-capitalized businesses that we believe will emerge from the crisis relatively unscathed. However, we are not increasing our recommended asset allocation towards US equities. Significant uncertainty remains surrounding COVID-19 and the concomitant economic fallout, and valuations as a whole are still not especially compelling. We hope, and expect, that there will be better opportunities to take more equity risk in the future.
As always, the most important thing for investors is to have a sound, full-cycle investing discipline, and not abandon it to greed when markets are up or fear when markets are down. Examine your portfolio and make sure that you can meet your family’s needs even if asset prices decline much further. Better late than never.
Hopefully, we can get COVID-19 under control without the worst-case scenario coming to pass. It remains to be seen what long-term effects the pandemic will have. It could bring about an increase in anti-globalization sentiment and xenophobia. We hope the effect is the opposite, that instead the world recognizes the need for better preparedness and a coordinated global response when the inevitable next novel pathogen arrives. Countries like Taiwan and Japan learned important lessons during the SARS epidemic of 2003, and they have been successful at containing COVID-19. We would be wise to follow their lead.
We wish you and your loved ones good health. Please contact us with any questions or concerns.
- Bireme Capital
Follow our content by subscribing here.