|April 23, 2020
Worry is like a rocking chair: It gives you something to do but never gets you anywhere.
– Erma Bombeck
What a difference ten weeks makes. Since my last quarterly commentary, the prospects of a 2020 recession went from highly doubtful to most definitely. I was too optimistic about our ability to handle the coronavirus epidemic in a way that would minimize the short-term damage to the economy. As my family and I continue to shelter in place, I tell them that we know how this will end, but we do not know when it will end.
The recovery from the COVID-19 pandemic is the key driver of financial markets today. The virus originated in China, then spread to Europe before making its way to the United States. Since the United States was one of the last countries to feel the effects of COVID-19, we can get an idea of what our recovery will look like by observing the recovery trajectories of countries that have moved past the peak of the pandemic. According to the widely followed University of Washington model, the states like New York and New Jersey, that experienced the first wave of the pandemic, are peaked in the middle of April. This suggests that the worst is behind us, but the road to recovery will be long.
As investors tried to comprehend the severity of the pandemic, the market turned down severely. Highly leveraged investors in both fixed income and the stock market were forced to sell in order to meet margin calls. This turned the sell-off into a crash with stocks falling almost 40% and investment grade bonds falling about 20%. At the bottom of the sell-off, prices had little relationship to the present value of these securities. AAA investment grade bonds like Microsoft decreased 15%-20% in value, even though there was no material increase in credit risk. The devaluation of asset prices was a result of forced liquidation into a market where there was a scarcity of buyers.
You know what your home is generally worth. There are a few ways to define the value of your home, most common is the value of homes comparable to yours that have recently sold. An appraiser may also take into consideration what kind of rent your home could generate, then value the home based on a multiple of the rent. The most simplistic approach is to determine the replacement cost of your home. Valuations are imperfect, based on an average of different valuation approaches.
You do not need to know the precise value of your home to know that if you had to sell it tomorrow, you are not going to get a price anywhere near fair value. The less liquid an asset is, the greater the discount you must absorb in order to sell it.
In order to receive fair value when you sell an illiquid asset, you must be in control of when you sell. Over the course of my twenty-five year career, any client that invested at the top right before the worst bear markets would show a gain within five years. This is consistent with long-term history. The only bear market that would not allow you to recover within five years coincided with the depression in the early 1930s.
We segment your assets based on the “job” that they have. Your growth assets are assets that you will not use for at least five years. Historically, stocks are the best long-term strategy to grow your wealth.
The job of the wealth that you need within the next five years is to maintain your purchasing power. These assets need to grow in excess of the rate of inflation but be stable enough to allow you to sell them at fair value. High quality bonds and fixed income securities are the best tool for this job. Fixed income securities give you the ability to outperform inflation, and they are far more stable than stocks.
For money that you need over the next twelve months, the most important characteristic is liquidity. It needs to be accessible when you want to spend it. Most of the time, high quality fixed income securities are very liquid, but every few years we run into these volatility storms. The only tool for this job is cash or money markets.
Segmenting your assets based on their intended use serves two purposes. First, it maximizes the likelihood that you will achieve your short, intermediate, and long-term objectives. Second, when faced with a period of confusion like today, it helps to compartmentalize the uncertainty.
History gives us a loose guide on how the current pandemic will play out. A virus needs a substantial number of viable hosts to become a pandemic. Once it runs out of fuel, it ceases to become a major health emergency. Sometime within the next twelve to twenty- four months we will reach herd immunity, either by way of a vaccine, or once the virus has gone through about 60% of the population. We may be closer to that 60% number than anyone realizes. Several random tests around the world show that 15-20% of the population has already been infected.
Stock owners who are not looking to sell within the next two years should not see any long-term impact from the current volatility. If you aren’t using margin or leverage, and you don’t need to sell into the current volatility, you are in a position of strength.
Why would someone sell for a substantially discounted price? Most of the selling is not by choice. A lot of investors are highly leveraged. When the downturn comes, they are forced to sell in order to raise cash to meet the minimum equity requirement mandated by law. Sometimes people allow themselves to be frightened out of capital markets. Fear, uncertainty, and confusion combined with a lack of control is a recipe for panic. You wouldn’t sell your house at a 30% discount, just because your neighbor had to sell his house in 24 hours. If anything, since you know the value as well as anyone, the ideal move would be to buy your neighbor’s house at a deep discount.
During the most intense phase of the market sell-off, investors were willing to sell good long-term assets at a 30-40% discount in order to get into cash. In that respect, cash was like toilet paper. If you needed it, you’d have to pay up for it. If you were one of the fortunate households who had an overabundance of toilet paper, the best move would be to sell your surplus at a substantial premium. When the market suffers its worst month since 1931, and you are a long term investor, there is no question that the right move is to scrape up all of the cash that you can find and buy from panicked or forced sellers.
Stock investors are the shock absorbers of uncertainty. This is what gives us the right to excess long-term returns relative to fixed income. Historic crises are never easy, but eventually the crisis passes. We learn our lessons and move forward a little bit wiser. Until that time, please stay safe and good luck in making the best of a unique moment in history.