After a strong 2019, 2020 appeared to be a promising year. Unemployment was at a record low, and wages were growing at a faster pace than almost any other time during the decade long economic expansion. Interest rates were low, consumer credit showed little signs of stress, and the consumer was financially healthy. 2020 was set to be the year the manufacturing sector rebounded as much of the trade war risk had passed. Most areas of the economy were poised to perform well, spurring corporate earnings higher, and enabling equity markets to grow into their valuations, which were higher on an absolute basis, but reasonable when adjusted for low interest rates and inflation.
Then what started as a mysterious virus outbreak in an industrial city in central China, quickly changed 2020’s optimism. The virus, later discovered to be a coronavirus, the same type as SARS and MERS, spread through Asia, then Europe, and suddenly 2020 was the year of the pandemic.
Global equity markets sold off in a straight line. Equities fell over 34% in 23 days – a pace that was faster and deeper than any other bear market including the Crash of 1987.
As shown below, the 36% crash ranked this bear market as the fifth worst in 100 years. The volatility index (VIX) spiked to over 80, essentially equating to an average stock market move of 4%…per day. Index and equity option Put/Call ratios ramped as investors rushed to buy puts to hedge or profit from further downside. Toward the recent S&P 500 low of 2193, money market cash levels exploded as investors panicked out of markets. The panic bled into the fixed income markets as the yield spread between junk bonds and U.S. Treasuries widened from about 3.5% to over 10% – meaning junk bonds were yielding over 10% more than U.S. Treasuries. Even high quality corporate bond spreads widened.
Quickly the market consensus became the following: The pandemic will cause a major recession, and most likely our first depression in 90 years. The economy will completely shut down for 2020, unemployment will rise to 20-30%, corporate earnings will plummet, and a large number of companies will be forced to file for bankruptcy. Once the pandemic passes in a year, the economic rebound will be very slow because of the massive number of bankruptcies, and it will take months or years for consumers to board a plane, eat in a restaurant, visit a casino, or attend a sporting event. So, equity markets will make a low that is far lower than the recent S&P 500 2193 level. In fact, the math is easy – if earnings fall by 50% and you use the same price-to-earnings trough as the 2007-2009 Great Recession, the S&P 500 will trade well under 1000. Does this narrative sound familiar?
Capital markets enjoy good news. In some ways capital markets are not overly bothered by bad news. Once the bad news is presented, it can be quantified, valued, and priced, in most cases fairly quickly. What markets disdain is uncertainty. Uncertainty removes the ability to calculate an outcome with a level of confidence. When this occurs, emotions overtake logic, and the uncertain outcome is negatively extrapolated. This continues until the consensus belief lies somewhere between a dire outcome and a nearly impossible negative outcome.
The 1972-1974 recession had one of the worst economic combinations imaginable – stagflation (inflation and negative economic growth), rising unemployment, high interest rates, and increased competition from developing countries in our manufacturing segment. The consensus was our manufacturing side was finished, consumers would be unable to buy necessities, and this combination should lead to a depression. Plus the Nifty Fifty stocks that everyone was crammed into were extremely expensive and falling fast. Wealthier consumers would be permanently hurt from the Nifty Fifty implosion. Ultimately, markets bottomed at the depths of pessimism, well before the recession was over.
The 2000-2002 recession was interesting because the fear level was low during the first half of the bear market. The common explanation was – tech, biotech, internet, telecom, and all of the IPO stocks traded to ridiculous levels, and of course they should all fall by 90%. But that is only a small part of the economy. However, once the bubble-derived weakness started to spread, people became a little more worried. Then 9/11/2001 happened. Suddenly the consensus shifted, and uncertainty was high. The new consensus was 9/11 caused a moderate recession to become a major recession. Consumers would no longer fly in planes, eat in restaurants, or appear at events with a large number of people. Commercial buildings were dangerous, and more employees would work from home. After trading at an exorbitant P/E of about 30 at the 2000 peak, entering 2002, the S&P 500 sat at a P/E of about 22 times next 12 months earnings, even after falling 37% from the 2000 high by the fall of 2001. The year 2002 corrected the overvaluation, and markets bottomed prior to the recession ending. More importantly, most of the negatively extrapolated consensus was inevitably incorrect.
The late 2007 to early 2009 recession arguably had the most uncertainty and highest probability of a depression of any recession. A financial crisis throughout the globe, along with an unprecedented credit and housing crisis domestically caused major uncertainty. At the time of the economic peak, U.S. consumer spending accounted for over 70% of our economy, while private investment was another 20%. As the recession accelerated, the prevailing consensus was the immense debt and credit bubble would take as many as ten years to repair. Much of the financial system would be permanently impaired, with many companies in finance and consumer discretionary sectors filing for bankruptcy. With consumer spending and private investment representing 90% of the economy, it should easily take 5-10 years to repair the consumer, financial system, and the economy. Many were talking about the S&P 500 trading to 500. In fact, when the S&P 500 bottomed at 666 on March 9, 2009, a high number of people felt markets were not near a low since S&P 500 earnings would probably bottom in the next year at $40 or $45 per share – meaning equity markets were still trading around 16 times earnings. Markets ended up bottoming many months before the deep trough of the recession.
The 2020 recession comes with a new set of uncertainties. So what strategy should be used in these extreme periods? On the surface, it sounds easy – sell everything, sit in cash, then enter the market once the recession ends. Is that a prudent strategy? Does someone sound a siren when the recession is over? Are markets coincidental to economic activity? Well, the answer is ‘no’ to each question.
Our Investment Team has a saying, “the most money is made when the outlook improves from dire to just bad”. Coincidentally, when you purchase a high quality investment during a dire environment, you are also purchasing at a more attractive risk/reward and lower point of absolute risk. Why is this true? One of the most difficult parts to successful investing is the notion that investments are priced on their prospective fundamentals six to twelve months in advance. This is the reason some highflying companies release great quarterly earnings and fall 10% the next day or a company that has underperformed for a lengthy period releases atrocious earnings and the stock rises 10% the next day. How does this work with recessions and equity markets?
In the table below, we show every recession over the past 80 years. The four columns show when the S&P 500 bottomed, when the recession ended, how many months in advance did markets bottom, and importantly how far did the S&P 500 rise before the recession ended.
The results are surprising. On average for the last 80 years, the S&P 500 bottomed six months prior to the recession bottom, and was up nearly 30% before the recession ended. If we consider 2020 one of the worst recessions, and extract the four worst recessions from the list, the S&P 500 bottomed eight months in advance and appreciated 35% prior to the end of the recession.
What have we learned so far? Global shocks are very damaging to capital markets. Global shocks that cause recessions are worse. Recessions with a high level of uncertainty are the worst kind, since fear and panic can extrapolate the consensus to an unprecedented and extreme negative outcome. Equity markets price in positive and negative news well in advance, which makes market timing and waiting for economic inflection points a futile and nearly impossible task.
How does our Investment Team manage your portfolio in uncertain environments? The problem with uncertain times is although almost every company trades down 30%, 40%, 50%, or more, deciphering shorter term earnings is difficult. Here is how our team screens and analyzes prospective investments today. The process commonly results in working on a particular idea for 50 hours or more. Since valuations usually do not stay at extreme levels for long, the 50+ hours sometimes needs to occur in a short period.
We use our time-tested four part process, but are customizing it for the uncertain pandemic. First, on a fundamental basis, we screen for companies that are either mostly unaffected by the virus, or in essential businesses, or will temporarily be affected from the virus, or had major positive long-term tailwinds just prior to the pandemic. Next we deconstruct the balance sheet. We isolate companies with either no net debt or a low net debt to EBITDA ratio. The company must have excess liquidity and ideally a small amount to no debt maturing over the next year. We are typically stripping the balance sheet by removing intangibles to analyze financial health. Now importantly, we stress test the company income statement by assuming a major recession similar to 2007-2009. Finally, we examine valuation. We are not looking for companies trading at multi-year lows, but more like valuations at recession lows. On a risk/reward basis, we ideally are purchasing these companies at a minimum of 3-to-1 upside-to-downside and no more than 15% absolute downside – which we know can be temporarily pierced in panic induced capitulation situations.
As most of you who have been clients for years know, our main data point in investment analysis revolves around risk. If we can reduce realistic downside to a low amount, the upside will take care of itself when the environment normalizes. Plus, the most money will be made simply when the environment shifts from dire to just bad. For those of you who joined Osborne Partners more recently, we want you to be confident that our inflated cash levels coming into 2020, and our subsequent methodical lowering of cash levels during this panic follow a strict discipline. Every purchase made in your portfolio goes through the rigorous process that was just detailed.
While U.S. equities have fallen steeply, we are uncovering some incredible opportunities in other asset classes like foreign equities and real estate securities. We feel many of our new purchases have more long-term promise than many of the new purchases we were making in the depths of the 2009 recession.
The key is to be diligent, methodical, unemotional, and patient. This means being able to stomach intermediate-term volatility and further short-term downside for the trade-off of future outperformance when inevitably the environment begins the process of normalizing. The goal is to stay safe and avoid catching the negative sentiment virus.