Originally published on March 1, 2020
We have spoken to quite a few of you this week and it is always helpful to hear what's on your mind. I have a lot to say so let's dive in. This is what we had to say last week.
But, if we are right about this virus, stocks are not discounting the risk to global supply chains and corporate debt enough. At some point, the consideration is the return of capital not the return On capital. This is one of those times.
We were right stocks were not discounting the risks associated with this virus. We were starting to think we were a little crazy after watching this virus for three weeks and Wall Street didn't blink. We watched the actions in bonds and gold and that was our heads up that we were right and risks were running high.
That's what we did. Now, what do we do.
The first thing is you must remain in control of your emotions. One of the reasons Wall Street reacted so strongly was that there are still so many great many unknowns. What's the course of the virus? What's the mortality rate? How is it spread? What effect will this have on global supply chains? It is easy to let your anxiety run away with you as there are so many things that we don't know.
If you keep control of your emotions, you can recognize where the opportunity lies. Stick to your investing plan. For us, we were running lower than normal equity allocations for all of our clients. Equity is where the risk is. We have also maintained a substantial allocation to bonds. Bonds acted as an effective portfolio diversifier this week and went higher in value easing some of the blow from lower equity prices.
Once the selloff came, we looked for logical support levels in the market and the first line of defense is usually the correction level of down 10% in the market. We reached that very quickly. The next point of reference is the 200 DMA - which for most investors defines whether we are in a bear market or a bull market. Those levels were coincidentally the same. A logical level to start buying is down 10%. We rebalance our equity allocation given such a drastic drop. With stocks having moved so violently, we decided to wait for a further drop and added to our equity holdings down 14% from the recent highs.
Now, we are all amateur epidemiologists and part-time sleuths. We don't feel that the data from China was accurate so we are left to detective work. The data from Korea, Italy and now the US will give us some more clarity.
We can see that the pollution data from China is well below normal. That tells us that they are not back to work yet. Remember, it is China that is the epicenter of the outbreak. They are bound to see some of the worst of this crisis. They didn't know what they were facing and were slow to attack the problem. The US has known for some time about the virus, was able to plan more effectively and take precautions. Vaccines are already in the works.
What happens next? The markets open in Asia in a few hours. Investors expect central bankers to make statements or moves to help defend markets. We shall soon see. No moves by central bankers may incur further selling in equity markets. Fortunately, we are not over-invested and, in fact, are still under-invested in equity markets. Valuations have been high and may come down some more. Markets will bounce at some point. There is not enough data here to be reliable but take a look at the following.
- In the last 20 years, we have had 11 selloffs of over 10%. Only 2 have been greater than 20%. This one was 16% at its worst.
- We have had 7 similar selloffs to this. That being a drop of more than 6% in two days while dropping from within 10% of a 52-week high. The average return 3 weeks later is + 5% - 6 months later + 10% and 1 year later is up 15%.
This virus is serious and as you can see from prior blog posts, I am very concerned about the global economy and the effects of the virus on global supply chains. This is probably a positive for the United States as more manufacturing needs to move away from China and Asia in general. Most likely some of that will come back to North America.
While we need to be invested to generate a return, we don't feel the pressure to be fully invested at all times. We have a generous amount of assets stored in cash, bonds and gold. Those assets will hopefully be put to work again where opportunities provide. For now, we expect markets to bounce at some point from oversold levels and advance back towards all-time highs. It is then that a decision must be made. Are we still in a bull market for stocks?
We have told you to watch CNN's Fear and Greed Index. It is a very simple data point that helps you manage your emotions and make good investing decisions. When markets were pointing towards extreme greed, we were sellers or at least not chasing stocks higher. Late last week, the Index turned to extreme fear. You can play the contrarian and know that you will be making better emotional investing decisions.
This virus seems to be spread very easily but much less deadly than MERS, SARS or Ebola. As a society, we managed to handle those crises just fine. As a side note, markets went 14% lower during the SARS epidemic. That is about the same level as we are now. We know that central banks can do nothing to stop the spread of the disease but our greater fear is corporations with no cash flow not being able to pay their debts. It is in the debt market that we expect problems to emerge from in the next crisis. The key factor to how markets react next week may be how central banks react to the crisis.
The way to tell whether the discounting has been fully reached is when the market stops reacting negatively to every bad headline, which has yet to happen. But once it happens, the market can truly bottom and begin to recover when some of the expected negative events fail to materialize, even though it may rally in the face of other "bad" news it already discounted.
Jim Biano Bloomberg 2/28/2020 Bianco Research
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
