- Human investors are prone to mistakes of cognitive bias, especially in volatile markets driven by an unprecedented risk factor - the COVID-19 virus.
- I explain how to use Bayesian inference to avoid cognitive biases. This process allows specific, verifiable, and update-able predictions to guide the investment narrative.
- I outline 13 specific predictions about the virus outbreak, the economy, and the market that guide my own fundamental analysis.
- Over the next month or so, I expect additional market volatility, with the S&P 500 ultimately declining below 2,400 (17x 2020 EPS of $140) as GDP growth and earnings estimates are revised lower.
- Toward the end of 2020, I expect economic conditions and the market to improve as we all learn to live with the virus and treatments are on the horizon.
Why I Need to Make Predictions
I am a fundamental business analyst, not an economist nor an epidemiologist. But right now, every company's fundamentals have been thrown into question by COVID-19 - an exogenous shock to both supply and demand unprecedented in modern markets. So even as a fundamental analyst, it is impossible to invest responsibly without forming an opinion about how this risk will unfold. This article shares the forecasts I am using to inform my own fundamental analysis.
My goal is to avoid the twin dangers of greed and fear that create cognitive biases and cause bad decisions. To do this, I use a technique called Bayesian inference. The general procedure is to make specific, verifiable predictions to which I assign confidence levels. These confidence levels can then be updated in a calculated way as new evidence becomes available. I then use these predictions to support or change my investment narrative.
The framework I am using for my COVID-19 analysis is divided into three parts:
- How the virus itself progresses. This is largely a matter of epidemiology but can cross into how sociological and political decisions impact spreading.
- How the economy responds. This is impacted by #1 but also by how producers and consumers react to the risk, regardless of the actual severity of the virus.
- How the markets respond. This is impacted by #1 and #2 but also by how investors react to uncertainty.
I will lay out the general narrative I am using to invest followed by the specific predictions I am using to support my narrative.
The Investment Narrative
Regarding the virus itself. In the northern hemisphere, the virus will worsen significantly through March before moderating during the spring and summer. However, the virus will then worsen in the southern hemisphere and re-emerge in the northern hemisphere in the fall. At that point, there will be hope for a vaccine or effective antiviral treatment, and the situation will begin to come under control globally.
Regarding the economy. The virus will cause economic disruption globally. Governments will attempt to curtail activity to contain the virus, creating additional disruption and volatility due to simultaneous shocks to both supply and demand. Q1 real GDP growth will decelerate relative to Q4 for many regions, with Q2 real GDP growth then turning negative. Eventually, the response will shift from containing the virus to protecting the most vulnerable. This will allow economic activity to improve sequentially in Q3 and Q4. By Q1 2021, most regions will return to positive GDP growth.
Regarding the market. This is the most difficult to forecast because it involves getting the previous two factors correct but also predicting how sentiment among market participants will evolve in the face of significant uncertainty. In general, I predict equity markets will experience further weakness from their closing prices on March 6, 2020.
These are the specific predictions I'm using to test my investment narrative via Bayesian inference. I will update these periodically to hold myself accountable.
Number of cases. I predict the number of cases as reported by the World Health Organization (WHO) will be at or above the following levels on the following dates (if WHO uses a range, I predict my estimate will be at or above the midpoint of the range).
- The number of total confirmed cases outside China will exceed 500,000 on 3/31/2020. Confidence level: 80%
- The number of total confirmed cases outside China will exceed 2 million on 4/31/2020. Confidence level: 75%
- The number of total confirmed cases outside China will exceed 10 million on 12/31/2020. Confidence level: 70%
- The number of total confirmed cases in the U.S. will exceed 10,000 on 3/31/2020. Confidence level: 80%
- On or before 5/31/2020, the number of new cases reported outside of China will decline for three consecutive days at least once. Confidence level: 65%
Treatments. I predict treatments will be in sight by the end of 2020.
- A Phase II clinical trial for a COVID-19 vaccine will be completed by 9/30/2020, as recorded by clinicaltrials.gov. Confidence level: 75%
- Either the U.S. Food and Drug Administration (FDA) or the European Medicines Agency (EMA) will approve a COVID-19 vaccine by 3/31/2021. Confidence level: 85%
- Either the U.S. Food and Drug Administration (FDA) or the European Medicines Agency (EMA) will approve a COVID-19 antiviral treatment by 12/31/2020. Confidence level: 80%
Response. I predict a rather dramatic social and political response in the U.S. and Europe, which could unsettle markets given the unusual nature of these types of events. Evidence so far includes actions on the part of the Italian government to quarantine much of Northern Italy as well as comments by the director of the U.S. National Institute of Allergy and Infectious Diseases on 3/8/2020 that suggest the U.S. would be willing to consider more aggressive mitigation strategies.
- Within the U.S., there will be at least one attempt to enforce mandatory quarantines on at least a city-wide basis by 4/15/2020 (verifiable by a news report from a major national news outlet). Confidence level: 70%
- NYC will close its public schools for at least one day on or before 4/15/2020. Confidence level: 70%
Economy. I predict a slowing through at least Q2 2020, with a recovery by at least Q1 2021. This is driven by simultaneous shocks to supply (evidenced by the sharp drop to sub-50 in China's PMI) as well as shocks to demand as customers and employees quarantine themselves. These predictions will be confirmed by bea.gov.
- U.S. real GDP growth will be less than 1.5% for Q1 2020. Confidence level: 75%.
- U.S. real GDP growth will be negative for Q2 2020. Confidence level: 75%
- U.S. real GDP growth will be positive for Q1 2021. Confidence level: 70%
Market. The S&P 500 will close below 2,400 on or before 4/15/2020. Confidence level: 65%. This will be driven by gradually deteriorating GDP estimates and downward revisions to S&P 500 earnings estimates as economists and analysts lower their forecasts, particularly as the Q1 earnings season approaches in April. My S&P 500 forecast assumes a 17x multiple on S&P 500 earnings that decline by about 15% in 2020 to $140.
How I Am Investing
My predictions become less confident the further we get from the science of the virus itself. While I believe the market has further room to decline, my confidence in that prediction is lowest of all.
For this reason, my investment objective is to reduce my exposure to broad indices and heavily exposed sectors (travel, tourism, energy, materials, most financials), but to avoid shorting and also to avoid COVID-19 "story stocks" given the risk of over-hype.
Meanwhile, I am making a list of high-quality companies with strong fundamentals that have been too expensive for the last several years and might now become attractive.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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