“This too shall pass.”
- Rumi; 1207-1273 (1)
Religions have long offered this expression to provide comfort in difficult times. There can be little ambiguity that our current circumstances qualify. We are deeply sorry for everyone’s pain and their challenges.
On the next page, we want to provide a high-level summary for those with a limited appetite for reading but will follow with more detail than usual.
December 31, 2019: China reported an “unusual pneumonia”.
January 7, 2020: Covid-19 spreads to Europe.
January 23,2020: U.S. patient zero shows up in Kirkland, Washington.
January 30, 2020: World Health Organization declares “a global health emergency”.
The virus has moved faster than humans could respond. Both Europe and the U.S. were ill-equipped to cope with the intense pressure on their healthcare systems. Resources, both human and equipment, have been stretched thin. Inadequate supplies and testing, coupled with emotionally charged scenes in Lombardy Italy and N.Y. City, left government with few choices. Social distancing offered the best chance to spread out the treatment of the critically ill – flatten the curve – to preserve the integrity of the healthcare system. Thus:
March 10, 2020: CDC issues guidelines for protecting yourself with good hygiene, staying home if sick and limiting large crowds.
March 19, 2020: California initiates mandatory stay at home restrictions. (7)
March 30, 2020: 27 states, representing 2/3 of the U.S. population are at home.
March 31, 2020: Estimates of deaths reaching 240,000 in the U.S. narrows the gap between credible medical reports and press meetings. (8)
The photo seen below, of the usually bustling Penn Station, exemplifies most downtown scenes today. Though some Americans can work effectively from home, the economy is essentially shutting down.
The graph below translates the photo of Penn Station into Claims for Unemployment. (9)
Of course, the U.S. economy started sputtering before the virus arrived when China closed-up shop, weakening many supply chains.
Complicating the insidious impact of the virus is a war between Saudi Arabia and Russia to see who controls oil prices. Oil closed the quarter at $20.48 per barrel, the lowest price in decades and, by way of comparison, half the price of oil in 2008. (10) Although lower energy prices provide financial relief for consumers, the industry employs 6.7 million people; approximately 4.6% of the American workforce that might not have been forced home but could lose their jobs irrespective of the virus. (11)
The virus instilled a pervasive level of fear, about both infection and mortality, along with a sudden and massive loss of job security. How could the financial markets possibly respond to this confluence of negatives?
The stock market yawned in response to the January 23rd arrival of Covid-19 in the U.S., ascending for another month before cresting on February 20th. Then, digesting the new world order…markets cratered as much as 40% (small cap stocks in orange below) over the next five weeks. (12) Notice how large stocks, small stocks and foreign stocks moved largely in tandem during a period of stress, consistent with the equity markets in 2008. (13)
Contrasted to the lockstep move in stocks, bonds, as seen in the graph below, followed distinct pathways, reflecting their varying degree of perceived safety. (14) Treasury Bonds (red line) shows a gain for the period. High Yield (junk) bonds (blue line) emulated stocks, dropping nearly 24% in a single month. (15) We have no exposure to junk bonds.
The orange line in the middle represents California municipal bonds (tax-free). We exercise a high level of discipline around quality with muni bonds. Despite our aversion to risk in this space, tax free bonds do not trade as heavily as Treasury Bonds and can be priced, on occasion,
to reflect that lower liquidity. We have seen this, in both 1994 and 2008, with California bonds. Despite the temporary quirk in pricing, we remain quite confident in these bonds and plan to hold them to maturity, thereby achieving the returns we expected upon purchase. As noted in our summary, the reported performance for those with taxable accounts, holding municipal bonds, or even C.D.s (insured by FDIC), your performance report for the quarter will look poor relative to the U.S. Treasury benchmark that we use for comparison. However, we fully expect this performance phenomenon to reverse during the next couple of quarters.
On Sunday, March 14th, the Federal Reserve announced that they were cutting the Federal Funds rate back to zero (like in 2008) and launching $700 billion of quantitative easing. (16) They issued the following statement to emphasize their presence and capabilities: “The Federal Reserve is prepared to use its full range of tools to support the flow of credit to households and businesses and thereby promote its maximum employment and price stability goals.” (17) The Fed actions did serve to improve confidence in liquidity and money flows, but the Dow dropped 3,000 points the following day, suggesting that the move may have spooked the equity markets.
Fiscal relief followed in the form of the CARES Act that seemed inevitable by March 23rd and passed by March 27th. (18) Benefits from the package are wide in scope and warrant a separate report that we will provide soon. The $2 trillion package estimated at 9% of the total U.S. GDP (19) was larger than expected, faster and more front-end loaded than the fiscal stimulus in 2009. The S&P 500 responded to the positive surprises by rallying 17% over the next three days. (20)
In our March 1st “Special Report” we shared plans for doing “nothing dramatic.” We had to revisit each holding in the portfolio and make our best determination on two issues: (1) Were the current challenges temporary or something that changed the structural attraction of the business model and (2) Did the company have the financial resources to ride out the expected storm? In addition, could we identify opportunities, while prices were marked down, to move up the food chain in terms of quality?
We sold our two “attire-centric” retailers, Nordstrom and American Eagle. We were highly exposed to the travel industry and sold Carnival Cruise Lines. The entire industry has been flagged outside of the U.S., in part to obviate U.S. regulations and taxes. We anticipated that any government bailout would exclude this industry. We purchased shares of Facebook (a near term winner as individuals need to connect and a pristine balance sheet), Microsoft (rock solid balance sheet and reporting a massive increase in their cloud services), Merck (3.2% yield; Keytruda is blockbuster drug to fight lung cancer), Home Depot (3.3% yield; more time at home), Zoetis (drugs for the veterinarian market) and a smaller company called Houlihan Lokey (a leader in complex bankruptcy settlements). We maintain a “watch list” consisting of several super high-quality names, waiting to see if the valuations become more compelling.
Existing core holdings include ResMed (global leader in respiratory medicine that is providing ventilators) and Steris (infection prevention through advanced sterilization solutions) should both benefit the current healthcare industry.
We did not sell several positions despite the obvious near-term headwinds. Let’s use Disney as an example. The stock traded at $140 per share toward the end of February, but dropped to about $86 last week, a haircut of almost 39%. First, Disney is an A++ rated company financially. Their revenues have grown with remarkable consistency except for 2009 when they dipped modestly. In that year they remained cash flow positive. Parks, the obvious vulnerable part of their operations, represent 37% of revenues. Studio Entertainment produces 15% of revenues and though the theatres are currently empty, new releases Black Widow, Mulan and new films from Marvel will be delayed, not lost. Disney +, their streaming service designed to compete with Netflix, already comprises 13% of revenues. The parks will indeed be closed for some finite time period. ESPN will also lose advertising revenues while the sports world goes quiet. We do not perceive ANY of these as being long-term challenges. Now, let’s pretend for a minute that our small group (WCF employees and our clients) owns Disney, the parks, the studios and ESPN. Would any of us vote to sell the company at 60% of last month’s price because we were heading for a single tough year?
We view stocks as ownership interests in real businesses as opposed to icons on a computer screen that can be moved with the flick of a wrist.
Dr. Anthony Fauci, the director of the National Institute of Allergy and Infectious Diseases commented recently, “And while the thrust of government policies is directed to ameliorating the economic and financial damage from the pandemic, the virus makes the timeline.” (21) Indeed, the core of the investment debate is how deep and how long does the economy need to remain shuttered?
Let’s start with the obvious: We are not scientists and predictions about Covid-19 are shrouded with risk. According to a recent article, “There’s a consensus that the pandemic will only end with the establishment of so-called herd immunity.” (22) This can be achieved either scientifically through the creation and distribution of an effective vaccine, or via sufficient exposure to the virus. Last week Dr. Barry Bloom of Harvard School of Public Health said, “One vaccine that produces even a reasonable amount — 60% protection in a naive population — would probably generate enough herd immunity to stop the epidemic.” (23) Moderna, a Boston based biotech company is already in Phase 1 of FDA clinical trials on a vaccine. (24)
Social distancing seems to help flatten the curve. “The disease is spreading at different speeds in different places in the United States. California and Washington continue to see new cases and deaths, but so far, they haven’t come in the spikes seen in parts of the East Coast.” (25) Research from the University of Washington suggests that U.S. cases may peak in May and California by the end of April. (26) Goldman Sachs is on record stating that “Any improvement in the curve will be seen as a bottom in equity markets.” (27) The Goldman position is supported by Mohammed El-Erian (Chief economist at Allianz, the parent company of Pimco) who has said, “And when the economic turnaround comes, and it will come, the economic snapback will be sharp.” (28)
News from China is encouraging. Their Purchasing Manager’s Index (a measure of manufacturing activity) registered a dismal 35.7 in February (below 50 is contraction) but rebounded back to 52 in March. (29) 100% of the Apple stores in China have reopened. (30)
Pessimists abound as well. Howard Marks of Oaktree Capital, someone we have long admired, acknowledges that the government can replace all of the lost income, but doesn’t know if that will be enough or if it is right to have so much of our economy dependent on government. (31) Ken Rogoff, author of “This Time is Different: Eight Centuries of Financial Folly” recently said, “We get a C- or worse…where is testing? We were ill-prepared, and we may give great stimulus, but if we aren’t solving the health problem, we are still going to suffer mightily.” (32)
Despite the staggering unemployment claims this week, equities barely moved, suggesting that the market has begun to size up the expected economic damage. Sebastien Galy, a senior macro strategist at Nordea commented, “As the market does not react very negatively to negative news, it has by definition bottomed out.” (33)
The stronger health of the banking system today, compared to 2008, might prove to be one mitigating factor. Michael Mayo, a leading bank analyst assures, “It’s night and day versus the financial crisis. Bank balance sheets were weak, and now they’re strong. The degree of resiliency is underappreciated. I would be shocked if one of the top 10 banks needs to raise equity or cut its dividend.” (34)
In addition to the banks, consumers seem to be much stronger than in 2007. “We entered this with the lowest household debt-service ratio since 1981, and a positive savings rate.” (35)
We remain braced for the next couple of weeks of steadily bad news on the health front, but also appreciate the vast scientific resources being applied to both therapies and vaccines.
Goldman Sachs, taking all dynamics into consideration, has a year-end target of 3000 for the S&P 500; a 20% gain from the 3/31 closing. (36) Morgan Stanley said, “Bear markets end with recessions, they don’t begin with them, making the risk/reward more attractive today than it’s been in years.” (37) Bill Miller holds a unique achievement, besting the S&P 500 for 15 consecutive years while at Legg Mason. When asked about the market in March he responded, “There have been four great buying opportunities in my adult lifetime. “The first was in 1973 and ’74, the second was in 1982, the third was in 1987 and the fourth was in 2008 and 2009. And this is the fifth one.” (38)
We accept Dr. Fauci’s proclamation that the virus will determine the timeline here. Still, we look across the chasm, acknowledge the “fog of war” currently enveloping the financial markets and the potential for volatility it may cause. As optimists, we believe that equity investors will eventually be rewarded.
We close out this long commentary with a sense of reflection, courtesy of Rumi, who said, “Yesterday I was clever, so I wanted to change the world. Today, I am wise, so I am changing myself.”
Be well and stay safe.