And what a Dark Quarter that was!

Subsequent to the last financial disaster, Nassim Taleb wrote about a foreseeable ailing set of interwoven financial structures and called it the “Black Swan”. Much like the making of a previous disaster and LTCM and the abrupt “Failure of the Genius”. Walking through the corridors of a large Swiss institution, back in 2008, I heard someone saying “how could anyone in their right mind think of such shabby debts structures as their asset”.

To a Wall Street insider, the failure of such concocted financial instruments, by a bunch of crooked financiers, was not a surprise. On the other hand, “Covid-19” was brewing silently in the south eastern part of our hemisphere and succeeded to take down the economy and the financial markets in the entire world. Perhaps it is time for Nassim to write about this exogenous public health problem, sending shock waves into the economy and call it the “Real Black Swan” or “the Black Crown” …

This time around no one is worried about the collapse of the financial systems, like they did last time. Well not yet. This is the result of an exogenous phenomenon, leading to the collapse of the credit markets.

The Disconnect in the Markets

Market corrections are normal and healthy until you are in one yourself. And by definition what actually makes people sell, to the degree they did, was that there was too much enthusiasm going into the peak, during the early part of this year. The way certain stocks, i.e., likes of Tesla and Apple were rallying was totally disconnected from the rest of the word. When Apple jumped to all-time highs, earlier on this year, the average stock on S&P 500 was actually down.

The way the stock market was acting at the back of a few Mega Caps Stocks was kind of Bunkers (which is a technical term :-), commented by Tony Dwyer (Chief market strategist at Canaccord) on CNBC. So on January 20^th we thought there was going to be a mere 5 – 10% correction concentrated on the biggest names. And then of course the Coronavirus hit that next week. Which brought in play a fundamental Dynamic that can weaken the entire global economy in 2020.

The cause of the action, this time, is not economic but health related and economically the banks are very strong. Though we are too far from a cure or the vaccine, there are a few Biotech companies, like Gilead Sciences, which is now opening up two one thousand patient trials. The initial stock piling orders are to prepare the clinical supplies. The other aspects are the preparation for broader use of the therapeutics. Although they don’t cure the disease, they are to treat more severe patients with coronavirus.

At Swiss Wealth Solutions we are not virologists, and hence unable to throw more colour onto this. Suffice to say, that certain company valuations were stretched coming into this and hence the severe pull back. Therefore, if it wasn’t Corona, it would’ve been something else. The rate of decline, however, is far sever than it was even with the 2008 financial crisis. Some of which can be contributed to the sharp decline in travel and leisure activities and hence overall consumption.

Having said that, we do realise the pain caused by this virus and our heart goes out to all who have and are suffering from this outbreak.

The Real Economy

We are already in a technical depression!

We had observed weakening consumer confidence since the second half of 2019. Coupled with the pandemic virus situation we expect a weaker global growth and profits and that at least for the first two quarters of 2020.

We are in unprecedented bad times. Worsening credit cycles will affect the banks, by becoming a collateral damage. And if economic shutdown jeopardises a lot of the outstanding corporate and consumer credit, the banks will be going down, even though this time they are not the epicentre of this whole thing!

Although, both FED and the congress are poised to stop the economy from a calamity but if we are all staying at home, it is going to be a big problem. There are however, limits as to what FEDs monitory policy and the announcement of an unlimited QE on its own can achieve. The FED is trying everything it can to stop this down turn and on the global growth. Despite all theses, the earnings estimates, are yet another unknown and hence work in progress.

The Supply Side – Despite FED’s cuts, we’ve seen some pervasive selling now that the story has been understood i.e., no matter how much liquidity gets pumped in the system, which according to some is already too much, it can neither spur the auto manufacturing and nor the production of the iPhones. Workers need to return to the shop-floor before anything can be produced.

The Demand Side – on the other side of the supply is the demand risk. Again here, although China does represent a big portion of the global demand, it is and growing to be a major part of it. And when the consequences of this outbreak hit the demand side and that specifically in Europe and the US, we will then see the dark side of the Swan.

S&P 500 Valuations

We have now gone from almost the highest valuations for the past 10 years, i.e., 18 x forward earnings, the P/E ratio to almost the neutral levels, that is around 15 x the earnings. Since 2014 we have been elevated into this higher zone of valuations, between 14 to 18 times the earnings. Within the past 5 years, due to easy monitory and recent fiscal conditions, we haven’t spent a lot of time below 14 x the forward earnings, except in December 2018, when we did dip below 15x the earnings. This however is on the slide now. The huge caveat today, is the fact that we don’t know the faith of the forward earnings forecast. The numbers haven’t come down that much on an aggregate basis since the end of January. With the sudden slowdown of demand on the markets. And the second wrinkle is how you equate the forward earnings of the equities, where they are now and where the bond yields are.

We hadn’t reached the valuation tipping point till Feb 21^st. and for the Coronavirus, the US was the safe haven. Overall, companies tend to metabolise a shock and then recover. Hence the question, will it be a U or a V shaped recovery. The lost revenues, in certain segments of the industry, like travel and entertainment, cannot be recovered. I won’t be travelling to Spain twice this year, just because I missed on my spring vacations. And neither will I be drinking twice as much Starbucks latte, just because I didn’t consume so much in the earlier part of this year.

And hence the downturn in the discretionary spending is given. Some argue that we are already in technical recession, with almost 90% of the industry in lockdown. Although, within certain segments like Finance and IT remote working does function, in the manufacturing industry this is not the fact.

Therefore, if this continues for a long time both the US and the European governments will have to come to the rescue of the Airlines and small businesses that have fallen victim to an exogenous event, through no fault of their own.

Cyclicals vs. the Defensives

We are not oblivious about market conditions and do realise the effects of the global slowdown, however, when you look at certain industrials, likes of Deere for example, and look into their valuations, on a relative multiples, they are trading down at around the financial crisis. Therefore, we do think that a lot of the bad stuff is already backed in with such sentiments. And this sector never really recovered from the trade wars with China. And therefore we think that this sector has really been de-risked to an extent. And that specifically after last Monday’s (March 9^th) total capitulation.

And then we have the ultra-defensives, i.e., the Utilities, which give you some of the best yields and there are not a lot of political or China risk within this sector. Effects of virus however, are yet to be observed and they are not overvalued. Now, if the interest rates rise, this sector can be vulnerable. But hey, if things muddle along as they do, a rate hike is by no means on the horizon. Quite the contrary, in fact the US market is not expecting a rise this or even the early parts of the next year.

Big Tech

The big tech. were clearly in the lead in taking us to the new elevated highs, before the virus raised its head. It was also part of the complacency. These were the easy names and whoever went in at levels above $300 for AAPL and such, is now feeling the pain. We took some of our chips off the table when AAPL reached $304 and that across all big tech. and some amongst us where complaining that we had gone out too early, when it was trading above $320. However, we were all very content now that we could buy it back around $270.

Having said that, it is always easier for the retail investor to come in when everything is going higher and everybody was piling in. Only to realise that the professionals are pulling out gently and when the ETFs get to the market, that’s when all lights tend to get red in Wall Street. What do they say? “The highest fall the fastest” and now we have it. There were no rhyme nor reason for the group to be so elevated, when at the same time other stocks were tanking within S&P 500. Except for the fact that the mass were rushing in, in order not to miss on the action and the ETFs were piling in easy money and pushing the prices ever higher.

After these lows we would like to see some of these names to stabilise and set a base, from where they can move higher again. This will give market participants some confidence to return.

The Airlines

There has been huge declines in revenues within leisure travel, stemming from the declines in future bookings, as well as the cancellations, with certain corporate travel vanishing all together. These two factors weigh heavily on the group and obviously the stocks have come down significantly, reflecting this short term lack of demand. The question here being the “Short Term”, that is to say, how long is the “Short Term”? And if you compare this with 9/11, the following September traffic was down 38%, October was down 21%, the November was down 18% and it kind of gradually improved from there. It took till February/March of the following year for the recovery (CNBC 10.03.2020). We are hence in unprecedented territory and the events around us will definitely have a negative impact, on the first two quarters of 2020.

The Spring breaks in the US will not see the same momentum in air travel and for summer breaks, most likely it is a wait to see. Airlines have very high fixed costs and therefore they’ll need to reduce their costs immediately, in order to preserve capital. As mentioned before, Leisure travel is down but it is responsive to lower fares. Hence if airlines are able to reduce the fares to their popular destinations, they can navigate through these rough times. The corporate travel, representing the more luxurious portion of this industry has vanished. The announced interventions by the US government, both for this sector as well as the Energy industry is therefore required to curb future disasters.

Oceanic cruise liners are yet another segment under heavy pressure. The Royal Caribbean recovered 7% on the 10.03.2020 only to have lost double digits the day before. The story is not any rosier by the others, i.e., the likes of Carnival and Norwegian.

The only good news for the Leisure industry stems from the energy sector. Oil prices just don’t find a bid here.

The Central Banks the FED – the Silver lining

The massive move from the European central bank and the announced unlimited QE and the Open Ended Asset Purchase from the FED, will in our opinion calm down the market.

In corporate credit, the movements observed since mid-February are 10 x the velocity they had during financial crisis in 2007/2008. Therefore, the dislocations in the credit markets are huge. And this fast movements has had a kind of a magnifying effect on the credit side, leading to the aforementioned unlimited asset purchase program from the FED to stabilise this market.

The Markets are the messenger and the Prices are the message. Looking at the slope of the down turn in the past 3 to 4 weeks, the market is telling us that we don’t have a plan to get out of this dilemma. And the market is sensing that we are caught in a kind of a long-term trap. Because there is no real hope right now, i.e., in the short-term, be it in isolated working, social distancing leading to a continuous operation or any such kind of solutions. Which is heart breaking for the service and manufacturing industry. It all began with travel but now it’s bleeding to all sorts of services industries. Hence we need to see clever government actions in a consorted manner and a new model for work before the effects of this virus are over and the world economy to start functioning again.

Restaurants, Hotels and Airline names have been side lined by an account of God. A majority of companies in these industries are embroiled in this crisis of their own makings. Some would name “Boeing”, as one such example. And although Trump has said that he’d like to tie strings to some of those fore coming packages, in order to make sure that the government get these deals on their own terms. And the question here, in order to rescue BA what terms will the government demand. BA has a huge defence basis and they’re suffering due to the fact that right now the Airlines are not buying any planes. For rescuing these industries is however, wrong to compare Boeing to AIG bank in 2008.

Given these circumstances the markets are functioning well, even if we had great volatilities in the past weeks.

We still don’t have real storm in the system and it’s merely anticipatory as to what might pop-up. Cash flows are being pinched and the market is trying to administer punishment in the correct segment, like airlines, leisure and discretionary and not across the entire broad market. This, however, could not be said on Monday 9^th March, when there was a massive pull-back, across the majority of the segments.

The Watchful Fed – The Liquidity injections by the FED may not really solve the basic economic problems. But in doing so, the FED hopes that the banks will step up and increase their loans to the industry. Banks, however, are not obliged to extend a helping hand. Therefore, FED is and remains the lender of the last resort.

Another good news out of all this is that the inflation will stay low. And hence the risk stemming from the inflation is not there. And that both in the US and in the EU.

Credit Markets

In certain markets, the bid / ask spreads have widened, given how much volatility there is in the market and you have to have that for people to make money. With FED flooding the markets with cash, today, it is a risk management problem and not a liquidity problem (David Tepper on CNBC 09.03.0202). Which means there are people out there reading the risk exposure although there is enough liquidity out there but not all contract sizes.

This is nothing like the past financial crisis, now there is much less leverage in the financial institutions. We are also not worried about convoluted financial instruments. Adding to the liquidity problem. The desks are split-up, because of the coronavirus. The situation will improve, when they are back together again.

People stay home due to Coronavirus but it doesn’t hamper the functioning of the markets and the banks i.e., the markets are still functioning.

The credit markets as bad as they are, have fallen victim to and are hence the symptoms of the disease and not the source of it. This is exactly, what separates this from the last Disaster in 2007/2008, when banks and credit were the source of the issue. Therefore, all these flood of liquidity around the world, including from the ECB and the US FED, are to help those credit markets in the short term, i.e., helping them from default. And that specifically the small and medium sized enterprises.

In recent weeks money has been flowing from corporate bonds funds, as people didn’t want to have anything to do with corporate credit risk (CNBC 20.03.2020). It has all been funnelled into cash like instruments like government money market, while treasury bills trading at negative yields.

Previously, during the crash everything was redeemed for cash. Be it municipal bonds or stocks and that including oil and gold. Hence the sentiment was, just don’t ask any questions and get out for cash or cash type instruments. We need to see activities normalising again. With lows tested and stabilised and have some sense of the correlation between all such financial instruments, before real long-term investors find their way back in the market. One disappointing note here was that the S&P did not hold the 2350 mark, which was not very optimistic.

The Volatility

For those with deep breath, Volatility really does bring up Opportunities. Prices move dramatically in different directions than the underlying intrinsic value of the business. Here one has to keep in mind that the real value of a business is determined by the present value of all cash flow streams. This year’s cash flow and to the future discounted to the present value. Hence, when the prices move so drastically and yes there will be some changes in value, however, it means big value gaps come up, providing an opportunity for truly long term investors. This kind of volatilities provide tremendous opportunity to value investors and bottom fishers. These are groups, who are looking at the price of the business and have the patients and the horizon to take advantage of such situations.

Now the answer to the question, if this is going to be a one quarter phenomenon or not, cannot be answered so easily. The outfalls from this can affect other businesses like travel, manufacturing and so on. Hence, it is difficult to judge if it’s going to be a one quarter or two quarter issue. This will however pass away, like all other viruses, which have come and gone. It might be away within the next 3 months and most definitely no one will still be pondering about it within a year. Therefore the impact should be taken into account and that for the short term earnings. But the intrinsic value of a business is not determined by a couple of quarters. Would you therefore now buy companies that are producing sanitary towels or hand sanitisers and such and that are out of stock to sell now? Well, you might form a trading point of view but not from a value view-point. This is exactly the opposite of value investing. Just because a company is doing well in the short term and that due to an unforeseen phenomenon, it doesn’t mean they will do well in the long-term. As mentioned earlier, one has to look at all their cash flow streams and not just what they’re going to do in the next couple of months.

Politicking of these issues is adding to the volatility of the markets, on both sides of the Atlantic. Although, here in the west the draconian (but effective) measures, adopted in China cannot apply, the governments in the west should find the most effective way to come out of this dilemma. Be it a one month quarantine period or whatever, in order to beat this evil, rather than banning certain Europeans from travelling across the pond, which does nothing but to add salt to an already a large open wound, amongst travel and leisure industries. Doing that will potentially put a base under the markets, creating a foundation.

When looking at Gold, one can say that there is margin selling to facilitate the purchase of equities. Gold was down 4.3% on the 12^th March. May be this is yet another piece of the puzzle, helping a very much washed out market to find some kind of a footings.

Where is Value

On the 19^th February, the peak of the market was concentrated at a few big caps. The duration and how much attrition we will have going forward? It might be a one or two quarter effect but the depth of it might lead to much attrition in the economic down

When it comes to future investments it isn’t easy to decide. What is true however, is that the same over bought sectors that have been purchased and killed during this February and March are the value facing sectors. For example the Financials and that specifically in Europe and certain materials like Glencore. You can look at some of the auto companies too. All these in Europe have been punished since 2018. Hence, if anything the value gap for such companies has widened, as people continue to flock over to stocks where they consider a safe haven, completely ignoring the price of the business.

Within our value investing portfolio, banks and specifically European banks, i.e., the likes of BNP Paribas, Credit Suisse and UBS. The rates situation especially in Europe has been tough for banks. This means that one portion of their earnings, i.e., the lending spreads get hit, due to net interest margin compression. But banks have other levers to pull. And they have been able to pull them. They have hence been growing their non-interest income and at the same time cut costs. Additionally, loan losses have been subdued. Hence, when you look at the whole picture, for the most part, the banks that we are interested within our portfolio universe have been able to grow their earnings steadily. And if we look at a year to date, with some of these, they are up 30 to 35 percent and are trading at multiples of 4 or 5 times normalised earnings and yielding 9 to 10 percent. Despite the hit, we don’t expect the earnings to evaporate completely. Now, if they have been able to maintain this kind of earnings in such rough environments, because Europe has been a good test case as it has had negative interest rates and many developed countries in Europe and yet banks like BNP Paribas have been able to grow their earnings and book value per share, over the last two or three years, despite the low levels of interest rates and hence they have demonstrated that they are able to pull other levers effectively and the market has recognised this. In the meantime, you have a bank BNP which yields over 9% and a French 10 year yield of -40 basis points. Hence to us at SWS here is a huge risk return opportunity with some of these quality financials.

About other constituents within our portfolio, the carnage in the energy sector has been negative however, our positions here are very small and the risk manageable. In travel we have a little more exposure and we have used these situations, in order to increase our exposure to a few of the airline we own. Although one can consider this segment as a capital trap due to their capital intensive operations and longer recovery period.

If we look at online travel however, i.e., the likes of TRIP, a Chinese online travel agency, which in our opinion will be a long-term growth story. This company has very low fixed assets. So there is not a lot of operational gearing with it. Oddly enough it has fallen, however, not to the levels that would make it attractive for us. We will, however, be adding to our positions, at the right price. But others have fallen significantly more than TRIP so this is just one area, which you’d expect to be weak and have glaring value which is not what we’d like to see from a valuation perspective.

On the 12^th march, when the bond market was seizing up and there was a terrible dislocation between the Bid/Ask spreads. There were securities that could not move and when the world’s largest Bond market seemed to be in trouble. The FED came in with infinite liquidity, as put by Steve Liesmann of CNBC (12.03.2020), i.e., as much money as the institutions may want to borrow, on a security, over a period of time. And to stop the total market capitulation with such indiscriminate sales across all asset classes and segments.
This REPO action although does not address the root cause of this crisis, cleared out the short term operations over liquidity and treasury markets. Additionally, it does provide a base upon which the congress and the treasury can build on.

These difficulties caused by the Coronavirus, which is also being spilt across to the energy market is definitely not a financial crisis. However, it can turn into a corporate crisis and hence the reason for FED’s action to move in with the above mentioned REPO agreement. This will allow banks to provide liquidity, whenever necessary, in order not to allow and that specifically some of the companies with high fixed costs, such as airlines and those in the energy sector from going bankrupt.

The remaining question, therefore, will the banks use this liquidity wiser and offer fresh loans to companies in trouble? One can ask if companies in the energy sector that don’t have a future with $18 oil, will have enough breath to make it to the other side of the crisis.

The volatility index rose by 19.37%, on March the12^th reaching levels over 70 points. If the peak, this can be bullish for the equities but is it there now? In any case, it is unlikely that we’ll be talking about the Coronavirus, in three to six months’ time. The effects of which might carry another quarter or two, at which point it will help the markets to recalibrate against their fundamentals.

US vs. the Europe

Although bond yields may not be the beacon for equity valuations, however, when the 10 year touches 30 basis points, there is trouble ahead. With all these uncertainties around us, from the macro, politics and now the virus, we don’t know the faith of the forward earnings forecast. It virtually hangs on a silk string and can go either way. If the northern portion of Europe follows the path of north Italy, it is predestined for a recession and default. That might spell the end of Europe and Euro as we have known it. However, if Europeans are able to manoeuvre around this virus cleverly the markets will rally sharply to the upside, towards the 3^rd quarter of this year.

The Coronavirus has also managed to empty out the streets of New York. The predicted recovery is now U rather than a V- shaped. The question which still needs to be answered is how deep and what is the wide will the U be? With Britain out of Europe, the community has to pay attention that the U does not become to be an L.

Therefore, right now, we are heavily biased towards the US, before entering European mainland. For us the only index in Europe, which provides certain safety is the Swiss Market Index (SMI) rather than the Euro quoted stocks.

Our Forecast

Following a market shock, tremendous trading opportunities arise. And we are now in one such period, where there are fantastic stock picking opportunities in segments with relatively low multiples. These are certain industrials, high tech and even some financial segments. Although we have been picking a few stocks within the past 3 – 5 weeks, it is not easy to pan the bottom, all the time. When VIX was hovering above 60 it was difficult to forecast exactly, but we cannot be more than 5-10% off the all-time lows right now.

And despite the economic setup pre-virus situation, we do find ourselves in a global recession. The question therefore “How painful this recession will be” hangs directly upon the length of time the lock-down will persist, within the developed west world. And although the production in China has already picked up, with more than 60% of the workforce back on the shop floor, the situation will not improve much if the consuming nations, that is the US and the west European countries still remain in lock-down.

Call me an uninformed optimist said Lee Cooperman, this is all about how the virus plays out. I don’t have a medical degree but I have two honorary PhDs. The market at the recent low of 2187 is close enough to the bottom to be called a bottom. If the economic shutdown goes beyond this quarter, I’ll be less optimistic (Lee Cooperman MEGA FAMILY OFFICE Friday 27 MARCH, on CNBC).

In the US, the FED remains the buyer of the last resort. And what makes us more optimistic this time around are the followings:

1. The nature of the downturn – this time it is not a pre-fabricated scam like last times, involving the financial institutions and hidden credit risk components. This is a mere act of God. Therefore if it does not last too long the excellent conditions, which existed previous to this unforeseen situation, do prevail and we expect the markets rally, when the work force returns to the shop floor
2. The FED has been aggressive, trying to be ahead of the curve rather than reactive
3. The US banks have the healthiest balance sheets, they’ve ever had throughout history
4. And last but not least a US president who, despite some of the rhetoric, is very watchful and concerned about the US economy and the markets, like no other before him

The US and ultimately the world economy is driven by the consumer spending. We therefore, need to see some confidence and there will be some pent-up demand, which will eventually be released. We do think that the GDP will turn positive, in the 4th quarter and with better outlook for 2021. However, given the lock-down which still persists, we are looking at three Quarters of contraction and that specifically for the 2-nd Quarter. Hence, we still have some things to get through but we have a good foundation here that will most likely cushion the blow and help us get to the other side.