A Bat Swan

“In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”

Charlie Munger

*Disclaimer* The following is not intended to diminish what is obviously a serious and terrible health crisis. I’m strictly reflecting on investing in an especially chaotic, uncertain, and frightful environment.

As I write, financial markets are cratering. In the U.S., markets just experienced the worst day since 1987, worst week since 2008, and fastest bear market in history. Entire states and even countries are shutting down; people literally are not allowed to go to work, if they’re lucky enough to still have a job. I shudder to think what the economic indicators will print, let alone for businesses. Down 20%, 50%, 80%? Markets aren’t waiting to find out, it’s clearly horrendous so just sell and do it now. Recession is squarely on the table, quite possibly worse than the last one. What happened?

COVID-19, an actual black swan – a sight to behold – did. Not only is the human tragedy incredibly depressing, the economic shock will have severe, widespread consequences as economies come to a screeching halt for an undetermined period of time. Thousands of people have already died and it’s projected that millions of people will become infected and severely sick. Healthcare systems are overwhelmed, and quarantines are being mandated to prevent catastrophic outcomes. As a consequence of the abrupt halt in demand, countless businesses will lose a ton of money and many will go bankrupt, millions of people will be laid off, and loans will go unpaid. Why in the world, then, would you want to loan to or own an equity stake in a business now? 

The sell off in equity and credit markets has been violent to say the least. However, that does not mean markets were in a bubble or were bound to sell off. Pundits patting themselves on the back for predicting a recession or 30% drop in markets for reasons completely unrelated to the virus outbreak are being utterly disingenuous. Or, for that matter, chastising businesses for not being prepared to withstand a massive disruption in supply and demand. Hindsight and confirmation biases can be pernicious, particularly when you’re right for the wrong reasons. Yes, tail risk strategies have paid off tremendously, this time. For the past 10 years, they have not. Sure, on some metrics the markets were highly valued, but assets are priced based on future projections at a certain point in time. Pre-virus outbreak, the economy and companies were doing well with growing cash flows, moderate growth and inflation, and steadily rising wages. Post-virus outbreak, the backdrop has dramatically changed, so the market is reassessing the economic and business conditions and adjusting prices accordingly. 

As an investor, you do not have control over market movements, but you do have control over your reaction. Risk arrives without warning, and now is a great time to reflect on your emotions, behavior, and response. We are undoubtedly in the trenches.

Everyone has heard the phrase, “If you can keep your head when everybody around you is losing his, then it is very probable that you don’t understand the situation,” remarking on the obliviousness of an unflappable person to what is happening. It’s a humorous play on the opening lines of the poem If by Richard Kipling: 

“If you can keep your head when all about you

Are losing theirs and blaming it on you

If you can trust yourself when all men doubt you,

But make allowance for their doubting too;”

Should you sell when others are selling because they probably know more than you? Or should you trust in your investment allocation and not do anything? Or should you double down? The answer primarily depends on the investor and their time horizon. Traders may feel comfortable riding the waves of the market, buying and selling as the market whipsaws up and down. But for the vast majority of individuals, sticking to your predetermined plan will prevent mistakes triggered by emotional action. Selling now is likely detrimental to any long-term goals because selling means you have to buy back in again, which is much more difficult. Doing nothing is likely adequate, but incrementally buying on weakness is likely better. For most that means dollar cost averaging into index funds, which has been a fantastic strategy over the years. For enterprising investors, selectively buying businesses to hold for the long-term may turn out to be very wise, while conceding that others’ doubts may prove accurate.

I was not investing in 2008/09 so I do not know what it is like to experience a recession. Maybe that renders the following moot, but I’ll record my thoughts anyway. Losing money is obviously painful, but volatility is the price of admission. There’s a strong possibility I have a screw loose because I rather enjoy it; it’s exciting. How often do companies lose 50% or more of their value in three weeks? Like Buffett says, if you’re a net buyer of stocks over the long-term you should cheer for price declines so you can buy them on sale. The difficulty, as always, is figuring out what actually is on sale. Simply because price has fallen doesn’t mean an asset is cheap; the intrinsic value may have fallen commensurately, or more. Fortunately, intrinsic value is derived over the long-term, and large short-term dislocations in price and value provide opportunistic entry points for potentially fantastic investments.

Price is most immediately impacted by supply and demand, liquidity, and psychology. In my judgment, all of these seem to be currently negatively impacting markets. Whilst every breaking news headline about the spread of the virus snowballs the level of anxiety, spreads are historically wide in recent days across multiple asset classes, between bids and asks, and within interbank lending, indicating a massive drying up of liquidity and leading some to comment that the markets are acting broken. Whether it is momentum, risk parity, or volatility-targeting algorithmic funds, or simply fearful humans, forced selling seems to be occurring, though nobody can know for sure. Buying from forced sellers has generally worked out well historically. But eagerly emptying your clip indiscriminately may leave you with egg on your face; it’s tough to own a stake in a business for the long-term if the business does not make it to the long-term. I’m definitely not proclaiming this indicates a market bottom; nobody should be that naïve, but these factors indicate that negative psychology is noticeably prevalent. 

Although it’s next to impossible to assess the near term impact of a partial economic shutdown, deriving an estimate of intrinsic value for businesses is still possible, though the confidence intervals have widened. To state the obvious, near term cash flows will be negatively impacted and risk has increased with the rising cost of debt and equity. Not great. Some businesses will be impacted much more than others, such as those with high operating or financial leverage, discretionary products, or operations in the services sector, particularly in hospitality. For many, solvency issues have jumped to the forefront, and the damaging knock-on effects will be widespread; the interconnectedness of the economic machine cannot be avoided. However, companies with superb business models and management teams will not only be able to withstand a downturn, but possibly even increase their intrinsic value. At first read that may seem foolish, but some high-quality companies may be able to improve their competitive positions and increase their market share coming out of a crisis as customers realize their products or services are either better or necessary yet were potentially overlooked during the good times. Capital allocation will be scrutinized, inefficiencies and wasteful spending will be reduced, and some secular trends may actually accelerate. A sudden heart attack is shocking and undoubtedly alters the patient’s lifestyle after the fact. 

In the United States, as well as globally, the Central Bank and Federal Government are reacting to the outbreak with the tools at their disposal. And, in my opinion, both institutions have ample firepower to combat a downturn in the economy and markets. Whether they should or not is a different debate; they will. Will it be enough to buoy the economy or market sentiment? Possibly. Probably. Eventually. Predicting what path the market or economy will take in the coming months, whether it is a V, U, L, or some other letter, is impossible and any prognosticator saying otherwise is lying. What you can bet on though is that panics always abate and markets will ultimately continue their upward climb.

This pandemic is truly a dire situation for humanity; we’re fighting an invisible enemy with insufficient resources and no silver bullet. Yet history has shown that humankind and economies are incredibly resilient. The birds will eventually flock back to the bushes, just maybe not the same ones. Possessing a long-term time horizon is one of the few remaining edges, especially during periods of fear. Investing is not meant to be easy; temperaments are tested to a much greater degree than is intelligence. Buying the exact bottom is impossible, but thank goodness it’s not necessary.

Do I think we are at the cusp of a collapse in the global financial system, as some do? No.

Do I think there is more bad news to come about the virus and economy? Definitely.

Do I think it’s a good time to buy ownership in quality businesses for the long-term? Unequivocally.

You can never predict when it will rain gold, but when it does, it takes fortitude to venture outside when everybody is sheltering in place.*

* “Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.” – Warren Buffet, 2009 shareholder letter

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