March 25th Liberty Market Update – How the Covid-19 health crisis turned into an economic crisis and ultimately a financial crisis.
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Brett Girard: Hi folks. Brett Girard here, portfolio manager at Liberty coming to you with a market update.
Now, normally we reserve these market updates for our quarterly newsletter, but there’s so much happening in the world today we thought we could put this out as a sneak peek.
In the news, increasingly we’re hearing stories of how the events of today are similar to the dot com bubble and the 2008 global financial crisis. I’m going to go out on a limb here and say the most dangerous four words in finance. This time is different! Sort of.
See, if you look back to dot com and you look at 2008, what happened in both cases is that we had a financial crisis turn into an economic crisis that then fed back into a financial crisis creating a negative feedback loop causing markets to lose a substantial amount of value.
In both cases, what happened was, asset prices ticked higher and higher. In the case of dot com, it was the tech stocks, while as in 2008, it was real estate. In each instance, what happened was a “Minsky Moment.” Now, this is an economic term whereby everything’s okay until it isn’t.
This usually happens when the next buyer decides that the price of an asset is too high and doesn’t commit. So, in the case of tech stocks, cause remember Microsoft or Cisco looked as though they were going to go on forever—they didn’t. That last buyer did not show up. And that’s when the market started to realize that these companies were very overvalued.
Same thing happened with real estate back in 2008. There was lending to people that didn’t have jobs, didn’t have credit, and eventually, some smart minds came to the table and said these people aren’t going to be able to pay for their mortgages. In both cases, the financial crisis out of the high-valued asset precipitated into an economic crisis.
Now today, things are a little different. With today what we’re experiencing is a health crisis as a result of COVID-19. This health crisis has caused an economic crisis, as you can see in the news in terms of the unemployment reports here in Canada as well as the US, and then more generally abroad, as every country locks down in an effort to quell the spread of the virus. And from that what we’re expecting to see is a financial crisis in the next quarter to two or three quarters.
Now, let’s get started with a health crisis. Here’s the data on COVID-19 as of March 25th, 2020.
[World map on screen: Coronavirus COVID-19 Global Cases by the Center for Systems Science and Engineering (CSSE) at Johns Hopkins University]
Now we won’t spend long on this data because you’ve probably seen this reported in the nightly news. What’s in front of you is information from Johns Hopkins University in Baltimore. On the left-hand side, we can see total confirmed cases. Here China represents about 20% of the total confirmed cases in the world. This has changed dramatically since the virus was first reported in late December, early January. What we can see, unfortunately, is that Italy and the US are catching up, and the way the projections are looking today, they’re going to bypass China sometime in the next week.
On the right-hand side, we can see total deaths is just under 20,000. Unfortunately, here again, we’re likely to see this number tick higher. Although, there’s been reports that are coming out of Italy that the rate of change for the number of people passing away is declining. And that’s an indication that potentially the viral load has peaked there. We’re going to be waiting for that to happen in the US, but it appears based on the data coming out of New York that there’s still going to be some time before we hit a point where the rate of people passing away will decline on a day-to-day basis.
In the meantime, it’s important that we all stay safe, follow the rules of our governments. If we are supposed to be locked down, let’s stay locked down, and let’s do our part to help.
Moving on from the health crisis, let’s look at the economic impact. Unfortunately, it now appears a global recession is unavoidable. The real debate is around how long and how severe this recession will be. Here at home, there are a number of reports coming in this morning that unemployment in Canada could be as high as one million in the next week.
Anecdotally, in Ohio, claims for unemployment insurance went from 4,800 two weeks ago to 139,000 last week. Now multiply that by 50 states, and the number of unemployed people could be in the millions. Really a staggering number. St. Louis Fed President Jim Bullard went on the record Sunday and estimated that at the peak, we could see US unemployment hit 30% and US GDP fall by as much as 50%. Further, in India, the country’s 1.3 billion people have been locked down for the next 21 days.
Let’s be clear. Economies cannot function when people are at home and away from work. Now, in response to everything that’s happened economically, federal governments have been coming to the table. There’s a silver lining in all of this. The G7 governments have not been caught totally flat-footed like we saw in 2008. In fact, a lot of these countries are taking out their 2008 playbooks, dusting it off, and trying to put things to work.
Well, initially, we thought that COVID-19 was going to be a problem for just China. Once the physicians in North America and Europe started to ring the alarm bell, governments did start to mobilize. Somewhat slowly, but we are seeing progress. In fact, in the US, interest rates were cut two weeks ago down to zero, and the Federal Reserve committed to making an unlimited number of securities purchases.
These purchases will alleviate the strain on the banks and hopefully keep the economy functioning. Yesterday, the US Senate passed a bill that allowed two trillion dollars to be committed in aid over the upcoming months. It’s unclear exactly where that two trillion is going to go, we are still waiting on details, but that’s going to have a significant impact helping businesses and people get through this crisis.
Canada’s also doing its part, and there have been some packages proposed. It’s yet again for details to emerge, but we are watching and waiting to see that. As we saw in 2008, TARP with the banks and TALF for the asset-backed securities, there are a number of programs that did come out from the government, and not one silver bullet does emerge. Rather, it’s a function of different programs at different times, released to really help out businesses and individuals. And the goal through all this is to get confidence back in the minds of people running businesses and people working at businesses. Once we have confidence return and combine that with the fact that the health risk has decreased and allowing us to go outside, I think we’ll see a corner be turned on this current crisis.
Now, we’ve talked about health, we’ve talked about the economy, but how does that translate to you, and how does that look from a financial perspective? Let’s look at some charts.
[Chart on screen- Looking for a bottom: stocks held onto small gains Wednesday after a prolonged selloff.]
The first of the three charts, courtesy of CNBC, displayed is the S&P 500 over the last six months. Just a note, we use the S&P 500 as our equity benchmark because it represents the 500 largest companies in the US, most of which have operations around the world. This index is much more representative of the broader economy than the DOW, which only has 30 companies, and the TSX, which is dominated by resources and financials.
You’ll note from peak on February 19th, the S&P fell from 3,393 to 2,191 for a total peak to trough drop of 35%. Now technically, we enter a bear market with a fall of more than 20%, so we are well through that threshold. While we did not anticipate the one-two punch of COVID-19, and oil price wars between Russia and Saudi Arabia, our view at Liberty was that systematic risk in the markets throughout 2019 and into 2020 warranted a significant cash position. Our reduced equity exposure as a result of this cash position, along with our bonds and the falling Canadian dollar, have meant that our client portfolios have been impacted but nowhere near close to the extent of the broader stock market.
Now, on this graph, you’ll see a yellowish line. That represents the 200-day moving average. This is a technical indicator that is used to help determine the general market trend. While we are still and will always be dyed-in-the-wool fundamental analysts, it’s helpful for us to use the moving average as a tool to see how negative the trend has been. Since bottoming on Monday, the S&P has now began to come back.
Along with the broader market, we’ve seen a rise over the past couple of days. Now while this might be a tempting opportunity to buy the dip, we will remain in our cash position until the S&P drops back below 2,000. The reason for the market rising are two-fold.
First, large institutional money managers have strict asset-mix mandates. This dictates how much of their portfolio can be in stocks and how much needs to be in bonds. When stocks fall as they have over the past month, managers are forced to rebalance from bonds into stocks to maintain their proper weighting. This happens at the end of every quarter, and as you can imagine, we’re at the end of the quarter.
Now number two is that we’re also seeing a lot of folks that piled into short positions through the early part of March have to scramble and cover. The rebalancing of institutional portfolio managers should end by the end of March. Short covering might last into April, but it’s yet to be seen.
[Chart on-screen- Stock market turmoil: Daily percent change in the S&P 500 index as of market close on March 25, 2020]
Moving onto the next chart, another one from CNBC, one of the big red flags about this current rally is the VIX—the Volatility Index—is still at very elevated levels. This presents itself in this graph here, where you can see that significant swings are occurring both up and down. To add some context with numbers, for the 12 months prior to February 2020, the VIX traded below 20. Since mid-February, the VIX has been on a tear upward, now crossing over 60. For those keeping score, today was the 8th day in a row that the VIX traded above 60. Now the only other time that this has happened was back in November of 2008.
As you can infer, these types of movements, both up and down, are neither normal nor healthy for the market. Ultimately, the VIX will continue to be high until the market gets its bearings. Before we think about moving cash into the market, we will need to see the volatility drop to a more normal level. In our view, this will be sub-20.
[Chart on-screen- S&P 500 After the 20 Biggest Up Days Since 1926]
The third and final chart is from Jim Bianco at Bianco Research. Jim compiled the best 20 individual days in the S&P since 1926. It’s interesting to note that out of the 20 days, one of them being Tuesday, where the S&P was up over 9.4%, 18 of them occurred in the bear markets of the Depression, the Crash of 1987, the financial crisis of 2008, or the recent episode that we’re currently experiencing.
Now, this is not a good sign. If you examine the following hundred days from the 20 best days, as indicated by the dark black line, there’s a troubling trend. What you can see is that the mean return is negative 18%. If history is any indication, while there may be some short-term trading opportunities, this is not the time to invest. It’s important for all of us to remain rational through this period and focus on the fundamentals. That’s when we’ll note the bottom, and that’s when we’ll be able to invest.
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Thanks again for tuning into our video, and please feel free to reach out to any of the portfolio managers below. We are always around to chat. As always, if you have any questions, please send them in, and we can answer them in future videos. And please, stay safe.
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