EQUITY MARKETS UPDATE – 26 March 2020 The COVID-19 crisis has caused a massive supply/demand shock to the global economy. We are yet to see the end point, and already, markets are off some 30 – 50% thus far. Outside of the historical and intellectual buzz of witnessing history (some of it 200 hundred years in the making) what are the key lessons/findings?
· There are only 5 asset classes – Equities, Bonds, Property, Cash/Currency and Commodities. Every product is linked to these 5 in some way – don’t assume that there is some new “class/product” that will diversify away your risk. It does not exist.
· When these 5 asset classes correlate to 1, risk models “melt” and prove to be highly ineffective and dangerous.
· Liquidity, liquidity, liquidity is critical. LTCM went to the wall because they held assets that they could not sell. If there is no buyer, then said assets are momentarily worthless.
· When buying a company on 200X Price Earnings Multiple (PE) you are paying for earnings 200 years ahead! Even if the share price falls by 90% it still trades on a PE of 20X, hardly cheap. Amazon lost 90% of its value during the dotcom crisis.
· Structured product invariably blow up when stressed against the sword of reality. Mathematical simulations can create whatever outcome you tell the computer you want!
· When markets are gorging at the table of greed, SELL. When the table is empty of all diners and the fear of the end is apparently nigh, BUY.
· Debt is a fabulous slave but a furious master – there are only 3 ways you can reduce debt. Sell assets, earn profits or raise fresh capital. By the time the crisis hits the only real option is to raise fresh capital, usually at a massive discount to the then share price which is highly dilutive to existing shareholders.
· A confluence of events is typically needed to cause a major crisis – in the current crisis we had extended valuations; the belief that Central Bank “put” options would ensure everlasting euphoria in global financial markets; the peak in the globalisation of trade and all ends of the risk spectrum rallying together.
· The change in the rate of change (either accelerating or decelerating) is what markets reward/penalise, not static numbers.
· When you feel that you have hit your philosophical use by date then markets have probably peaked.
· Never waste a good crisis Current Triggers/Markers that we are Monitoring to Navigate Out of COVID-19
· The AUD/USD cross rate. The Australian Dollar is regarded as the global barometer of growth. In July 2011, at the height of China’s demand for Australian commodities the AUD/USD cross rate hit US$1.10. On 19th March 2020 it plunged to US$0.55. The Little Aussie Battler is predicting a major global economic fallout in the next 6 months. The all-time low for this cross rate was US$0.4775 in April 2001 just before Australia experienced the biggest bull run in commodities in over a century! The proximity of the AUD/USD cross rate to this all-time low would suggest that significant economic slowdown has been priced in.
· The Chicago Board of Exchange Volatility Index (VIX) – its current level has exceeded that reached at the nadir of the GFC. There is a lot of fear priced into markets. We need to see this stabilise to determine whether we have hit bottom. A period of the VIX travelling above 50 but below current highs of 80+ typically indicates a bottoming out process in markets.
· Watch the interaction between government bond yields and equity prices. We need to see these 2 asset classes performing in an inverse manner (bond yields up, bond prices down/equity prices up) to ensure normal transmission has been resumed. One variation of this measure is known as the Equity Risk Premium. data indicate that much fear has been priced into equity markets already.
· Monitor corporate bond yield spreads over equivalent duration government bond yields. When the spread is high then much fear has been priced in. Whilst not at the extreme level reached in 2009 at the peak of the panic in the GFC, the current spread indicates a significant change in investors attitude to risk.
· Price shares at the same level they hit at the bottom of the market in the prior crisis – this is a good indicator for an actual level of “cheap”. Barclays Bank in the UK in 1974 hit a forward PE of 4X and dividend yield of 14%. No guesses as to what valuation level it reached in March 2009 when it was priced at 65p down from 8 pounds?
· When you first put fresh money to work during a crisis expect to lose 10 – 15% – you can never pick the bottom. Within 12 – 18 months you are likely to be rewarded. Investment Conclusions We need to distinguish between event as opposed to corrections driven by structural change. COVID19 is an event driven correction – fast and furious. The timing and speed of recovery when the event passes, history shows to be sooner and more exuberant than when structural change is afoot. Post the Spanish Influenza Pandemic we moved into the Roaring 1920s. How ironic is it that we may move into the roaring 2020s! On the policy front, all Governments and Central Banks of the largest economies are alert and aware as to what they must do to avert a deep, prolonged recession. On this occasion, even the IMF has joined the liquidity injection party. There will be failures and fall out, but the stimulus and zero rates provide significant impetus for recovery when COVID-19 subsides leading to a sharp recovery in markets. Where there is certainty is in China. The “powers that be” can execute unilateral control. When China “re-opens” expect Australian equities to outperform the rest of the world and witness the AUD/USD cross rate to jump dramatically. When this occurs, if you hold significant levels of US cash, you should carefully consider whether it would be better to switch it back into Australian Dollars and be prepared to buy local shares. Based on the above experiences and monitoring the markers noted above, my hunch is that we are 75% to 85% through this current crisis. Fear is now rampant where once Greed was dominant. As we said before ‘Never waste a good crisis’.