Frightened Investors Trigger Sell Off Due to Coronavirus Pandemic
In less than one month, the S&P 500 gave back almost the entire 43.7% return it achieved since the low on Christmas Eve 2018; and, it revisited levels not seen since Feb-17. Since our last update on 20-Feb-20, the S&P 500, TSX, and MSCI Indices are down 29.3%, 31.1% and 29.8% (as at 16-Mar-20).
While the sheer degree of the pullback is newsworthy, the volatility and velocity of the move is really astounding. In fact, the 12% drop on 16-Mar-20 marked the first time since the Great Depression that investors have seen either 6 consecutive days of 4%+ moves, or 3 consecutive days of 9%+ moves in the S&P 500. The blowout in volatility has not been confined to equity markets either, as it has crept into gold and oil, among others. Speaking of oil, it has experienced its own fair share of problems in March. Russia refused to comply with a planned production cut to help alleviate the demand disruption caused by Covid-19. In response, Saudi Arabia showed once again who truly runs the table at OPEC, announcing they would increase supply to record volumes, over 12MM barrels per day, beginning in April. With this and planned increases from Russia, UAE, Iraq and Nigeria, the supply glut has pushed the price of WTI down 45.2%. This will surely add strain to an already weak US Shale sector, further adding stress to weak corporate balance sheets.
In 2019, many investors became increasingly convinced that stock markets only move in the “up” direction. They found themselves chasing a market that was running away like it stole something. Today, these same investors are complaining that the pullback, spurred by Covid-19, is a Black Swan that nobody could have foreseen. While foreseeing a global pandemic is difficult, Coronavirus has been newsworthy since December and it was highlighted in our newsletters since January. Irrespective of the predictability of the virus’s impact on capital markets, the economic slowdown was evident before the respiratory illness was distinguished from a Sunday morning reaction to a Corona overindulgence.
It was plainly obvious that leverage in the corporate system was becoming a potential red herring. A rising stock market was diverting cash flows to stock buybacks rather than strengthening the balance sheet, optimizing the supply chain, or investing in PP&E. Further, the popularity of just-in-time inventory management to better streamline working capital caused corporations to become more fragile to any interruption in sourcing and maintaining adequate inventory. Does this mean that these aforementioned points were enough to spur a 30% equity rout? No, but it indicates that corporations and the global economy were uniquely sensitive to anything that could disturb the status quo. Introduce a novel virus … which is uniquely contagious in its underlying ability to be spread by asymptomatic or mildly infected persons, but severe enough to hospitalize between 10-20% of the afflicted… and, you have a perfect storm for the healthcare system, credit markets, the economy, and small and medium businesses and their owners/employees.
Is this to suggest that GAVIN anticipated where the puck was going and was short equities/long duration beginning on 20-Feb-20? We wish! However, we have been managing our clients’ assets with prominence for downside protection. Considering the economic factors discussed above, we maintained exposure to ‘risk assets’ (ie. individual stocks and long-only funds) to approximately 40-50% depending on our long-term investors’ risk tolerance. Moreover, we were consistently increasing exposure to Alternative Assets, excluding private equity, as economic perils mounted. In addition, we know each clients’ cash needs for any given 6-month period and ensure that there is always adequate liquidity in the form of cash or short-term instruments to cover these obligations. This has allowed us to minimize our downside participation in chaotic times; and, equally important, we can monetize and reallocate to risk assets when we feel the discounts are sufficient to allow for a proper margin of safety. This does not imply that we will time the bottom, far from it, but we have the flexibility to average into positions in great companies that we are comfortable holding through and post Covid-19.
It was difficult to field questions in 2019 about the absence of 30%+ returns in our client portfolios. Further, our apprehension with valuations and the sustainability of the bull market caused us to miss out on new clients who were reluctant to part with their 100% equity allocation. However, we are in the business of preserving wealth; as such, during turbulence we can demonstrate the benefit of investing through a full market and the value of active management. It is now on us to continue to stay vigilant, and to effectively transition from the defensive zone through the neutral zone and into the offensive zone.