COVID-19 Making Sense of it All

April 9, 2020 by Martin L. Yokosawa

Our hearts and prayers go out to you in this difficult time. Be rest assured that all systems remain at full throttle here at Torii Asset Management and we are working tirelessly in monitoring, digesting, and adjusting our path forward to mitigate risk where possible and look for opportunities to recoup some of the losses that are occurring.

In my last quarterly review, I suggested investors should “Buckle up for the Ride” which aptly describes what happened in the quarter. It became apparent to this portfolio manager that investors were operating in a bubble environment soon after Apple revised down their quarterly guidance on February 17^th. Apple’s share price dropped only momentarily before trading up to a level near where it was before the announcement. In that brief time before the COVID-19, aka coronavirus, took a hold on the markets, investment chatter was that Apple’s initial price stability was a clear sign that the market was going to continue its upward trajectory. In my opinion, that’s a clear example of a bubble mentality in investing, or, irrational exuberance, as former Fed Chairman Alan Greenspan put it during the dot-com bubble of the 1990s.

During the first quarter of 2020, the S&P 500 Index lost 20.0%, the NASDAQ Index lost 14.2%, the Russell 2000 Index lost 25.9%, average Crude Spot Oil Spot Price dropped 49.2%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 10.2%.

From my experience, which extends over many market disruptions including the 1987 Crash, there are common threads of major market declines. Volumes have been written about past corrections and will continue to be written about the current state of affairs. We have seen this narrative many times.The following are some of my observations, hopefully in understandable terms, to provide insight as to how to make sense of and how I handle portfolio management during these situations.

1. A catalyst, which many times doesn’t have a direct correlation with the market, initiates a sell-off.
2. Margin (borrowed funds) calls erupt as the lower stock prices accelerate and borrowers are forced to sell at any price in order to access cash to satisfy required margin levels.
3. Contagion spreads across asset classes causing more forced selling, and markets drop in what seems to be a vacuum as would-be buyers step away. This is the “baby thrown out with the bath water” effect, which even solid companies cannot escape.
4. Share prices plummet from a lack of bids (buyers).
5. Eventually the calls are satisfied and/or the borrowers become insolvent and the selling abates.
6. A rally manifests itself as buyers begin to nibble at the bargain prices, and the rally compounds on itself as many jump into the market so they don’t miss out.
7. The rally loses steam as the unsolved underlying issues resurface in economic and financial reports.
8. During the correction process, analysts, portfolio managers, investment committees, economists, and a slew of others tackle the impossible task of accurately adjusting their models and forecasts. 
9. As these new models and forecasts are implemented with actual buying and selling, the market goes through a period of new price discovery. Since this is a dynamic process the period’s length, volatility, and a precise value cannot be pre-determined due to the high number of participants and dynamic variables which play on each other.
10. As the news flow slows and market volatility abates, the stock market begins to more accurately reflect the traditional method of stock pricing, which is the risk adjusted return a company generates from its present and future operations.

The basis of stock market pricing is a reflection of all the buyer’s and seller’s perception of current and future earnings streams. Included are adjustments made for variables such as the cost of financing, the probability of future earnings materializing, unknown external factors and the list goes on and on. One of the most difficult inputs to identify is the impact of investor optimism or pessimism in pricing. An example of this fuzzy pricing variable can be explored by studying the 1990s to early 2000 Dot-Com internet era and risk. 

During that era many internet companies generated great optimism and valuations by touting an exciting story. Despite the fact that many internet companies operated at a loss, investors simply couldn’t miss out on the rally. As a result, investors piled into these financially money losing names with disregard to fundamental valuations and risk. 

Abruptly in early March 2000, after the Federal Reserve raised the Fed Funds Rate to 5.75% in an effort to slow the economy, the Dot-Com bubble popped. One such seemingly intuitive investment named Register.com, which registered internet names, comes to mind. What could go wrong with a company serving an area of explosive growth? From its IPO (initial public offering) in March of 2000 it quickly peaked out at $116 per share, and one year later it traded at $5 per share.

A stock’s price change represents an incremental change in what is known. It is a reflection of new news from the net price change derived from buyer and seller conviction. A higher level of monetary conviction means more buying than selling; hence, the price goes up and of course the opposite is true. 

Why stock market pricing drives so many people crazy is the lack of understanding that all available public information is already reflected in a stock’s current price. In essence, no matter how good or awful a company is, buyers and sellers who act, believe they hold new information that gives them an edge above all other investors as to the future success or failure of a company. It is prudent for a potential buyer of a stock to recognize their information is competing against all other investors, analysts, portfolio managers, and company management and workers that are involved with the stock.

In long up-trending markets, investors are prone to failure by succumbing to a belief that they are smarter than all the rest after a few favorable investment outcomes in a one-way market. In reality they are gambling on continued momentum with little or no regard to valuation or price paid; the results can be devastating. This is also referred to as “herd” investing.

Calculating Price, Asset bubbles (overvaluation), and Market Drops: On a basic level, let’s start with the idea of discounting. It is a method to value a future benefit in today’s dollar. A dollar today is worth more than the same benefit promised in the future, due to variables such as inflation and outcome risk. For our discussion, the benefit will be a company’s cash flow or earnings. The discount is measured as a percentage rate.

The following formula is one fundamental and frequently used building block for valuing a company that is used by professionals to discount future benefit. In practice, it involves much more, but my example is only to provide an insight to the effect of discounting.

Below is what discounting looks like: It depicts that the same dollar value of something in 5 years is less than what it is today, just as an equal stream of discounted dollars received over 5 years is less than if they were all received today in today’s dollars. 

As the discount rate R increases, the value of future dollars decreases, and conversely, as the rate drops, the value of future dollars increase. R is a real bugaboo since it is determined subjectively and includes adding many inputs on top of a base rate. Traditionally the base rate is the “risk-free” U.S. Treasury interest rate. From its genesis one can see that there are problems with the calculation since U.S. Treasuries, as measured by the Standard & Poor’s (S&P) rating agency, are rated AA+ out of a maximum rating of AAA. In reality, risk- free is unachievable and should only be viewed as theoretical.

In my opinion, the most recent asset bubble situation of overvalued stocks, bonds, real estate – more or less everything–stems from actions taken by central bank authorities around the globe; ours is named the Federal Reserve Board of Governors. Since the last financial crisis of 2008-2009, authorities have been meddling aggressively by dropping interest rates, thus artificially increasing the value of future dollars. In return, a positive artificial economic and financial environment has led investors to erroneously reduce the degree of risk in their discount rate calculations, which further increases value (stock prices).

The silver lining in the COVID-19 induced correction is that a giant reset button has been pushed and investors will likely be more grounded in assessing value and risk in the market.

The stock market is forward looking, so most likely the COVID-19 virus doesn’t have to be completely eradicated before new growth can begin. As of today, here is what I see for the balance of the year. 

1. Things will be better at year end than they are now. 
2. Continuing of market volatility as the market digests the peak and waning of reported COVID-19 cases against the economic fallout due to the draconian measures required to promote public safety.
3. The market may test or make new lows as corporate management’s inability to provide forward guidance is coupled with selling from 401k participants experiencing statement shock as they receive their quarterly statements.
4. Volatility lessens going into the summer months as investors are placed in a holding pattern of waiting for an economic recovery.
5. In late summer the market moves upward if corporate management exhibits the fortitude to provide clarity in forward earnings guidance due to improved business prospects.
6. An excruciating election process as the political parties play the blame game against each other.
7. Investors realize a stronger second half than the first half of the year.

Again, this is my view at this exact point in time and may change due to the dynamic times we are experiencing.

Below are the incremental changes I am watching for to confirm or deny my current thesis:

1. The movement of currency between countries as institutions and countries adjust their finances and risk. In addition, the strength of the USD is an added headwind for global US firms.
2. Further banking or financial weakness. A concern of mine which stems back to September 2019 when the Fed began supporting the overnight repo market. Currently the Fed is making unprecedented purchases of securities to support the financial securities. My intuition tells me that preparations are being made to mitigate the demise of a large financial institution or country.
3. The movement of fund flows from money markets back into the stock market. Reuters recently reported that global investors sent a net $61 billion into money market funds in the week that ended March 4, hitting 30-week highs for the category, while global equity funds posted their largest asset losses since December 2018, according to data released Friday by fund-tracker EPFR. 
4. The expansion or contraction of economic policy.
5. The mood of corporate management and investors.
6. Data concerning the past and future trade deal with China.

Areas of stock interest which should reveal themselves during the upcoming earnings reporting season: Remember, intuitive thinking alone is not enough and investors are competing against the trading pros in the short-term and analysts and portfolio managers in the long-term in capitalizing on new news. 

1. Inexpensive long-term ideas less affected and possibly a benefactor of the COVID-19 situation, such as logistics companies which support companies like Amazon or Walmart, healthcare, communication.
2. Ideas which may benefit from the current stimulus in leading the economy out of its depressed state. If the gov’t institutes a 1930s WPA type program, infrastructure companies should do well.
3. Areas which promote efficiencies as companies tighten their belts. 
4. Companies exhibiting sound business models and future prospects which have depressed current stock prices.

As predicted, 2020 is a news filled year and is offering an abundance of risk and reward. 

To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.