April 02, 2020
In the midst of a market crash most investors are left wondering if the market has found a bottom and if the crash has resulted in bargain hunting opportunities. On the other hand, they question whether we are in a bear market, meaning we should sell on strength in major dead cat bear bounces. There is unfortunately no crystal ball available, nor a time machine to navigate back and forth. A prerequisite is always to consider equity market as a “warehouse of cash-flows, not a casino”.
“Modern” portfolio theory (modern but getting closer to its 70th birthday) referred to the “random walk theory”, where changes in stock prices have the same distribution and are independent of each other. It assumes that past movements or trends of a stock price or market cannot be used to predict its future movement. In short, random walk theory claims that stocks take a random and unpredictable path, without any memory of previous walks. This theory faces at least two major headwinds. The first and classical one is that in some instances, stock prices are highly correlated and exhibit some sort of memory of a volatility regime. This regime is observed during boom and bust phases on financial markets. Needless to say, that the current market is bang in the middle of a bust phase. The second take away from the “modern portfolio theory” and its random walk concept is the idea that the random walk is normally observed with a positive drift. This positive drift should be understood as the only rationale for any equity investment in the long run and there is no need to have a master’s degree in stochastic analysis: the drift can easily be assimilated to the dividend paid on stocks.
We currently observe significant pressure from regulators, politicians, and bottom-line results on dividends. While dividends are traditionally less volatile than earnings, investors should now prepare for some sizeable cuts in forward payouts, especially for EU domiciled companies. According to Morgan Stanley, in a classical recession dividends have been cut by around 10% (peak-to-trough), while during the Financial Crisis it was around 30%, their current estimate. The mix of corporates acting to preserve cash, ECB instructions towards banks and EU legislation towards companies that make use of state financial support, are combining to make dividend cuts all the more likely.
Don’t stop reading here, or you will be throwing out the baby with the bathwater…
As is rightly purported by Charles Gave, in the current market regime, “the inmates have taken over the asylum”. Macro-economics, corporate earnings and all other fundamental perspectives are irrelevant. Financial markets are no better than a casino.
Trying to navigate the pros and cons, it’s clear that the force of monetary and fiscal responses, China’s path to recovery and the accounted losses on financial assets are supportive, while reasons to remain cautious loom large: the uncertainty as to how long it will take to bring the pandemic under control (the prerequisite being a vaccine, treatment or collective immunity), the absence of a clear exit strategy (out of mass confinement) and the risk of a domino effect that hits liquidity.
A new dilemma seems to be emerging: The longer the confinement, the slower the economic recovery. The faster the confinement, the riskier the recovery.
The key variable in assessing the economic damage wrought by the covid-19 virus is the length of the lockdowns now in force. What is almost certain is that restrictions will be lifted in stages, meaning some could remain in place for at least some months. Testing, technology and life sciences should enable some differentiation of the general population, meaning that higher-risk groups could stay confined for longer. Decisions to relax restrictions and resume the prior modus-operandi are going to be much more complex. We can expect variances in the treatment of industries, services, leisure and travel.
According to mathematical modeling done by Bale University, the outbreak should have reached its peak by mid-May in both Europe and the USA.
Clearly we are not out of the woods yet. Covid-19 testing capacity and a containment of stress on small company balance sheets are key in order to have some light at the end of the proverbial tunnel. Disparity inside the European Union should be put aside to allow for immediate collaboration through the issuance of European bonds, while the US social system will have to tackle its profound lack of solidarity, suffering from the lack of a partial unemployment system.
Our advice stays
unchanged for the time being. Don’t try to be a hero by catching a falling
knife, but don’t despair either by throwing everything away. This unprecedented
crisis is being met with an onslaught of monetary and fiscal measures, coming
from all around the globe in unison. The best advice we can give for the moment
to anyone is to stay busy, to try to avoid looking at the sea of red across the
Bloomberg or Reuters terminal and keep your long term investment objectives in
mind. Social distancing from financial information platforms should be part of
the prescription. This will pass, but realistically nobody knowns when.
 « When to get back into the market” Charles Gave from Gavekal Daily Note 02/04/2020
Author: Group Investment Office