COVID-19 - It Will Pass

Good Morning All, 

The Covid-19 virus has emerged as the black swan no one saw coming. Investors are rattled and many are still adjusting to a world of uncertainty. Three main fears are preoccupying investors: first, that the virus will (and may already have) spread widely across America and the rest of the world. Second, that fear of Covid-19 and measures to stem its spread, like advising workers to stay home and shutting down air-travel, will have severe consequences for economic activity. And third, that policymakers may be unable to keep short-term disruption from becoming long-term damage.
 
We believe all of these fears are well founded. Think of what is happening as a major paradigm shift for economies, institutions and social norms and practices that, critically, are not wired for such a phenomenon. It requires us to understand the dynamics, not only to navigate them well but also to avoid behaviors that make the situation a lot worse.
 
As we suggested in our last newsletter, the data was weakening even before the outbreak of Covid-19 and thus we believe that a recession in the coming months is more probable than not (we may already be in one). Investors are already pricing this in. 
 
The bottom line is that the economic disruptions we are experiencing and those ahead will be more severe and widespread than the ones experienced by the bulk of the population in advanced countries.
 
Nevertheless, for the long-term investor drawdowns are an opportunity. Were share prices to fall exactly in line with the value of lost profits, they would be no cheaper. But in recessions, stocks tend to fall by a lot more than that. Consider the following: 

These numbers are gut wrenching but recessions are typically not the end of the world.  The last cycle lasted 11 years and many have forgotten that economic downturns are (or should be) a fact of life for investors. 
 
Charlie Munger has said: 
 

“I think it's in the nature of long term shareholding of the normal vicissitudes, in worldly outcomes, and in markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact, you can argue that if you're not willing to react with equanimity to a market price decline of 50% two or three times a century you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations."
 

Downturns eventually give way to recoveries from which those who have prepared for, and persevered through can profit from. 
 
Many shareholders cannot look past drawdowns and this panic is all too human. Big drawdowns affect people deeply as the pain of loss is felt far more intensely than the joy of gain. Suddenly, risks seem to be everywhere- to your job, to your business, to your pension, to your loved ones, to your dreams about the future. 
 
Mohamed A. El-Erian has rightly pointed out that:
 

“We live in a global economy wired for ever deepening interconnectivity; and we are living through a period in which the current phase of health policy — emphasizing social distancing, separation and isolation — runs counter to what drives economic growth, prosperity and financial stability. The effects of these two basic factors will be amplified by the economics of fear and uncertainty that tempt everyone not just to clear out supermarket shelves but sadly also reignite terrible conscious and unconscious biases.”
 

It is important to emphasize the impossible benthamite conundrum governments face. On the one hand preserving life and public health is of critical importance, yet on the other, the short, medium and long-term costs of full economic shutdown are immense. What decision will maximize utility, or happiness, for the greatest number of people? 

Right now it is impossible to ascertain how much worse things may get. We are being yanked out of our comfort zones making it increasingly difficult to focus on life after containment and reversal. Nevertheless, extreme fear like we are seeing cannot last indefinitely. The pendulum will eventually swing back and humans will carry on as they have after every one of the recessions listed above. Every crisis is also an opportunity.
 
At times like this the prudent long-term stockpicker will have a watchlist ready of quality company shares which have been and will continue to be priced below a reasonable estimation of their future long-term profits.
 

What specifically are we doing? 
 
We consider the impending recession to be a 1 in 10-year opportunity for the long-term investor to tactically rebalance the portfolio for the next decade. In previous letters and newsletters, we mentioned that we expected future returns to be lower, but as we get deeper into the current selloff, we are becoming more optimistic about the probability of attractive annualized returns over the next 5 years – 10 years.
 
At present, we have been selectively initiating positions in stocks clustered under 3 key core themes that we believe have a high likelihood of delivering large earnings and revenue growth with rising returns on invested capital over the next 10 years. These themes are:
 
1. The rise of the emerging market Millennial/Gen Z: YY, BZUN;

2. The continued expansion of the ‘virtual’ economy as effective work-from-home policies are likely to stick (fintech, video, e-commerce, virtual purchasing, gaming, esports betting): ADBE, TTD, ATVI; and

3. Mission critical cloud computing and related applications as well as advanced artificial intelligence for the enterprise: NOW, ZS, INTU, AYX.
 
We think these core themes will shape the investment landscape over the next decade.
 

Why now?
 
Since 1950 there have been eight periods on the U.S. S&P 500 when there has been a decline of at least 15% in a 30-day period. Picking the absolute bottom is a guess each time, but at the end of that 30-day period of declines, the immediate and mid-term future was almost always positive.
 
These are returns without dividends, so they underestimate the actual returns.
 
Even without dividends, we can see the following:
 

-Next 20 trading days (roughly 1 month) — the average return was 9.0 per cent and 7 of 8 were positive.
-Next 40 trading days (roughly 2 months) — the average return was 12.3 per cent and 8 of 8 were positive.
-Next 60 trading days (roughly 3 months) — the average return was 10.6 per cent and 7 of 8 were positive.
-Next 260 trading days (roughly 1 year) — the average return was 28.7 per cent and 7 of 8 were positive.
-Next 720 trading days (roughly 3 years) — the average cumulative return was 50.1 per cent and 8 of 8 were positive.
 

Watching history unfold over the past few weeks (the market has gone from 52 week highs to 52 week lows in 20 days for the fastest bear market ever) and fielding questions about what to do reminds us of an old zen proverb: 
 

A student went to his meditation teacher and said, “My meditation is horrible! I feel so distracted, or my legs ache, or I’m constantly falling asleep. It’s just horrible!”
 
“It will pass,” the teacher said matter-of-factly.
 
A week later, the student came back to his teacher. “My meditation is wonderful! I feel so aware, so peaceful, so alive! It’s just wonderful!’
 
“It will pass,” the teacher replied matter-of-factly.
 

In a recent post about the current carnage Nick Maggiulli remarked that:
 

“In bear markets, stocks return to their rightful owners.”
 

We like you have found the speed of this drawdown to be particularly distressing, but we believe that it will pass. Life will go on. Humanity will prevail and we will thus take our chances in becoming one of the rightful owners.
 
Every economic shock leaves a legacy. Covid-19 will be no different.

Keep healthy, stay safe and best wishes to you and your loved ones during these trying times.

Outlook For 2016 And Beyond

As we reach the end of 2015 many market participants are dusting off their crystal balls, preparing their predictions for 2016. Coming off the worst year for asset allocation since 1937, dubbed as “The Year Nothing Worked”, perhaps this year’s predictions will be all the more important.

So far, as the forecasts begin to come out, it shouldn’t come as a surprise that 2016’s annual stock market predictions are looking quite bullish. Consensus estimates from Barrons indicate that there are few bears and the average return predicted on the S&P 500 is 10%. Should we be surprised? Probably not given that on an annual basis the S&P 500 is positive about 80% of the time and has averaged about a 12.74% return in the post-war era. Thinking in terms of probabilities it would appear that the year’s predictions aren’t really telling us anything we don’t already know.

Now we can argue all we want about the wisdom of these pundits or why they continue making predictions in the first place but perhaps the most important takeaway about yearly market forecasts is the negative effect they can have on investor psychology. For most individuals, investing is a long-term activity. Stocks and bonds are long-term instruments. Thus, looking at our investments in one year increments can detract from this reality and cause us to make poor investment decisions.

This reality is even more evident when one considers the fact that the average lifespan of a publicly traded company in the USA is 15 years and the average maturity of a newly issued corporate bond is 17 years. This means that the typical investor has instruments with an average lifespan of about 16 years. Furthermore, successful investing requires consistency and predictability and it is only over time that returns take on these qualities. Thus, in response to such yearly forecasts investors would do well to remember that a more useful frame of analysis for one’s stock market investments is 3-5 years. It is for this reason that instead of presenting a simple one year outlook for 2016 I’ve chosen to discuss some trends that I believe will play a key role in shaping market conditions well beyond 2016.

The Fed’s Actions Will Remain Crucial To US Equity Markets

On Wednesday December 16, Janet Yellen held a news conference where she announced that the Fed would raise its benchmark interest rate for the first time since 2006. This raise was exactly what the market anticipated as the raise was only a quarter point, the pace of the hike would be gradual, the Fed’s outlook on the economy was upgraded and belief that inflation would rise to its 2 percent objective was confirmed. To more sophisticated market watchers this amounted to a non-event as the move was the most anticipated rate rise in history. Nevertheless, this rate increase was uncharacteristic, as most increases occur to stave off inflationary pressures and come when investor appetite for risk is increasing. The data does not confirm either of these two factors suggesting that the Fed’s reasons for moving rates may reflect its fear of losing credibility rather than its faith in the strength of the US economy.

Either way history suggests that such small initial rate increases generally do not move markets and thus the key question is the timing of future rate increases. With inflation running far lower than the Fed’s 2% target the risks of tightening too much too soon remain severe. The strong dollar, weakness in emerging markets, stagnant domestic wage growth and looser monetary policy elsewhere give the Fed little margin of error to address any threat of recession. Furthermore, many have suggested that market mood has become dependent upon the support of central banks leading to the irrelevance of economic fundamentals. As the Fed begins tightening, market mood will re-connect with fundamentals.

Unlike during 2015, in 2016 good news on the economy should translate into good news for markets. Nevertheless, the Fed will most likely proceed cautiously with further rate hikes knowing full well that a sharp rise in bond yields, spreads and the US Dollar in 2016 would have a debilitating effect on economic activity. So all in all, 2016 and potentially beyond is shaping up to be a year of continuing uncertainty.

Monetary policy will remain a key theme as the Fed struggles to get its rate manipulation just right and market participants will have to wait a little longer to get a clear signal that economic conditions have improved enough to begin “safely” allocating unprecedented cash reserves.

Nevertheless, we believe that not only will the consumer be stronger in 2016, but that the Euro will rise relative to the USD as the market inevitably prices in the end of quantitative easing in Europe beyond 2017 in addition to modest growth within the region. Big bulge, trust and regional banking sectors in the US will be the greatest beneficiaries, since this ‘peak rate’ thesis leading to a slight drop in the USD will increase the value of loan portfolios (in addition to exposure at the short-end of the yield curve), all the while enhancing yields extracted from stronger economic actors.

Major world events (this is a rare year of having the Euro, the Olympics, and a US election) will have a slightly positive incremental impact on spending as well, leading to earnings growth a few basis points greater than expected. Furthermore, if both oil prices and Chinese growth stabilize, market participants may wish they had allocated their cash reserves sooner as it won’t be a bust we will be worrying about but a boom.

The Price Of Oil Will Stay Low And Volatile

In 2015 oil prices have slumped to levels not seen since the dark days of the last recession in 2009. The energy sector has become the biggest job cutter of 2015 and is set to remain so in 2016. Having led the nation’s economic growth, oil-rich states including Texas, Oklahoma, and Colorado are now facing unemployment which could surpass the national rate next year. Not to mention the damage such a fall has caused to entire nations such as Canada and Venezuela.

At first the culprit was deemed to be excess supply in the form of over extraction yet the oil market is being decimated by a perfect storm which will cause further volatility and lower prices beyond 2016 ($40-$60 range). Three distinct forces are to blame. The first is a destabilization of the supply side due to the onset of shale energy technology. The second is the demand side which has been thrown into disarray by weak global growth and a more severe downturn in emerging economies (think China and Brazil). Finally, OPEC’s influence and effectiveness as a swing producer on the downside (by reducing output when prices are low) has been put in jeopardy by the US.

This has dragged Saudi Arabia into a dangerous a game of chicken (flooding the market to lower prices further) against US producers. Over the long term this may be a good thing as natural market forces of supply and demand could fully shape price yet the short and medium term risks of this arrangement are significant. Firstly, oil producing nations have varying degrees of economic resiliency in the face of lower prices which could lead to political crises and further global instability. Secondly, Saudi Arabia is taking a risk betting against the innovation and tenacity of American oilmen who are working tirelessly to further reduce extraction costs.

As a result of ongoing volatility and low prices, two competing forces will influence US economic growth. On the one hand, the consumer and non-energy corporate earnings will benefit from lower oil prices. Consumers may spend their windfall from lower energy expenditures on domestic consumption and thus drive growth. On the other hand, the energy sector remains a key US growth driver with positive spillover effects flowing through the entire economy. Any protracted weakness in this sector could certainly slow growth.

Capital Will Get More Selective

In 2016 founders will find it harder to raise capital at all stages (seed, series A and late stage). With America’s Federal Reserve beginning to raise rates we should expect a shift in the funding environment moving the balance of power from entrepreneurs to investors. In the “unicorn” environment in which we find ourselves (144 unicorns valued at $505 billion most of which are unprofitable) such belt tightening would be a welcome development.

As capital markets begin to get more conservative a sort of mini-correction may start to roil the start-up ecosystem (this may already have begun in light of mutual fund valuation write downs and the growing number of “down rounds”). This correction would be a welcome development as it would leave the start-up ecosystem healthier and more disciplined.

Strong firms would begin to stand out from a crowded field of pretenders. Achieving “unicorn status” would become less of an end in itself and instead simply be the result of a business with sound fundamentals. Finally, private markets would begin to regain their role as a precursor to public markets instead of shielding weak firms from the more rigorous scrutiny and pricing associated with an IPO.

New Consumption Patterns Will Continue To Change Corporate America

“The more things change the more they stay the same.” This saying certainly applies to many classic retailers like Macy’s, Nordstrom and Sears who are playing by old rules and failing to capture the new American consumer consciousness. Besides re-shaping American banking, the financial crisis triggered the beginnings of a fundamental change in consumer values. More is no longer better. Mindless consumption is losing its luster and individuals are no longer allowing themselves to be manipulated into buying the “latest thing”. Instead, consumers and especially millennials, are shifting their focus to value and experience as they focus on personal growth, collaboration and inner meaning.

In the On-Demand Economy consumers are becoming more content living with less and more focused on getting the most bespoke experience for their dollars. This shift in the American consumer will have a far-reaching effect on corporate America. It will make winners out of companies who are able to build the best relationships with their customers and give them exactly what they want when they want it and losers out of those who continue to focus on inauthentic discounting and commoditization.

Artificial Intelligence Will Change The Way We Solve Problems

As computers became smarter and faster than ever before in 2015, AI moved from the fringes of the news media to primetime. Cloud computing infrastructure has become more powerful and affordable while software development tools, neural networks and datasets became more accessible and plentiful.

With consumers and machines producing more data than ever before (think smart phones and IOT) AI has become one of the most transformative opportunities of our time. Tech’s largest players have taken note with Google, Facebook, Microsoft and IBM each operating their own AI labs and viewing such research as a critical driver of future growth. Although many discuss the existential threat posed by AI, the main thrust of such research focuses on teaching computers to think for themselves and improvise solutions to common problems. More specifically expect AI to shape the future by:

• Linking data silos to one another for a more holistic view of a complex problem from which new insights can be identified to make predictions.
• Addressing focused, high value, recurring problems using a set of AI techniques that tackle the shortfalls of humans. (Ie. fraud detection, tax evasion, and insider trading)
• Developing new frameworks (feature engineering, data processing, algorithms, model training, deployment) that are applicable to a wide variety of commercial problems.
• Studying the repetitive, mundane, error prone and slow processes conducted by knowledge workers on a daily basis. (Ie. answering emails, organizing information, document review and due diligence)
• Mapping out the interactions that occur between autonomous agents in the physical world which rely on contextual sensor inputs (perception), logic and intelligence.
• Focusing on research/development traditionally deemed to be too commercially risky and thus otherwise would be relegated to academia (but due to strict budgets, often no longer is).

How We Chose To Address Inequality Will Shape The Future

As a topic I’ve been following since I began my academic career, inequality is now receiving more attention than ever before. The publication of Thomas Piketty’s best seller Capital in the Twenty-First Century catapulted the topic into the media’s consciousness and world leaders have taken notice. Dignitaries such as Barack Obama, Hilary Clinton, the Pope and the IMF’s Christine Lagarde have gone so far as to shape the discourse surrounding inequality as “the challenge of our time”.

Yet perhaps the most shocking indicator of the growing unequal distribution of wealth was Mark Zuckeberg’s public promise to use the vast majority of his fortune to support charitable causes. Much ink was spilt in both the media and the blogosphere dissecting the righteousness of this act as either self-serving or truly altruistic but I believe these discussions wholly miss the mark. What such extreme philanthropy suggests is how such a fortune could ever be accumulated in the first place and secondly whether such extreme philanthropy can ever make up for the unequal distribution of wealth it typifies.

Morals and ethics aside, what is so concerning about the rise of inequality is that growing wealth concentration can cause people to lose faith in the fairness of their “liberal” market oriented system. Disillusion of this nature could lead to political crises and socio-cultural instability. Extreme inequality evidences inefficiency and thus exposes the weaknesses of our current capitalist system. We have moved towards a winner take all society in which industry is concentrated and competition is stifled. Thus, contrary to those who believe that the best way to respond to inequality is to raise taxes, it is pre-tax inequality which should be addressed. Moving forward it will be the creation of pre-tax corrective policies that will shape both the contours of our economic system and the fabric of our society for years to come.

Article originally featured on Seeking Alpha.

S&P 500 For 2016 And Beyond: Lessons From The Past To Guide Your Portfolio

Over the past year and a half, there is no doubt that some investment banks, research firms, money managers and other bears alike have been waving the red flag as to the inevitable crash of the global economy, predicting not only lower than average future returns but impending doom. Their claims come from the usual data points: S&P 500 profits are down, S&P 500 P/E ratio at decade highs, a slowing Chinese economy, a weak transportation index, the steadiness of housing starts, US GDP barely growing at inflation, the end of the commodity super cycle, and, of course, the usual cop out of “these strong returns realized by the market over the last 2 years are not sustainable because they are propped up by a Fed bubble”. Oh, and let’s not forget “watch what the bond markets are telling us”, the usual cliché posed by some managers and analysts as if they are the next boy who cried wolf predicting the come of the ‘Great Recession, Part 2’.

To continue reading please visit Seeking Alpha.

Time To Buy European Equities?

Despite the recent spate of volatility linked to Greek debt talks, it may be time for the prudent long-term investor to consider increasing exposure to European equities. Recent weakness in European equities due to a reversal of bond and currency market trends coupled with Grexit fears may constitute a favorable entry point. The case for increasing European equity exposure will be made, the U.S. equity market alternative will be considered, and the market risks of Grexit will be evaluated.

To continue reading please visit Seeking Alpha.

Further Weakness Expected For The Canadian Economy?

Last week Statistics Canada reported that Canadian Q1 GDP declined 0.6% vs. a prior estimate of a 0.3% rise. This decrease is notable as it exceeded all 22 economist forecasts in a Bloomberg News survey with a median estimate of a 0.3 percent expansion. In addition, the drop was the most significant since the 2009 recession and was the first decline since 2011. This has caused the Canadian dollar to weaken further as represented by CurrencyShares Canadian Dollar Trust (NYSEARCA:FXC).

More specifically, economic activity decreased in almost every category. Of note was a 9.7% annualized fall in business gross fixed capital formation and a 0.4% annualized decrease in consumer spending which was the slowest since the start of 2009. In addition, exports fell 1.1 percent, the second straight quarterly decline and imports dropped 1.5 percent. Bank of Montreal chief economist Doug Porter stated that BMO's overall 2015 projection have been chopped down to 1.5% GDP growth which would be the slowest growth for Canada - outside of recession - in at least the past three decades. As for CIBC, their forecast has come in even more bearish, predicting that the Canadian economy will only grow 1.4% this year.

This data seemed to validate Bank of Canada governor Stephen Poloz's comment earlier this year that Canada's first-quarter numbers would look "atrocious". Statistics Canada indicated that this poor reading was linked to collapsing energy prices and a plunge in business investment. Bank of Canada held its borrowing rate at 0.75%, stating that consumer demand "is holding up well" and that the current stimulus was enough to prevent a downturn.

Nevertheless, some commentators have suggested that in light of this fresh round of sluggish data, interest rates are looking flexible again. Will the weakness in the Canadian economy persist? Several key indicators will be considered.

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