With increasing questions about the virus and its effects on the financial markets, I thought I would take some time to share thoughts. A good chunk of this article contains financial-speak and technical sounding terms. And there are no photos and it likely contains poor editing. Sorry for that in advance. But for those of you wanting to know in-depth what I am thinking, here it is straight…
Note that most of this was written Friday morning before extra stimulus was announced by the government and Fed and with the stock index up 3% (it ended the day up 10%).
First off, regarding the virus itself, the Mayo Clinic put out a special report that you might all find helpful which I will link HERE.
Secondly, you have seen financial markets reaction. This virus situation can morph into many possible scenarios which leaves a lot of uncertainty. And you may know that market participants hate uncertainty. Many money managers and investors simply sell out if they don’t understand the situation and that I think is with good reason!
Nonetheless, I do believe there exists many structural weaknesses in financial markets that PRE-EXISTED the virus scare, but simply were not a worry while everyone was partying in the stock market. Here are a few of those culprits:
Leveraged investors who rely on continuous up markets and perfect conditions to succeed - get exponential losses if unexpected downside happens. Then many of these players need to sell to cover their borrowed funds (think angry bookie). Their forced selling likely makes stocks go down farther than they normally would if there were no leverage in the system.
High yield bond financed projects, especially in US oil regions where “frackers” rely on $50/barrel oil to pay the higher rate of interest on the high yield (“junk”) bonds they’ve issued to fund operations. At $30 oil (where we are now) they lose money, can’t pay their debts and blow up financially. There’s good reason to believe that Russia and the Saudis did this on purpose to blow out a pesky competitor (USA). If these companies contract, hundreds of millions of dollars of spending on oil field work, not to mention the high paying jobs, go away.
Excess capital for numerous startups and venture businesses that will never work. This is fine in my eyes in principle, because this is how new innovation comes. But funding companies that will never turn a profit and by design can only sell their products cheap because they are burning through the funds raised from investors, won’t last in a risky environment. Potential cost to the US economy = less investment in risky ventures and job losses in companies with no profits who can not continue to raise capital.
Buy the dip muscle memory for the last 12 years, a whole generation of investors has been conditioned that every time the stock market falls, the Federal Reserve will lower interest rates and the market will pop back up. This is dangerous thinking and many have been lulled to sleep on this. So that if the dip buying doesn’t work, it could cause massive panic selling in a public that has no idea what to do in a real bear market. This is probably the worst thing because investors have lost all sense of risk management.
Low interest rates from the Fed encouraged companies to BORROW money to buy back stock. Some of those companies are now looking for bailouts. This reckless behavior would be punished in a normal capitalist system. But I have a sad feeling that this reckless behavior will be REWARDED with a bailout.
Increased technical trading where many players seem to buy and sell at the same “strategic” points leading to “trap door” moves in stock prices (these two weeks make me think of 1987) to the downside and “vacuum” up moves up in stocks.
So you can see how “financialized” our economy has become. I believe we truly have turned into an economy that is addicted to the stock and bond market and raising funds cheaply from unsavvy (often rich and unsavvy) investors.
Virus Exposed Our Fragility - Here Comes More Money Printing
So there is real risk that wasn’t “caused” by the virus but in my opinion, exposed by the virus. That being said i would not rule out a massive stimulus program coming from a combined government & Fed package at any time (some of this happened as I write this on Friday).
The real test comes after that is announced. If the package is followed by more stock market selling (an unsuccessful “buy the dip” attempt), we could be in big trouble. However, if Fed stimulus and cheerleading leads to another successful “buy the dip” in the market, then we go with it and participate in stocks. Believe me, these guys (Trump, Powell, etc) don’t want a crash and they also don’t want to see their stimulus fail. Please realize that it could be psychologically damaging worldwide if the Fed’s policies were seen to be losing their effect.
Buy the Dip?
I personally do believe that after a decade plus of index investing being the “way to go,” we will see more value added in active money management. Furthermore, I believe that intelligent risk management will be at a premium.
Moreover, for those who REALLY dislike excessive risk, the concept of Floor + Upside approach to retirement income will sound very appealing. This is something I have shared with most of you - with the idea that you use more defined investments to provide retirement income - and not leave all of your money to the vagaries of the stock market. Especially when you only have one life to live and not enough time to “ride through” long bear markets like the 1970s, 1930s or even 2000-2010 when the average S&P return was close to 0%/year.
Overall, risk management means developing an “anti-fragile” retirement portfolio - a concept that well-known author/mathematician/fund manager Nicholas Taleb discusses often and wrote a book on. What does anti-fragile mean? Here is a quote from the article that summarizes that book:
“We have been fragilizing the economy, our health, political life, education, almost everything” by “suppressing randomness and volatility,” much the way that “systematically preventing forest fires from taking place ‘to be safe’ makes the big one much worse.”
I am of the belief that index investing is '“fragile.” With that all said, I was interviewed by Marc Glickman - a LinkedIn publisher on the topic of defining a retirement income and respecting the market risks to your retirement. This might help explain the idea of risk management/floor+upside/antifragility to you better than words. You can watch that interview here:
Liability Driven Investing to Help Clients Achieve Their Goals
Post note:
I wrote this mostly during Friday’s crazy ride in the markets. The Fed has put up $1.5 TRILLION of additional lending collateral (probably for those oil guys that can’t refinance their debt) and someone reported they have quietly restarted $60 BILLION/mo of stimulus. With the government offering help (paid for with more borrowed funds) we are on our way to the type of stimulus that has helped the market bounce in the past.
And because of this and other hope, the market had a very strong Friday. Understand that some of the strongest days in the stock market come DURING a bear market. However, the market did bounce at a critical level on Friday morning. So this might be THE bounce - the “buy the dip” moment that everyone is hoping for (maybe with such a fast fall they don’t “expect” a bounce like they did in 2018 but now just “hope” for it).
If that’s the case, we will increase stock allocations. We reduced them tremendously 2 weeks ago and last week. If however, market prices fall through the low level of early yesterday morning, I would expect another possible “trap door” drop like we 2 weeks ago.
Understand that in real bear markets, extreme sentiment signals that tell investors that it’s time to buy don’t work - and stay negative - we call them “oversold sell” signals. That simply means that there is real legitimate institutional selling, and not just short term fear.
My instinct says we get some kind of bounce. The KEY to all of this is how the market processes and reacts to more stimulus, more government borrowing and more money printing. In the past we would make fun of 3rd world countries that printed money and borrowed too much.
Now when fancy PhDs from Wharton do it in the US and other G8 countries, it’s considered intelligent and creative. Not sure how that happened but if for some reason, markets have had enough of negative interest from Europe and 30 year US bonds paying 1%, we could be in for trouble.
Conclusion and What We Are Looking For
We expect A LOT more stimulus
We expect a bounce from that stimulus
We are watching to see if the bounce “works” or it “fails.”
If it works, we likely go sideways and drift up in in market prices for the rest of the year (my opinion). And we would add stock exposure.
If it doesn’t work and market prices drop below Friday’s lows, we will take massive defensive action.
If prices do fall below that level, I would expect even more stimulus from central banks and governments and a very bullish case for gold (which isn’t far from all time highs already). Side note on gold - gold stocks are a small part of the market and they were pushed around tremendously (can happen easily to small market sectors) this week by leveraged mutual funds that own them.
And a loss in confidence in central bank omnipotence could have wildly disastrous effects - from the bond market on out.
We will react to what happens, not try to guess.
Much of this article is technical so I appreciate you reading through it. If this was too heavy a read, and you want to take one thought from all of this, it’s this:
we don’t expect anything to happen based on prior market experience, we are open to anything happening and will react in real time to what is actually happening now, not what should happen.
Thanks for reading!