Heads in the Sand

When your head is firmly in the sand, another part of your anatomy is fully exposed. The month of April saw the biggest rally for the S&P500 since 1974. While some form of recovery was inevitable in response to the largest coordinated central bank intervention on record, we believe that this rally is now getting ahead of itself. Stock market performance no longer seems to be an indicator of economic realities. We are in the eye of the storm.

There is no need to discuss the merits of different policy responses to a pandemic such as this, because the fact is that the majority of the planet is choosing the same response: Favoring economic destruction (disruption is really no longer a strong enough word) over risking further spread. We must accept that this response comes with all the related unwanted downsides. Yet most of these are being ignored.

We have not shied away from making specific, outspoken and often contrarian calls this year. Recommendations and commentaries are not worth much unless one can look back at them in retrospect and continue to stand behind them. In January we recommended taking risk off completely, or at least hedging. By March this recommendation was validated. At the start of April following one of the most violent corrections most of us have ever witnessed we selectively recommended putting on risk and taking advantage of specific opportunities (most notably selling extremely high levels of volatility and selectively buying high quality equities). That appears to have been the correct call, although it is early days.

If you wish to continue aligning yourself with our view, then here it is: Do not buy into a market that has just rallied more than most seasoned professionals can justify. Do not believe analysts that are still touting the V-shaped recovery. One month is an extremely short period of time in the context of how long this pandemic will require to play out. You should not be selling volatility at these levels either. Last week the VIX briefly came close to a 20 handle only 5 weeks after it reached 83. Volatility right now is quite simply too low, and not reflective of the true level of risk. Don’t be overexposed to equity, regardless of the sector (this includes tech). Instead, keep a large allocation to cash (at least 50%).

It should not be necessary to list the host of issues that will ultimately prevent an orderly recovery, but given they still seem to be underplayed here are a few soundbites of the most concerning ones:

• Economic data has been incredibly poor globally, but the market continues to “look through” the crisis and expects a resurgence of economic activity in Q3 and Q4. This is optimistic at best. More than 30 million jobs have been lost in the US over the last month (about 20 million of those were created over the last 10 years).
• Problems in credit are only beginning. Delinquencies in commercial real estate are increasing rapidly, thousands of borrowers are unable or unwilling to pay, and the high yield energy crisis is still only in its infancy. Loan losses provisions are being made, but the brunt of real losses and defaults is still to come.
• Opening up economies is taking longer than expected (but still under-estimated). Regions that have opened up have done so in underwhelming fashion. In many regions where retail stores have re-opened volumes are now 20% of what they were before the pandemic. There is no fast bounce-back for retail in sight.
• Implications of longer-term social distancing coupled with consumer psychology are preventing the come-back of certain industries altogether. As was addressed in our previous piece – the vast majority of hospitality businesses cannot survive at 50-60% capacity.
• Travel and leisure face an enormous challenge to get back to any semblance of a healthy industry. We have not made bets on the likes of Carnival Cruises and various airlines and hotels because it is quite simply impossible to gauge the viability of the industry going forward. Warren Buffett admitted in April to making a mistake when it came to investing in airlines, and subsequently his firm Berkshire Hathaway sold 6.5 billion of exposure (their entire stake in airlines).

One could go on for pages about the extent and depth of economic carnage on the horizon, but the point is clear. There is a worrying trend of impatience, perhaps even denial, amongst parts of the investment community right now. The human tendency is often to believe anything that comforts, and to deny what discomforts, in order to ignore ugly truths. Bank analysts looking for the quick recovery are talking their own book; the alternative scenario is an unpleasant one to envisage.

Having said that, we do not believe in a downright apocalyptic scenario either. We predicted at the start of the year that the S&P500 could dip as low as 2200 with an outside chance of going as low as 2000. That assessment still holds. It is possible, even probable, that we see another bout of sell-offs which could be similar to what we saw in March, but in our opinion not worse. At this stage we know more about the pandemic than we did in March, have developed a number of easing methods (treatments, testing, hospital logistics) and have deployed a massive arsenal of liquidity. It would be overly pessimistic to think that we go crashing significantly through the lows we have already seen. As with most things in life, the reality probably lies somewhere in between the extremes: V-shaped recovery is optimistic, but a complete meltdown worse than what we saw in March is pessimistic. Our medium-term view is that markets will be fairly range bound (albeit within a broad range). There will be a continual tug of war between economic disruption and virus containment which will create some form of stability.

With that in mind we continue to position ourselves cautiously. This approach has led to most of our portfolios being close to flat YTD and some up as much as 4% YTD. Clients that we took on at the start of the year are enjoying moderate, positive YTD returns. This is set against a backdrop where some of the most lauded asset managers on the street are in the red. We have liked nibbling at various momentum trades (particularly in the tech sector) and have periodically sold volatility when levels are elevated (anything from 50-60 on the VIX is compelling). Most trades have been short dated in nature, and we continue to sacrifice potential upside in favor of downside protection.

As usual we are happy to discuss our strategies and individual trade ideas in more detail at a client level.