5/14/2020

COVID-19 update #3, 5/14/2020:

Dear Client,

This market update note has three sections. Each section is approximately two pages long.

Table of contents:

Section I. Where we began: revisiting and updating the five key points from Long Game Financial’s (“LGF”) 3/5/2020 and 3/25/2020 COVID-19 market updates

Section II. Where we are now: LGF’s top-down economic base case currently

Section III. Three points regarding the stock market for clients to keep in mind

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I. Where we began: revisiting and updating five key points from LGF’s 3/5/2020 and 3/25/2020 COVID-19 market updates

LGF’s 3/5/2020 COVID-19 update had three main points:

Point #1: We noted that, as of 3/5/2020, the virus had primarily been a Chinese phenomenon, albeit with global economic spillover effects due to the global importance of China’s economy.

Update (5/14/2020): In retrospect, it would only take weeks for COVID-19 to directly affect countries all over the globe.

Point #2: We stated that we believed it was difficult to envision a nasty US recession if the US consumer and US housing were ok.

Update (5/14/2020): This was LGF’s top-down base case as of 3/5/2020 but we revised our thinking rapidly soon thereafter—particularly when the price of oil dropped by 24% on March 8th and, separately, COVID-19’s effects in Italy worsened.

Point #3: We emphasized that the stock market is not a monolith but, rather, an amalgam of industries and companies that do not necessarily move up and down in tandem with each other.

Update (5/14/2020): For evidence of this look no further than the year-to-date S&P 500 market visualization below (source: finviz.com, 5/12/2020).

Although the S&P 500 has returned approximately -9% thus far in 2020, energy and financial services shares are down more than -30% year-to-date while software and internet stocks are up.

LGF’s COVID-19 update on 3/25/2020 contained two additional points:

Point #4: We opined that COVID-19’s negative economic effects would likely last for at least one year because a vaccine and widespread herd immunity both appear far off.

Update (5/14/2020): It is too soon to say how long COVID-19’s economic effects will last — but one to two years remains our working assumption.

Point #5: We noted that we considered the stock market’s March 2020 COVID-19 panic overdone due to (1) historically low investor sentiment and record high mutual fund redemptions, (2) the fact that COVID-19 is not universally bad for the world’s companies, and (3) important countervailing forces that offset COVID-19’s economic effects—especially government economic stimulus (in an election year, no less) and record-low interest rates.

Update (5/14/2020): The stock market rebounded considerably from its March lows, ostensibly due primarily to subsequent announcements of government stimulus.

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II. Where we are now: LGF’s top-down economic base case currently

The following three assumptions constitute LGF’s current (5/14/2020) top-down base case with respect to COVID 19’s macroeconomic effects:

(1) The economic burden of COVID-19 will continue to be felt extremely unevenly across the global economy.

(2) LGF continues to believe that “back-to-normal” is at least 1-2 years away, if “normal” is even possible.

(3) We anticipate continued high levels of government stimulus globally for as long as the current COVID-19 status quo lasts.

(1)    The economic burden of COVID-19 will continue to be felt extremely unevenly across the global economy.

COVID-19’s economic effects on the corporate world are now abundantly clear. As evidenced by the heatmap above, COVID-19 is awful for traditionally cyclical sectors like energy and financial services. Certain firms in the software and internet industries, on the other hand, have shown themselves to be extremely economically resilient.

With respect to society, COVID-19’s effects are similarly unequal and also highly regressive: small businesses and low-wage workers are experiencing much more economic distress than larger businesses and higher-wage workers (at a time when schools are closed, no less). Last week we learned that US unemployment is now 14.7% (!) versus 3.5% earlier in 2020 (data and graph source: the St. Louis Fed, 5/12/2020).

(2)    LGF continues to believe that “back-to-normal” is at least 1-2 years away, if “normal” is even possible.

In our view, the only way for the global economy to return to as it was prior to COVID-19 would be to manufacture and distribute seven billion doses of an effective COVID-19 vaccine that does not yet exist. Clearly, this may take some time to accomplish. Herd immunity will naturally build over time as well, of course—but even with herd immunity it stands to reason that at-risk segments of the population and everyone close to them would remain reluctant to resume riskier activities like dining out and travel.

Hence, we do not see how it is possible to fix the world’s COVID-19 problem anytime soon.

This is not a pleasant notion for many companies—especially high-fixed cost cyclical businesses that cannot generate profits without consistently high capacity utilization such as restaurants, airlines, and hotels. Relevant here, Warren Buffett announced in early May that Berkshire Hathaway liquidated 100% of its airline shares. As of the beginning of 2020 Berkshire Hathaway owned 11% of Delta Airlines, 10% of American Airlines, 10% of Southwest Airlines, and 9% of United Airlines.

Finally, we note that if COVID-19 can mutate like the flu virus it could become an intractable problem should today’s hypothetical vaccine and/or herd immunity have no effect on tomorrow’s COVID-19 strains.

(3)    We anticipate continued high levels of government stimulus globally for as long as the current COVID-19 status quo lasts.

All governments seem to recognize that COVID-19 is a serious problem and consequently most are extending unprecedented levels of financial assistance to their citizens.

We see no reason why this government financial assistance would subside meaningfully prior to solving COVID-19—and, as we noted previously, our working assumption currently is that COVID-19’s economic effects will last one to two years.

Protracted government stimulus, of course, would be an important ongoing positive for the stock market.

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III. Three points regarding the stock market for clients to keep in mind

To conclude, we have three items we would like clients to keep in mind when thinking about the stock market and investing generally.

(1)    Increased portfolio turnover and investing based on multi-year investment theses are not mutually exclusive. LGF invests based on multi-year investment theses…but we can and will make interim portfolio changes if we believe the incremental data warrant action.

As we share on www.longgamefinancial.com and as one can infer from our name, we make all of our investment decisions on the basis of multi-year investment theses. We run all prospective investment opportunities through our CAM and Four-Step Pattern frameworks and will invest in an asset only if we feel it presents a superior, multi-year risk:reward.

It is vital to recognize, however, that “multi-year” for us does not mean “let us buy some stocks, ignore them for three years, and then see how we did.” On the contrary: if anything, at any time, should occur that affects our multi-year reasons for owning or not owning an asset, we believe the only correct course of action is to make a change as soon as possible.

LGF did this in March. This year COVID-19 came out of nowhere and immediately invalidated the reasons we owned several of our once favorite stocks. Once we incorporated the potential challenges posed by this virus into our thinking, we changed our positioning as rapidly as we reasonably could—selling certain assets and buying others. Thus far in 2020, this attentiveness has benefited our clients.

(2)    Do not conflate the economy, the stock market, and LGF’s stock holdings; they are three distinct things that do not necessarily move in unison with each other.

The global economy is all about the current production and consumption of goods and services, and the current allocation of investment capital. Economic statistics are similarly backward-looking because they describe what has already happened, as opposed to what may happen.

By contrast, the stock market is only about looking forward to the future. Underlying every stock price is some distribution of investor expectations regarding the potential magnitude and timing of future cash flows to which each share of stock is entitled, and the future discount rate investors might apply in order to present value those cash flows.

This simple but powerful point—that the stock market is forward-looking while economic statistics are backward-looking—is vital to making money in stocks. It is also easily forgotten—and anecdotally we know many who presently believe that the (forward-looking) stock market simply must go lower right now because quarantine life is a pain, and because most of the (backward-looking) economic news we encounter these days is negative.

Regardless of whether market bears are right or wrong about the short-term direction of the stocks (we do not particularly care and the point is unprovable anyway), we can definitively say that relying on backward-looking economic observations to make assumptions about the stock market’s future path is an objectively poor strategy.

Case in point: recessions have of course proven to have been an above-average time to buy stocks historically (think early 2009) while late-stage expansions have proven to have been an historically poor time to do so (2000 and 2007 for instance). As Warren Buffett once said, it typically makes sense to be fearful when others are greedy and greedy when others are fearful.

Just like backward-looking economic news is not necessarily predictive of the stock market’s future path, we would also like to emphasize that the broader stock market’s returns are not necessarily predictive of LGF’s returns.

This is because LGF’s stock holdings are not broadly representative of the stock market. LGF, again, invests in a concentrated portfolio of businesses that we believe exhibit CAM and Four-Step Pattern characteristics and present compelling multi-year risk:rewards. A paramount corollary here is there are sizeable stock market sectors, like energy and industrials, in which LGF will likely never invest a single penny.

Because LGF’s holdings differ strikingly from those of the market broadly, it is possible for LGF’s investment results to diverge substantially from those of the market overall—and indeed, this has been the case in the past. Therefore, we encourage clients to be cautious when applying opinions that they may have with respect to the stock market in general to LGF in specific—especially if such opinions concern stock market sectors to which LGF has zero exposure.

(3)    Most people know far less than they think they know with respect to where the stock market will go in the short-term, and timing the stock market is exceedingly difficult.

As markets troughed and rebounded in March and April 2020, several clients inquired as to when an opportune time to contribute additional capital to LGF might be. The subtext to these conversations, however, was usually “do not say ‘now’ because I do not trust this rally and you will not convince me otherwise.” After all, who in their right mind would trust a market rally amidst a global pandemic?

As always, some invested and others did not.

One might ask, “would investing additional funds today make sense, in that case? Markets have already rallied substantially from their March lows, and COVID-19 is not going away anytime soon. Governments and central banks are stimulating the global economy, sure—but that also means that government stimulus is no longer a potential incremental positive. Why would it make sense to invest incremental capital in stocks now?”

The reality is that worrying endlessly about economy-level concerns, company-level concerns, and the price of the S&P 500 is always a possibility, regardless of whether the economy is good, average, or bad. And, when it comes to considering whether to contribute additional funds to stocks most, kicking the can down the road is always psychologically easier than taking the plunge. Yet, we know that we cannot remain window shoppers forever.

Help is on the way: finance statisticians observe that though stock prices are volatile, the stock market in expectation embeds a positive expected return—and, undeniably, multi-decade historical stock returns far exceed the multi-decade returns of less price-volatile investments like government bonds. This is as empirically observable as it is completely logical: if there were no financial incentive to own stocks no one would own them. The stock market generally embeds this financial incentive into stock prices.

Statistically, this means that keeping one’s long-term savings (that is, savings for which short-term price volatility is of minimal concern) out of the stock market for an extended amount of time is a high opportunity cost proposition. Put differently, keeping long-term funds out of the stock market for years is akin to betting against the house in Vegas: although one can “win” every so often—in this case, when stocks underperform cash—as one’s time horizon increases the probability of stocks underperforming cash decreases.

LGF cannot tell clients when it makes sense to contribute or redeem capital. This is a personal question. We will say, however, that if a client has both the ability and willingness to make a multi-year investment in the stock market, doing so sooner rather than later almost always makes statistical sense and doing so during a time of pessimism usually makes more sense than doing so during a time of optimism.

Clients can also take comfort in the fact that—once again (we will continue to repeat this because it is important)—LGF seeks to invest in businesses that exhibit CAM and Four-Step Pattern characteristics when they represent compelling multi-year risk:rewards. And, notably, such investments can exist in falling markets as well as rising ones. For instance, Walmart shares returned more than +15% in 2008, and Amazon shares have returned more than +25% so far in 2020. Neither company was a secret ex ante.

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Thank you for being a valued LGF client and know that we will continue to be vigilant during this possibly protracted bout of market volatility. As always, please contact me at [charlie at longgamefinancial.com] if I can assist with anything.

Stay safe out there, sincerely,

Charlie

© 2020 Long Game Financial, LLC