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This blog is a bit longer than usual, but a lot happened in the first quarter. We started the year with a big party in tech, but around the middle of February people started getting nervous, presumably about Covid-19. Then in early March we saw panic across all asset classes, ending, at least for now, in a strong government response.

There are a lot of different takes in the media on what’s going on. I think most of them are pretty simplistic and not particularly good. Here is my SIT-REP (Situation Report) on what I think happened. If we understand as accurately as possible exactly what happened, we stand a better chance of responding appropriately as the future unfolds.

Why did the first quarter decline happen? A lot of people will tell you it was Covid-19. While I think there’s some truth to that, it tells a pretty incomplete story. Markets started going down in the middle of February. At that point, the Covid-19 issue was well known, but not many people took it very seriously. What else happened at precisely that time? The U.S. escalated its trade war with China (who remembers that?) by cutting sales of semiconductor chips and chip technology. I’m not claiming that’s the only thing that happened. We’d also been hearing more about Covid-19, disappointing earnings among all but a handful of generally large companies, and we were starting to hear concerns that the Fed flood of liquidity since September 2019 was set to taper. Those are all relatively broad concerns, though, and the trade war escalation matches well with the timing of the start of the decline.

Things really started to get wild in early March. Why? People were getting much more worried about Covid-19, as it had traveled to Europe. Global supply chain issues were also more of a worry, market liquidity started to get bad, concerns about lack of Fed supports increased, and people had started selling wildly, causing the fastest 10% correction ever. The biggest surprise was the dramatic selloff in Treasurys. In a traditional recession, Treasurys are the safest place to be, but they suddenly went from great to awful, crashing over 20% from top to bottom. How did that happen? Near as I can tell, the biggest factor was foreign central banks needing dollars.

Honestly, it’s a bit hard to trust Fed data on Treasury holdings. They’re subject to enormous revisions and seem a bit questionable in general. But that’s a topic for another time. If you go through what happened in March, for the week ended March 12, we saw foreign central banks sell a record $105 billion in Treasurys. Whenever something like that happens, people immediately assume it was China or Japan selling, as they’re the big Treasury holders. In this case, I suspect Europe was a big seller, whether to deal with the fallout from Covid-19 or for other reasons. Some of the Treasury data is released on a long delay, so we may know more in a couple months.

Whatever the case, as we got further into March, equity volatility elevated, and bond volatility was rising fast. This is a difficult situation for risk-parity hedge funds, who basically use risk to determine their asset allocation and leverage. Higher market risk drives them to move to lower volatility assets, to lower risk and return assets. These funds use leverage to boost returns. But leverage hurts returns quite a bit when everything is going down, so risk-parity funds were big sellers of assets into an illiquid market.

Everything was going down. This was panic and it was rapid. The market’s trading system we now have only provides liquidity when all is well, and it tends to go away when assets start dropping. Apparently it was hard to even sell a Treasury, which is supposed to be the most liquid asset market in the world. The Fed tried to step in and calm people, but at first it didn’t really have an effect. Then, the Saudis threw a bomb into the fire by reacting to Russia’s rejection of an OPEC oil production control deal with a decision to flood the market with oil. So, in an already tenuous economic situation, where energy demand was low and likely to continue so for a while, the Saudis flooded the market with supply. That helped cause the market to plunge even further.

At that point everything was going down – risky assets, safe assets, everything. Panicked investors and leveraged investors wanted the only safe spot – cash and cash equivalents such as T-bills. Selling was forced and intense, creating the fastest plunge from highs to a bear market (20% down) ever. By late March things started to settle down. You can point to a few possible reasons. Sellers may have exhausted themselves, March 27 quad-witching futures and options exposure expired, and global central banks issued a gigantic flood of financial markets support. For whatever reason, after plunging for most of March, the market started to look better.

To this point, we have covered a lot of stuff.  A lot of things happened, and my job is to pick out the signal from the noise. I think what we reviewed above has all the markings of a financial panic rather than an economic slowdown. I’m not saying a slowdown isn’t happening, but I don’t think that was the cause of this decline. In a slowdown, you see growth stocks fade while value outperforms. Things like Treasurys do great, as people price in a slowdown. What we saw was a rush for cash and for dollars. People wanted to own nothing. That’s a panic.

Why? It seems that, at some point in the process as fears started to surface, we got forced sellers, presumably at least in part from forced deleveraging – margin calls. To add to the problem, it happened when liquidity was poor, which exacerbated extreme pricing volatility. The good news is that forced selling seems to have at least largely run its course. The main point, though, is that the decline was more about forced selling and panic than it was about recession fears. That has possible implications on the future.

The end of 2018, for instance, was a somewhat similar event. Starting in September we went down quickly, but we also went up quickly in late December. This situation is tougher, because there are very real problems that probably aren’t going to be papered over by Fed and Congressional actions. But I do think we should bear in mind that the quick 20% upside at the end of March shouldn’t surprise us, and the possibility exists for the rally to continue for a while. We have globally accommodative central bank monetary policy, and investors generally don’t seem to be taking much consideration of the things that can go right. There is a lot of pessimistic talk about the near term.

Imagine if a month from now, in May, China is coming back to work, Europe and the U.S. are seeing declines in new virus cases and are starting back to work in some parts of the economy, and energy demand is springing back after a slew of production shut-ins slowed supply. In short, the world could look more normal in a month or two. Would there still be issues? Of course. You can’t just stop and start the global supply chain. You could, however, see things improve versus expectations.

I’m not going to deny that a recession seems practically guaranteed. I’m also not going to deny that there are plenty of long-term problems. All I’m saying is that the sell-anything panic has produced potential opportunities, evidenced by the 20% rally we saw at the end of March. Should we ignore the opportunities, just say the long-term looks rough, and stay as safe as possible? Certainly we want to be cautious, but I think we may be able to make good money from this panic and get portfolios incrementally better positioned for what lies ahead. One of the problems is the question of whether the standard recession playbook applies here. Usually in a recession you sell growth and invest in bond-equivalents like utilities, consumer staples, and REITs. In March, that didn’t work as well as it has in the past, as everything went down. Will it work going forward?

Again, let’s speculate a bit on the future. In the short-term, markets started to bounce back from a panic. Going forward, we could see natural buyers reemerge, re-balancers buying stocks, risk-parity hedge funds coming back to stocks as volatility calms down, and trend-followers climbing on-board. China may be coming back, there are signs places like Italy may be turning the corner, and the rest of the world could follow suit over the next month or two. There’s also the potential for positive surprises, such as the Peoples Bank of China’s March 30 surprise easing and money injection. On the same day the first junk bond offering in about a month saw high demand. Markets got very oversold during the panic, and we should bounce back some. For how long can that last? That is really hard to say, as history and present conditions suggest a fair amount of variability. But looking at probable timelines, I’d say the next month or so could be constructive for taking some risk.

What happens after that? That’s even tougher to say. But we will adjust as the evidence unfolds – information such as Covid-19 data, economic data, corporate data, Fed monetary actions and Congressional fiscal actions. Longer term, there are a lot of unknowns and a lot of problems. After the initial euphoria fades, who buys stocks? Corporations have been the biggest buyers over the last several years, but current buybacks are way down. Will positive news flow support organic buying by investors? Hard to say. In general, in times of greater hardship, value stocks tend to outperform, and growth stocks have certainly had their time in the sun. Maybe we’ll finally see a rotation into value later in 2020.

Once you get out about six months or so, I find it hard to be too optimistic, in part because so many people are still optimistic that the current economic stress is just temporary. Again, you can’t just put the global economy on pause without repercussions. I’m often happy to lean against people’s short-term pessimism, and I’m equally happy to lean against people’s long-term optimism. In the long-term, there’s going to come a point again where it pays to be cautious. Traditionally September and October is the period where hopes tend to die, and by then I think it will be harder to see gains. It could happen sooner. We are talking about possibilities and probabilities, not certainties.

Let’s try to get a little better sense of what may lie ahead.  It’s always difficult to foresee the details, but in general it’s easy to imagine some amount of chaos going forward.

First, I’d point out again that the general consensus seems to be that you can’t invest until Covid-19 at least peaks, but that longer-term we should bounce back pretty well. Thus, for a month or three it will look like the end of the world, then we can pick ourselves up and get back to work – your average person is cautious now, but ready to BuyBuyBuy at some point down the road, probably when Covid-19 gets better. That seems to be the general consensus, so that’s what we’re shooting against.

We’ve already seen that consensus hasn’t worked all that well for the last two weeks or so, as the market has bounced quite a bit off the bottom. I expect that may continue for a bit, though it certainly doesn’t have to do so in a straight line. As I’ve said a couple of times, this is mostly a financial panic, and to the extent the panic can get calmed the market can stabilize. We have this flood of liquidity and stimulus coming. I don’t think most people realize the Fed got a $4.5T credit line with this latest stimulus. I don’t think they’re currently dealing in junk debt, but anything of investment grade debt should have good access to capital.

Are there still problems? Absolutely. We have had a huge economic slowdown and business losses, and getting back 80% of what we lost in the economy is going to be tough. But for now, at the very least, there’s been a lot of chaos and that usually means a lot of opportunity. Let’s go over my thoughts on the landscape:

I don’t think it’s easy to make big calls. How much can you lean on REITs, with access to credit funding more questionable and so many tenants stressed? With economic activity way down, and cities potentially facing a prolonged slowdown, do you need to worry about utilities? So two of the three traditional defensive sectors have possible issues. The one traditional sector that I think still looks good is staples. They’re definitely in demand, and that never really stops.

The other space that seems like a potential long term good bet is precious metals. Pricing of the actual metals isn’t super-attractive, but the miners have been hit. There are certainly problems there, like potential Covid-19 issues or their country of domicile, but if ever there were a time to be a gold miner, this should be it. Any time we’ve had a global debt explosion we see two or three years of good performance out of miners, so that’s a place I’d tend to look at to buy and hold.

Otherwise, the way I keep thinking about the future is that we’re probably going to have to play whack-a-mole for a while. What I mean is that if something we own becomes the latest fashion, we need to consider selling it, and we have done that already. Conversely, when a company gets unreasonably hit, and it’s a solid business, we should look to buy. It’s just being opportunistic both ways. It may shorten our holding periods, but I can’t think of a better way. Basically, we’ll own staples, precious metals, some utilities and REITs, and whack-a-mole. In this chaos, my tendency is also to have more positions than usual to spread the risk. I’d rather have 2% in something so I can opportunistically buy more – or sell with less pain. It makes a lot of sense to do incremental adjustments as more evidence becomes available. If we see more crisis pricing like we saw a few weeks ago, maybe we’ll buy bigger lots, but that may be hard to do, as liquidity can be terrible at those times.

Fixed income is rough right now. After years of loving Treasurys, it’s hard to get behind them right now. There’s a likely flood of supply coming down the pipe to handle all this stuff, and while I think the market can handle it, they’re hard to love at this point. We’ve been reducing our asset allocation position, and we could reduce some more in the weeks ahead. Muni’s aren’t as bad, but duration risk worries me a bit. Due to the rush to cash and equivalents, Treasury bills are at unattractive rates and there’s already a flood of new supply. What do you own in fixed income right now? That’s hard to say, but with patience I bet an opportunity will come up.

My last speculation is that this disease hit Asia first, then Europe, and the US last. I’d bet that we may initially find better opportunities internationally than we’ve been able to in the past. I think there should be one-off opportunities, and a lot of dangers, in the months ahead. Traditionally we’ve managed times like these fairly well, and I’d like to think we can do the same this time. The first quarter was difficult, but there are three more quarters before the end of 2020, and I think we have a reasonable, flexible plan to deal with what lies ahead.

That’s my best current thoughts on where we were, where we are, and where we may be headed. We hope to publish our Quarterly Investment Letter in about a week.