There are many things that I am not.
I am not an epidemiologist. Or a virologist. Or any kind of medical professional.
I am not an economist. Or even interested in playing one on TV.
But I am a pragmatist, and an investor who can humbly claim a respectable breadth of experience, and some notable success investing through the last major financial catastrophe, a distant eleven years ago. So, I thought it might be worth sharing with Clear Path’s investors some of my current thoughts.
First, let’s highlight the nearly unprecedented tumult in financial markets recently. Then, we can rewind to talk about how we got here, and what might happen going forward.
Casual market observers know we have been in the midst of an eleven-year bull market, with the S&P 500 peaking recently at about five times the trough prices seen in the depths of the Financial Crisis in March 2009. But after several weeks of bubbling tensions, the market moves became truly drastic in the last week. Consider the following:
After the October 1987 “Black Monday” crash of over 22% on the Dow Jones in a single day, “circuit-breakers” were introduced in order to provide a mechanism for markets to temporarily stop trading if an unusually large 7% move occurs during any single trading session. Until this week, that had only happened once in over three decades, back in October 1997. This week, it has happened twice!
As I write, the S&P 500 is about 26% below the all-time high marked only one month ago.
On Thursday, with the S&P 500 down about 7.5% intraday, the Fed fired a bazooka (see below) to bolster markets. The market quickly rallied an incredible 6% in less than twenty minutes. But the rally was short-lived, and almost all those gains were erased within a half hour.
On Thursday, the S&P 500 closed down 9.5%, the worst single day since the 1987 “Black Monday” crash.
And these stark moves are just the ones easily observable. My friends sitting on financial trading desks could surely cite a litany of other signs of panic in equity, credit, and other markets.
So how did we get here? It is fair to cast some blame on the Saudi-Russian oil price war as the accelerant of this past weekend. But undoubtedly, the primary culprit is the Coronavirus (COVID-19). There is much we do not know about it yet, but there is also enough that we do know to make some intelligent observations about its spread, both past and future.
COVID-19 took hold rapidly in Wuhan, China, and has since spread globally. As in the early days of any crisis, mistakes were made, and as a result the spread accelerated outside Wuhan. But then Wuhan was effectively locked down as an authoritative government regime stepped in to enforce quarantines to limit the spread.
If I put on my (not an actual) epidemiologist hat for a moment, the data from China (questionable as it might be) has led actual experts to a couple of important conclusions – first, the Reproduction Number is estimated at about 2.5; and second, the Case Fatality Rate is estimated at about 2%. What does this mean?
The Reproduction Number (or R0) is a measure of the average person-to-person spread. The flu has a R0 only slightly above 1.0, which means typically each infected person infects only one new person. But with COVID-19’s R0 of 2.5, exponential math quickly takes over as one person infects 2.5, and then those people infect 2.5^2 people, who then infect 2.5^3 people, and so on. For some perspective, 2.5^20 would be 91 million people! The numbers grow staggeringly. In fact, an accepted calculation for forecasting the expected percentage of infected population (without mitigation efforts!) is 1-1/R0. Using the flu’s R0 of 1.2, the upper bound for world infection is 16% of the population. But using COVID-19’s R0 of 2.5, the upper bound for world infection is 60% of the population.
Case Fatality Rate (CFR) is exactly what it sounds like – a measure of the likelihood of death for each infected person. The flu has a CFR of about 0.1%; COVID-19’s CFR remains up for debate, but most estimates overlap in the 2% area.
We can predict the percentage of population wiped out by a pandemic – again, without mitigation efforts! – from the formula R0 * CFR. For the flu, that yields 0.016% of the population, or around 50k Americans per year, which has been in the ballpark of actual outcomes. For COVID-19, the formula yields 1.2% of the population, making it potentially 75x worse than the flu. If unmitigated, this suggests COVID-19 could kill four million Americans, and one hundred million globally! The most vulnerable are the elderly.
Thus, it goes without saying that severe mitigation measures are necessary. We likely cannot decrease the CFR anytime soon. But, we can try to push the R0 as low as possible to slow the spread. Mathematically, as R0 approaches 1.0, the spread exhausts itself virtually immediately, and containment sets in. But that would require a 60% reduction from the current R0, which is difficult to accomplish without drastic measures.
We have probably all read about “flattening the curve” recently, which is basically an attempt to reduce the R0. If we do nothing, the epidemic spreads so quickly along a predictable path that our hospital systems will be overwhelmed. If this happens, even unrelated and otherwise minor illnesses become major threats because modern medical treatment will be virtually unavailable. Doing nothing is simply not a choice.
The good news is that the curve can be flattened. China has largely done it, and the total confirmed cases there stand around 81k, or less than 0.01% of its total population. South Korea has been successful as well. But we should note that the epicenter of the outbreak – Wuhan – has over 0.5% of its population with confirmed cases, and some estimate the actual number is much higher. Regardless, that is far from the unmitigated forecast of 60%! After a significant period of reduced activity aimed at flattening the curve, China is reportedly starting to reopen for business, including reports from companies like Apple that are reopening retail locations. Of course, it remains to be seen if this will prompt a resurgence in new cases.
The bad news is that flattening the curve is economically damaging. Moreover, it requires meaningful action at the government level, not just the individual level. As the World Health Organization said yesterday, a comprehensive approach to controlling the pandemic requires four pillars:
Prepare. The majority of countries have less than ten cases, and many still have none, but that won’t last long.
Detect, Prevent, and Treat. Robust surveillance is needed to identify and isolate cases in order to break the chains of transmission.
Reduce and Suppress. We cannot stop transmission, but we can slow the spread.
Innovate and Improve. As we learn more about COVID-19, we can and will find more ways to slow the spread.
There is a strong argument to be made that the US has basically already botched the first two pillars. This is not intended to be a political judgment, but rather an observation of reality. We did take some mitigating actions, such as President Trump’s January 31st decision to limit entry to the US by most non-US citizens that had recently been in China. Of course, by then, COVID-19 had already arrived on our shores. Unfortunately, most experts – including the White House’s own advisor, Dr. Fauci – either explicitly or implicitly concede that we did not take advantage of the window of opportunity for the second pillar, which begins with detection. Again, I am not a medical professional, but most reporting on the topic suggests a bungled process which – regardless of the culprit – has meant widespread testing and early identification was not available to assist in mitigation efforts.
The US has suddenly and dramatically entered the third pillar – Reduce and Suppress. Imagine yourself entering a room packed with people that have been tested and shown to not be exposed (even though that is not a continuously possible scenario). Would you worry? No. But, if you enter a room with likely exposed people, you should worry. So, we have collectively made the abrupt decision to stop entering crowded rooms. This extreme “social distancing” has had a rapid nationwide impact that most people would have found unimaginable weeks ago – mass cancellations of schools, sporting events; working from home; avoiding anything with a crowd. The direct economic impacts will be profound and expansive. How will working parents care for kids that unexpectedly must stay home without compromising their own income? If we limit attendance of crowded events, how long can airlines, cruise companies, and entertainment venues survive? The indirect impacts will continue to unfold as well. If we all increase our time at home, how will restaurants fare during this period? If we fear others entering our home, how will the industries that service homes fare? The list can go on and on.
A recession, even if it is only a brief one, seems inevitable.
We are in uncharted territory, both medically and economically. COVID-19 has the potential, if unmitigated, to become the worst global pandemic since the Spanish Flu of 1918 which killed an estimated 50-100 million, or about 3%-6% of the population at the time. But due to global mitigation efforts, we will not come anywhere close to the upper bound forecasts of 1.2% of the global population being wiped out by COVID-19. However, we cannot simultaneously minimize both deaths and economic impact. The efforts to minimize deaths, in and of themselves, must inflict significant economic damage for some period of time. Unfortunately, we can’t have it both ways!
With all that in mind, what comes next? We can segment the next efforts into two categories – medical and economic.
From a medical perspective, there is no doubt that COVID-19 will continue to spread, most likely along a mathematically predicable path similar to what has been seen already in China and Italy. Within days and weeks, confirmed cases will spike from the current level of about one thousand into the tens of thousands, if not far more. Sadly, there will be many deaths, especially of our oldest and most vulnerable citizens. US efforts to flatten the curve are far behind where they could have been, but hopefully catching up quickly. The current social distancing to “reduce and suppress” will ideally buy us some time to accomplish large-scale roll outs of testing kits to aid in detection, and thus the ability to further mitigate the spread.
As a country, we will get through this, although we cannot know with any certainty how long it will take, or how severe the damage will be.
From an economic perspective, there will be a meaningful hit, and again we cannot know with certainty the duration or depth. During this time, the role of the US government will be critical, and simply cannot be understated. As an example, businesses in the US and worldwide are about to undergo short-term liquidity shocks. Most are healthy businesses, dealing with an “act of God” that they could not forecast. This week, as the US market plunged, many companies took the rational action of borrowing as much as they could against revolving credit facilities to ensure access to capital. The rational behavior of one company, if conducted en masse, can stress the liquidity of the entire financial system. There is no bank large enough to provide short-term liquidity to the entire US. Only the US government itself – through the Fed, the Treasury, or other vehicles – can provide the liquidity needed to grease the wheels of capitalism. And in fact, the mere promise by the US government of access to capital is a calming act. It was comforting to see this morning that Treasury Secretary Steven Mnuchin, after much prodding from Jim Cramer, stated, “There will be liquidity available — whatever we need to do, whatever the Fed needs to do, whatever Congress needs to do, we will provide liquidity.”
As always, the devil is in the details. There are tools in the government’s arsenal that may not serve the immediate need of meaningful short-term liquidity relief – like payroll tax cuts, and delayed IRS payments. And then there are the “bazookas” – to borrow the term from Hank Paulson circa 2008 – such as major liquidity injections like yesterday’s Federal Reserve announcement to provide what could amount to over one trillion dollars of short-term liquidity to help stabilize the US treasury market. That said, that particular bazooka only briefly settled markets. Many more bazookas will be needed before this is over. We hope administration officials understand this and are preparing for major actions.
Our biggest near-term concern on the economic front (and frankly, on the medical front as well) is inadequate government leadership. There are very few people in the world prepared to take the immediate actions necessary in the early days of a crisis. Looking back to the Financial Crisis, President Bush was not ready, nor was President Obama when he took over. And neither was Congress. We only need to remember the first failed TARP vote in September 2008, when Congress voted down a “bank bailout” because they did not understand the severity of the crisis. The market understood, however, and it quickly plummeted 7% that day. The next week, Congress approved the plan.
We have seen similar early stumbles which suggest US leadership only recently began to understand the nature of the crisis. However, it seems as though government officials at least recognize now that the crisis is real. The US government has at its disposal incredible intellectual resources, with experts that can provide real-time advice on virtually any subject. It is incumbent on our leaders to heed that advice.
Going forward, we believe the government must formulate and clearly communicate its plans, both on the medical front, and the economic front. Those plans must be bold, specific and large-scale, and will invariably evolve, which is to be expected. But financial markets hate uncertainty, and until there is a clear path forward, we should not be surprised by continued massive volatility, and potentially steeper declines.
We should expect that those plans will eventually involve some form of government bailouts for the hardest hit industries – especially for industries like airlines which will be directly impacted by government restrictions.
And finally, given the market backdrop, what should intelligent investors do?
At Clear Path, we always advocate for a long-term investment horizon across an appropriately diversified portfolio. The longer your horizon, the more irrelevant market volatility becomes. We generally subscribe to a few of Warren Buffett’s most well-known philosophies – “Be greedy when others are fearful” and “Keep some dry powder ready.” As such, a good market crisis should be approached as an opportunity to add to positions. We will continue our ongoing hunt for new, and even more attractive, investments.
We have heard a few examples of real estate investment firms suspending new investment activity. We do not share that view. In fact, we still plan to close on an acquisition scheduled for next week, and continue to move forward on one scheduled for next month. Could one argue that prices could or should be lower for these acquisitions? Perhaps. But we believe we underwrote these transactions conservatively, and that while the ongoing crisis may delay implementation of plans, the crisis will pass and we will still be able to deliver attractive returns. For investment firms that have been aggressively chasing returns and overpaying in a frothy market, cancelling planned investments would make sense. We do not believe we fall anywhere near that camp.
On our existing portfolio, we are already taking some important steps. Although we have not yet seen any signs of tenants’ stress, it would be foolhardy to assume “business as usual,” so we are being proactive. While some may disagree with this approach, we have already told many tenants that a deferred rent schedule for April could be negotiated without incurring late fees. We believe it is important for tenants to be incentivized to stay in contact with us about developing financial issues, and we will benefit from early visibility. More importantly, though, the underlying holding entities all have capital cushions that we believe will be more than adequate to get through some tough times, should they unfold. And there are financial levers we can pull, if necessary, to maintain liquidity. Specifically, if needed, we can defer quarterly distributions to investors. We do not yet know enough to make that decision, but we will monitor each investment closely, and decide appropriately. As we have said before, one of the most important ways to ensure the success of a smart but leveraged investment is to never run out of cash. That will be our heightened near-term focus.
In closing, I am reminded of a story I heard during the depths of the Financial Crisis when I was actively trading public financial markets on a daily basis. It may or may not be true, but a Wall Street trader recounted his wife’s concern after hearing from a friend about a stock that was down 120% from its all-time high! It is just that type of nonsensical hysteria that typically marks a market bottom. Or to be fair, it at least marks a time as we approach a market bottom, and better investment opportunities are forming. Just yesterday, as markets plunged, I received a panicked call from a close family member new to investing, and had to briefly talk him off the ledge. To be clear, I am not calling a clear market bottom here. But I am suggesting a calm and clear-headed approach, and a reminder of the benefits of long-term investing. It has been eleven years since the market bottom of the Financial Crisis, which in hindsight was a historic financial opportunity (and one my former firm took advantage of superbly!). And I will gladly bet any of you that eleven years from now, we will look back on this moment as not just a horrific health crisis, but also as a financial opportunity.
