The Bottom Line
We again begin with our conclusion.
- The market has staged a rally this week, with several positive developments surrounding COVID-19, however it is unclear whether we have reached a “bottom”.
- History has shown the depth of a sell off depends on:
- Valuations: how expensive investments are to begin with
- The mechanism: the cause of the sell off and its flow on effects
- The response: the measures taken by government and other actors to mitigate
- The “mechanism” in this case has been unique in that it is rooted in a health crisis which has impacted the real economy and financial markets.
- The response by governments and central banks has been aggressive and prompt.
- However, success will be defined by how well the health crisis is ameliorated – which cannot be predicted with certainty.
- We have been pleased with the rebound in many of the stocks we have acquiring, while we continue to hold some cash in reserve.
Market movements this week: a belated “bounce”
For the first time in over a month, we saw the market (as represented by the All Ordinaries index: XAO) bounce higher on two consecutive days:
Source: First Samuel, IRESS
This has likely come in response to several positive developments this week including:
- Significant action by the US Federal Reserve to provide support to debt markets and corporations.
- Signs that pressure in the plumbing of the financial system is easing
- Positive signs that measures to contain the spread of the virus are having an impact. This includes a reduction in the number of new cases in Italy.
- US congressional leaders agreeing on a large fiscal stimulus package (approximately 5.5% of GDP or $2 trillion). As seen in the chart below, the speed of this response will be unprecedented and is of a similar magnitude to what we saw during the GFC.
COVID 19: Unprecedented response by government
Source: MST Marquee
In these unprecedented times, history serves as a guide as to how the market may progress from here.
The anatomy of a sell-off
In dissecting at the anatomy of sell-off, there a few of points to consider:
1. Valuation: markets are expensive leading into the period of adjustment;
- In the case of the Global Financial Crisis (GFC), Black Monday (1987) and Crash of 1929, markets had become very expensive.
COVID-19: Markets were almost as expensive in general and at least as expensive in some particular areas.
2. The mechanism: the “transmission mechanism” for the crisis;
- Crash of 1929: a fall in markets impacted the broader economy and in turn the population.
- GFC: a fall in markets impacted the financial system, then the real economy and in turn, the population.
- DotCom and 1987 crash: the impact was mainly confined to markets although the repercussions played a role in broader economic downturns in the following years.
COVID 19: The real and potential health impact on the population has spread from the economy to the markets - this is a phenomenon that we have rarely experienced.
3. The response by government;
- GFC and 1929: there were a series of government failures, and a considerable lag between the point of friction and action. There was no direct support for business, and only pockets of support for the general public.
- DotCom and 1987 crash: governments responded adequately but sowed the seeds for future problems.
COVID 19: Governments have been much more responsive and aggressive with monetary and fiscal intervention. Actions such as supporting people in their current jobs, supporting small business and providing liquidity to banks and markets should avoid many of the mistakes of the GFC. However, it remains to be seen how successful actions to stem the health crisis will be.
The bottom line –Because the transmission mechanism is different this time,success will be measured by the collective effort control the virus, which in turn will define the recovery of the economy and market.
In our view, an investment approach in this environment must balance two scenarios;
- A scenario in which the current unique transmission mechanism, the health of the financial system at the outset, and the level of government support provided, reduces the impact to a dramatic loss of activity to a short period of time;
- A scenario where there is some longer-term loss of economic value. This could be due to changes in behaviour, or losses (people and capital) that overwhelm a range of institutions, due to the depth of the impact and more importantly the length of time we take to recover.
In view of the first scenario, we have spent more than 60% of the cash as the market fell. This has been used to re-balance the portfolio and buy cheap stocks that will generate value over a 3-5 year period. We have been pleased with how many of these stocks have rebounded over the week.
The remaining cash will be held in consideration of the second scenario. This will be deployed if further shocks roll through the market, capitalising on any opportunities that present.