How to invest in the time of Coronavirus
What you should be doing about investing in these uncertain times
Given my hedge fund career, I have been getting a lot of questions on what to do investing-wise right now.
First, we have to acknowledge that COVID-19 is causing tremendous suffering. Not “shelter in place.” That’s just annoying for many of us. It’s the combination of loss of life and loss of economic security for those who have the least economic resources that will mark this as a crisis to be mourned. And hopefully, never repeated. Worrying about our portfolios is a high-class problem.
The answer as to what to do about your portfolio is, per usual: it depends. It depends on your liquidity needs and investing time horizon. If you are going to need the cash this year, cash is the right place to be. If you are not going to need the cash for three years or more, then you can ride out this storm as you are — you don’t want to sell a bottom unless you have no other choice.
The stock market is a wondrous mechanism. It works the same way regardless of what is going on in the world. It is a mechanism that is a combination of the world’s best expectation of how economic activity will drive returns to equity holders in the future, and a discounting mechanism on how those earnings should be valued.
Are we at the bottom? No. We are still in the relief rally. Despite the Fed and Treasury actions, there is another leg down in this Bear Market. I don’t know where that is, but I have a good sense as to how you can tell when it is. We need to focus now on the “EEC:” the Earnings Estimate Cycle.
There are generally two key drivers in the market. The first is news flow. Is it getting better or worse? In a normal cycle, we would be obsessing about the election and probably the trade war with China. When did you last think about those? Right now, news about COVID-19 is all we can think about. How many deaths? Is the curve flattening? When is the vaccine coming? What is the government doing to respond? How many people will file for unemployment insurance? All these are important questions, but they are more about the noise in discounting earnings than in the earnings themselves. But news about COVID will not help us find the market bottom.
It is the second market driver that will determine when we are at the bottom — the Earnings Estimate Cycle (EEC). This is the market’s best guesstimate of future earnings. The key is to look for the inflection — that when the future earnings estimates stop getting cut. Typically, the EEC bottoms out within 1–3 months of the commencement of a crisis. It takes that long for analysts to have enough information to get a reasonable handle on the impact of the crisis.
We are not at that point yet. Next week into early May is the quarterly earnings season. It will be ugly. While strategists have come out with top down forecasts of S&P earnings dropping 20–40% this year, we haven’t heard from the companies yet. Many companies have withdrawn their forward guidance, making it harder for sell analysts to generate their estimates. Volatility around those estimates is unusually high and unlikely to abate until late April at the earliest — ironically, around the time COVID-19 is projected to peak in the US.
How many times have we heard “this time it’s different.” But how the market discounts information is not different. It’s like the human body: there are only 200 symptoms, but there are thousands of things that can be going on.
The market, despite aggregating the hopes and fears of an entire human society, is fairly simple. It has only two major symptoms — i) earnings and ii) valuation of those earnings. Sure it has a million other little symptoms like hedge fund leverage and “normalized” valuations and the like, but those are minor symptoms around the major symptoms of earnings and valuation.
A lot of people look at economic activity indicators. Those may be helpful, but they are sub-symptoms to the Earnings Estimate Cycle. You can look at all of them (PMIs, employment data, whatever), but they aren’t of value in and of themselves, they are indicators that the EEC is getting better or worse. If you need to move around billions of dollars, having more time lead on the inflection point in the EEC is helpful to get deployed. For most individuals, the Earnings Estimate Cycle itself is good enough to monitor.
Looking at past pandemics for how the stock market will move on this one is in vogue, but is not all that instructive. The market reacts more to the earnings cycle than the shape of the pandemic curve. To the extent the pandemic and the response to it hits the earnings expectation curve, it is the EEC we should be looking at, not the pandemic itself.
We are glued to CNN wondering what our government will do to “fix” the situation. The government is doing what it can to save lives (flatten the curve), provide liquidity (the Fed’s “whatever it takes”) and to bolster aggregate demand (we have never seen a single spending bill of $2tr before). We can argue if it is doing a great job or a good job or a poor job, but it is not sitting there doing nothing in the name of “moral hazard.”
Government action can impact the timing and magnitude of the Earnings Estimate Cycle, but it cannot override it. The government has two tools in its arsenal: monetary policy and fiscal policy. Both are powerful medicine, but they both take time to work. They can have an immediate effect on confidence (good for valuation), but they are rather slow-acting when it comes to actual symptom relief (impact on the EEC).
Monetary stimulus via interest rates (and related Fed actions) is slow in its impact. Rate cuts usually take up to two years before they really start impacting the markets. Eventually, it has a double effect in that it helps the EEC and valuation. In the near term, it can help with the valuation of earnings by supporting confidence in the future. But it can’t make the market go up.
Fiscal policy in the form of cash transfers from one set of taxpayers (usually future taxpayers) to another (current consumers) has a more immediate impact. This is the $1200 per person checks and the bailouts to airlines and the purchase of corporate assets by the Fed. But even this has a lag, usually of months, before it shows up in corporate earnings. And it now looks like much of this money won’t be disbursed for months.
So, the Earnings Estimate Cycle is still flashing defense. I’m not doing any math here as you don’t actually need the math. I’m not doing any prediction about the level it bottoms at, as that isn’t really important. You just need to focus on the inflection. Once that inflection occurs, investors will shift from looking for reasons to sell stocks to looking for reasons to buy stocks.
In the meantime, don’t worry too much. The market is not panicking when it drops. It is discounting the future in its usual way. Will it be a V-shaped or U shaped or L shaped recovery? It will be one of those, but what is the point in worrying about it? My view is that 2020 is a bad year, 2021 is a rebound year, and in 2022 we will be back to normal worrying about something else (maybe the new tax regime required to pay for the COVID-19 response). This was the pattern for the Global Financial Crisis.
As in all crises in the past, when earnings estimate bottom, the market will be ready to rebound. This has been true for pretty much every major market dislocation in the past 40 years. The inflection point in stocks tends to come 2–3 months after the initiation of the crisis. In 2001, the world as we knew it ended on September 11. The information around that took about three months for the world to process. The EEC fell, fairly precipitously, before bottoming out in Dec 2001.
Does this mean the market will not go up until the EEC bottoms? Of course not. There will be lots of ups and downs along the way. In particular, the market will probably rally on good news around government support or an abatement in cases or progress on a vaccine or treatment or flattening of the curve. Likewise, it may fall on news about deaths and setbacks.
Don’t get confused by the noise. Stay focused on what matters — the EEC. And stay at home and wash your hands!
H. Perry Boyle, Jr., CFA is an investor and philanthropist who had a 35 year career on Wall Street as an investment banker, a stock analyst, and a manager of hedge fund managers. He recently retired as a Senior Director at the hedge fund Point72. He is currently the Chairman of The BOMA Project, a poverty-graduation program for women in the arid lands of East Africa.
© 2020 Howarth Perry Boyle, Jr.
