Volatility goes Viral.

The last couple of weeks have left many investors shell-shocked. And for good reason. By historical standards, the moves can easily be categorized as rare, but not the worst we’ve seen. Since 1990, here are the most severe 10-day declines in the S&P 500. We’re somewhat away from the hall of fame:

The VIX Index, which keeps track of underlying volatility assumptions built into Options on the S&P 500 Index, is generally considered a proxy for market fear. Option traders have ratcheted up their estimates of S&P 500 volatility. This is how it looks now compared to the past:

Look at the spike at the end. Smells like fear.

Bonds are Rallying.

When in fear, buy bonds. That’s the old financial prudence motto. Bonds are the bright spot in the financial market now. Yields are crashing to record lows. That implies Bond prices are rising fast. Why is this happening? Bonds are considered safer than stocks. Why? Because there’s a good chance you’ll get your money back, especially among government bonds of reasonably productive countries. This shift of money into government bonds is called “flight to safety”. It’s the next best alternative to putting money under the mattress.

The US 10-year Government Bonds just broke some yield barriers this week. Reminder: Yield being down means prices are shooting up. This level is shocking to some of us who’ve been in the investment arena for a long time:

The other reason this is happening is because short-term bond yields are also at record lows. And that’s because the US Federal Reserve (and most other central banks) have kept rates pretty low since the Great Financial Crisis of 2008. Why? They don’t see a sustainable pick-up in Inflation, which is their main metric. Why Inflation? I’ve gone over this in considerable detail in The Buylyst Fed Papers:

1. WTF 1
2. WTF 2
3. WTF 3
4. WTF 4

Just a few days ago, the US Federal Reserve cut short-term rates by 0.5% as an emergency response to the Coronavirus crisis. This level of “emergency cut” hasn’t happened since the Great Financial Crisis. The rationale for doing this is simple.

The economy runs on credit. Individuals and firms need to borrow money to go about their business. An economy is healthy when firms have access to credit to grow their business – which includes hiring people – and when people have access to credit to buy more goods. So, the Fed’s job is to maintain a banking environment in which credit runs smoothly so most people in the country are gainfully employed. They want the Supply Side of the economy to run as smoothly as the Demand Side of the economy. Of course, the two sides are interconnected.

Will the Fed Vaccine work?

The Coronavirus threatens the Supply Side first. Companies with supply chains in China are likely to experience a supply shock. China has been almost shut-down for a month. Put simply, this means that some companies won’t have enough goods to meet demand. This will shock revenue and profits. If this happens to enough firms, the second-order effect is that there could be big rounds of layoffs. If there are mass layoffs (let’s say 5-10% of the workforce), then the third-order effect is a Demand Side shock to the economy. Then the fourth-order effect is that revenue and profitability for firms will be pushed further downward, leading to more layoffs. You can see how this downward spiral can continue.

But the spiral can be stopped. The second-order effect – mass layoffs – is what the Fed is most concerned about. When it cut rates this week by 0.5%, its thinking was: let us be proactive and make it easier for banks to borrow from each other so that the whole banking system is more willing to lend to firms who need credit after this supply shock. Why will they need extra credit? Because they may want to ramp up production at double-speed when this coronavirus epidemic is contained. If they can do that, they won’t layoff people. In fact, they may hire more people. If that happens, then the demand side of the equation doesn’t go down a spiral.

Will this work? The Market apparently thinks it won’t. In my view, it will, but it will take some time to transmit through the system. Firms won’t ramp up production unless they’re confident that demand hasn’t been depressed. Airlines, for example, are already in a demand-shock. They won’t stop cutting routes out of their schedules unless the virus is contained, and people are confident of flying again. But when that happens, Airlines will already have a depleted cash balance, and some of them may not have enough cash to restart cancelled routes again and do the requisite marketing/pricing-incentives campaigns to nudge travelers. They may need to borrow heavily from banks to get back to a pre-virus revenue and cash flow profile. The Fed is proactively addressing this situation.

The hard truth is that economic activity will take a hit. And recovery is up in the air until the virus is contained or is deemed non-lethal (to most people). The Fed can’t do anything about that. But it can make it as easy as possible for firms to recover from this Supply and Demand shock.

If politicians behave rationally, this monetary move will be supplemented with a massive fiscal stimulus. Let’s be clear: this is not a banking crisis like 2008. This is a temporary shock to Production and Consumption in the “real economy”. The banking system in most countries has fully recovered from 2008. They’re in it for the money, for opportunities to lend. That’s how banks make money – by borrowing cheap and lending at higher rates. The Fed’s policies can grease the wheels of the banking machine. That will transmit reasonably fast through the Supply Side of the economy. On the demand side, Fiscal stimulus would transmit faster.

The Federal Reserve Board has another meeting in March in which they may cut rates even more. But this needs to be a tag-team effort.

How severe should the “correction” be?

The “natural” inertia of stocks is to go up over the long-term. Ebbs and flows will happen. Shocks will happen. But the reason firms produce goods is to make money. And they make money if they invest in the right goods for the right market. That’s Management’s main role: efficient capital allocation. Some do it well. Some don’t. On average, corporate America does a decent job. The S&P 500’s long-term returns are a decent proxy for how well the average firm allocates shareholder capital. The number is about 8%. Over the long-term, that is what we should expect “the market” to return – about 8% a year on average. The long-term prospects of American and Global companies, on average, will be relatively unaffected by such shocks. Some shocks will hurt. Some will help. The upward inertia will continue. Therefore, the term “correction” is decidedly short-term in nature.

As humans, we are naturally myopic in our outlook. In times like these – the last month or so – it seems like everything is not only crashing but will remain at depressed levels forever. We’re taught in school that markets are efficient. Some investors take that to mean that the financial markets are always right. So, a 20% correction means that it was justified. That’s just plain wrong. Markets are essentially a sum-total of different participants with different risk and return objectives. Many are short-term oriented, and they make decision based on short-term horizons – like how will XYZ stock return in 2 months? Last week, I jotted down a few numbers to show that being long-term oriented is not only good for your blood-pressure, it’s also good for your returns. If you don’t believe me, here’s a notion that the best investors live by: Markets are irrational in the short-term, they’re somewhat rational in the long-term. I’ve collected the greatest hits on Market Efficiency here.

Let me try another angle. So, the original question was: by how much should markets correct? Short answer: Nobody knows. Long Answer: Hear me out…

Let’s take the stock market. In the US, it’s proxied by the S&P 500 Index. But the index is not a giant monolithic entity. It is made up of a diverse set of individual stocks, issued by a diverse set of companies. The value of any of these productive assets – stock or bond or a dairy cow, for example – is the sum of discounted cash flows. You buy any asset based on how much it will yield in the future. It makes sense. In the case of a stock, it represents ownership in a company that makes or is expected to make money – cash – every single year in the future by selling a product or a service. We discount all that – because the value of money inherently decreases in a growing economy – to the present to arrive at a value (what we think the company is worth).

OK – too much theory. Let’s come back to reality. Let’s try and answer the question of how severe the correction should be. The coronavirus shock can last 2 years. So, let’s assume that over the next two years, most firms will see depressed or negative growth rates. How will that change their value? Let’s do some discounted cash flows (DCF).

In a world before the coronavirus struck havoc, each stock price had built into it some growth assumptions. We’ll do a “before and after” analysis. Here are the assumptions for our before-and-after DCF analysis.

Notice that the only thing I changed is the growth rate applicable to the first two years – from 10% to 0%. This reflects the Coronavirus shock. It turns out that the decrease in value is about 16% - the shaded gray area in the chart below.

What happens if the growth rate in those first 2 years goes to -5% instead of 0%? The decrease in value is 24% - the shaded gray area.

Now, in my view, the economic shock to companies would probably last one year instead of two. But even if it last 2 years, companies, on average, will see a resurgence of growth rates in Free Cash Flow as the virus subsides. Let’s factor in a 10% growth rate in Year 3 (after a severe -5% decline in Years 1 and 2) and see how that changed the equation.

It turns out that the decline in value will be milder – at about 21%.

Some Finance nerds will point to the cost of capital number and say that it overstates or understates reality. And that it will increase with this scare. Yes, I agree. But it just points to the fact that DCFs are garbage-in-garbage-out models. I can justify any assumption. Here’s my argument: cost of debt decreases will offset increases in cost of equity estimates (which are based on flawed models to begin with). Forgive me if I don’t want to waste my time (or yours) on intellectualizing cost of capital.

We can play around with the assumptions all night long, but it will just confuse us more. Suffice to say, DCF models will be restated to reflect a 15 to 20% correction in the most stocks. Let’s settle at -18%.

Since February 23^rd, the S&P 500 has declined by about 10%, as of Thursday, March 5, 2020. So, we should be prepared for some more pain. The point of this exercise is not to predict but to give you a broad perspective of these wild market movements these last 2 weeks. “The Market” is trying to digest the economic impact of the virus, and unsurprisingly, different investors have different opinions. Some days there are more buyers than sellers. On other days there are more sellers than buyers.

Now in the first part of this Coronavirus Market Crash analysis, I had mentioned that even after the worst declines in the S&P 500, prices recover within a year. If we view this through a DCF lens, why does this happen? It’s because once the shock is over – let’s say starting Year 3 – the short-term growth prospects of a firm that has survived the scare suddenly looks a lot brighter. The Coronavirus shock is removed from the spreadsheet. Valuations get restated. Stock prices start moving up.

Remember that valuation is like time-travel. We’re trying to assign a value to each “state of the world” in the future and then sum them all up to come up with a value. Many (if not most) Wall Street Analysts tend to rely a lot on this type of DCF analysis. At The Buylyst, we follow the footsteps of the giants of investing in focusing on “sustainable” numbers and the “believability” factor. When we “project” future cash flows, we ask ourselves: Through ebbs and flows, how much cash can this company generate on average over the long-term? We don’t obsess over model intricacies. This is not Physics.

Safe to say that the market is not “efficient” right now, in the strictest sense of the word. As time goes by, these wild movements will settle down. As a long-term investor, all we should be thinking about is this: Can the companies in my portfolio withstand two years of negative growth? If so, am I able to stomach a 15-20% decline in the short-term?

If the answer is Yes, keep calm and buy what you think is cheap. If you’re looking for a Buy List at a time when the short-term traders are panicking, feel free to reach out to us.

Many Happy Returns.