Have we missed the bottom in stocks? Is it time to all-in?

I received a few queries from readers the past week:

Hi FH, I remember you were talking about the double dip in the stock market… do u still think it is going to happen?

Hi FH, what are your views on the current market conditions. Do you think this rally is sustainable (looking to add more positions), or is a bear market rally?

Great questions! I touched on this the past week, but I think this deserves a full article.

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Basics: How have stocks performed so far

This chart gives you an idea of where the S&P500 has been so far. It was a 34% fall from the top, then about a 50%+ retrace of the fall, which is roughly where we are today.

And where do I think we will go going forward?

Now it’s important to note that predicting the future is not a science. This isn’t a math equation that if I solve it right, I know what happens next.

Instead – It’s all about shifting probabilities. If you think that there is a 60% probability something happens, and it doesn’t, it doesn’t mean you’re wrong. It just means the future that materialized wasn’t the high probability event.

Which is why in investing you never bet the house. When you bet on probabilities (like poker), one day you will be wrong. And if you bet the house, one day you’ll lose the house.

That’s important to understand.

Historical Precedent – Why do stocks double dip / have a complex bottom?

I’ve set out the charts for 2008 (S&P500) and 1930s (Dow) above.

What is clear, is that stocks never bottom so quick. In 2008, the bottoming process took about 12 to 18 months depending on when you start counting. In 1930s it took about 3 years.

But the key lesson goes beyond the charts. The key lessons goes back to understanding – why did stocks take so long to bottom?

I’ve been reading up on the 1930s and 2008 recently. My thinking so far, is that it usually plays out like this:

1. Step 1 – At the start, a lot of bad news happens, and there is a big fall in stocks. Then the monetary stimulus comes (interest rate cuts, easy liquidity etc), and investors think that stimulus will offset the economic impact. Stocks go up.
2. Step 2 – As stocks go up, underlying economic data continues to deteriorate. At some point, investors recognize that the economy is not picking up, and stocks start going down again. Usually at this stage, we see mass unemployment, and corporate bankruptcies.
3. Step 3 – Eventually, when things get bad enough, governments and central banks coordinate to unleash a gigantic fiscal + monetary stimulus via money printing to replace lost credit. When this happens (usually when stocks hit depressed valuations), that marks the bottom in stocks. From then on, the economy usually takes a few more months to bottom, but stocks have already bottomed.

This played out in 1930s, and it played out in 2008. Take a look at any other deflationary crisis and you will find that it plays out this way too.

Will 2020 be the same?

So let’s apply this to 2020.

The key difference between this crisis and the previous ones, is that central banks and governments are very quick to respond with stimulus. It’s about 1 month into the crisis, and we’ve already seen the Feds unleash their entire 2008 playbook (and then some more). Congress has already passed a $2 trillion dollar stimulus. The ECB has restarted QE, in a big way. Even Singapore and Hong Kong have come out with stimulus packages that are a large % of our GDP.

In no other prior deflationary crisis – have governments and central banks responded this quick, this early into a recession.

That’s definitely unprecedented.

So the million dollar question now – is that will this be sufficient to shortcut the deleveraging process. Will we still have Step 2, or do we skip straight to Step 3?

There are 2 ways this plays out:

1. Scenario 1 (Classical Economics) – The classic scenario. We go from Step 1 (now) to Step 2, and then Step 3. Stocks will either have a retest of prior lows, or stocks will break prior lows. This plays out maybe over a 12 month period or more.
2. Scenario 2 (MMT Economics) – Modern Monetary Theory. This theory basically says that governments should print unlimited amounts of money, because they can. Under Scenario 2 we go from Step 1 to Step 3 immediately. Stocks only go higher from here, and they will never retest prior lows. The decline in stocks takes place over March to April 2020. This will be a stagflation style scenario.

Scenario 2 is quite widely accepted

Scenario 2 may seem stupid – but it’s actually not.

A lot of really smart people believe in Scenario 2 right now – and it’s a popular opinion on Wall Street.

Lots of top investment banks like Goldman Sachs and JP Morgan now adopt this thinking for US stocks.

People who believe in Scenario 2 believe that the Fed’s actions, and Trump’s actions, have signalled a willingness to do whatever it takes. The Fed’s power is theoretically unlimited, so if stocks continue falling, they’ll just print another $10 trillion dollars, and if that doesn’t work, another $10 trillion. Oh if that still doesn’t help, they’ll just buy stocks like the Bank of Japan.

It’s perfectly legitimate, and makes perfect sense. I wouldn’t rule this possibility out.

My Personal Opinion?

So what is my personal opinion?

Feel free to disagree with me on this. In fact I’m actively looking for people who disagree with me.

But my current thinking – and I could be wrong, is that we still see Scenario 1. I don’t see this time being different.

Why do I say this?

I think that this time around, the economic damage has been / will be too massive.

Economic Damage will be unprecedented

The latest IMF forecast is set out above. The numbers are staggering. -5.9% for the US in 2020, -7.5% in the Eurozone. -1.2% across Emerging Markets.

These numbers make 2008 look like a cakewalk, and the only historical precedent here is the 1930s Great Depression or World War II.

So we’re looking at unprecedented economic damage, and because of that, we need an unprecedented stimulus package.

Everything the Fed does so far looks massive, because what will come is massive. But my thinking is that as at right now, it’s probably still not enough to forestall the coming wave of insolvencies and unemployment.

Liquidity =/= Solvency.

I’ve been using this phrase a lot on Patron recently. And I think this will be the defining theme as we move into Phase II of this crisis.

Most of what central banks and governments have done so far is to solve liquidity issues. It is to solve the financial plumbing, and to keep money flowing.

What it doesn’t do, is stimulate underlying earnings or cash flow.

Think about it this way. Will interest rates at zero, the Feds buying junk bonds, a stimulus check in your account – Will that make you go out and watch a movie? Or dine at a fancy restaurant? Or buy a new car? Or buy a condo?

Probably not right? You’re worried about the virus. And you’re also worried about the coming recession. All the talk about layoffs and paycuts makes you worried.

Your spending is someone else’s income, so when you stop spending, someone else loses their income. That guy then needs to reduce his spending, which hurts someone else’s income.

That’s a demand shock, and the longer this drags on, the worse it gets.

And then we also have a supply shock.

Lots of producers can no longer get the parts they need for production. It’s a byproduct of decades of just in time manufacturing.

One story recently caught my attention. It was about this chicken farmer, who couldn’t get any delivery of chicken feed during the lockdown period. He couldn’t feed the young chicks, so he had to kill them all. About 100,000 young chicks.

Now every industry is slightly different of course – but imagine this playing out across the globe. The car manufacturer who can’t get the parts they need. The goldsmith who can’t get his gold shipment.

That’s a supply shock.

And that’s the impact to the underlying economy.

All the Feds are doing – is trying to flood the economy with enough cash so that the financial system doesn’t break. The farmer who had to kill all his chickens? The car manufacturer who can’t make cars? Their earnings are still gone.

So the next Phase of this crisis will be an economic one. The Feds hands are tied here because of legislation – they cannot lend directly, nor can they stimulate consumption. That requires actions from the government. We’ve seen snippets of it so far from the $2 trillion bill, and the Singapore stimulus package. But it will need to be far bigger in size.

Any small delay, and a lot of business owners could be in real trouble.

Everything goes back to the USD

The way I see it, everything goes back to the USD.

If you can tell me where the USD  goes from here, I can tell you where stock prices go.

A lot of people think that after the massive $6 trillion USD stimulus, the USD is going lower from here.

I disagree. I still think that the USD is going higher before all this is over.

Why? It all goes back to the demand and supply shock.

The US economy is about 20% of the global economy. But about 50%+ of global trade and commerce, is transacted in USD. That’s what being a reserve currency means.

Let’s go back to the chicken farmer. In the good days he sells his chickens to a supermarket maybe in the US. The supermarket pays him in USD. The farmer takes this USD, and he pays for chicken feed, and he buys more chickens. Maybe he uses it to invest in another farm. Maybe he takes up a USD loan, to fuel his expansion.

Now times are bad. The chickens are dead, so he can’t sell them for USD. Even if he can, the supermarket no longer takes his shipment. But he still needs to repay his USD loan. And he needs USD to buy new chickens after all this is over.

Of course this is a very simplistic analysis. But on a certain level, it’s what I think will play out over the whole world in 2020.

The Feds know this, which is why they’ve extended USD swap lines and repo lines to central banks all around the world. But that swap line is to a CENTRAL BANK.

Let’s go back to the farmer. How the heck is the chicken farmer going to get a USD loan from the central bank? He needs to go to a normal bank right? And the normal bank looks at the farmer’s situation, and they don’t want to lend, because the farmer has no cash flow right. What if the farmer goes bankrupt? Then the bank would be on the hook for the loan. So banks are reluctant to lend, and without that lending, the farmer is in trouble.

2008 was a financial crisis. I think 2020 will be a main street, corporate default style crisis. So the swap lines that worked in 2008 are of less use here, because who really needs the USD, is the SMEs, the corporates. Central banks will need to find a way to solve this, fast, because this could play out at a rapid pace in the second half of 2020.

What if they can’t solve this?

Back to the farmer example – what happens if he can’t get his USD loan? The farmer will have to sell his farm to get cash, and convert the cash to USD, to repay the loan. Multiply this across the globe and you have a huge demand for USD globally, which will cause USD to go up. The more it goes up, the more local currency the farmer needs to repay the same loan.

Again – a very simplistic analysis. But to me, this will be a key part of the endgame. If the Feds cannot stop the USD from going up, then a strong USD will crush most global economies.

There are no old, bold pilots

There’s a saying I really like:

There are old pilots, and there are bold pilots. But there are no old, bold pilots.

Investing is the same.

In investing, we are betting on how the future will play out. And the future is uncertain.

If you bet the house on an uncertain outcome, and you do it often enough, one day you will lose the house.

So don’t be like that. Take measured risks.

Create scenarios that if you are right, you win a medium profit – but if you are wrong, you still win a small profit.

Avoid scenarios where if you are right, you win really big – but if you are wrong, you go bankrupt.

Create a heads I win, tails I win scenario

The same logic applies here. There are 2 possible scenarios set out above. I think Scenario 1 plays out, but Scenario 2 is not impossible too.

How do I set up my portfolio to benefit in both scenarios?

I create a balanced portfolio, split among stocks, bonds, cash, gold, and real estate.

I really like Gold at this stage of the investment cycle. I have about a 10 to 15% position in gold, and it’s gone up a fair bit the past year. Gold is one of those key components of a balanced portfolio, and I think it will continue to be a good hedge for my portfolio going forward.

Let’s say Scenario 1 plays out. It’s a deflationary cycle short term, so gold price goes down, but my cash and my bonds retain their value. That ok to me.

If Scenario 2 plays out, it’s an inflationary cycle, so my gold goes up a lot, but my cash and bonds lose their value. That’s not ideal, but at least the gold went up a lot and offsets my losses elsewhere.

That to me, is the essence of asset allocation.

Run this analysis across the rest of your asset allocation, and you can decide the appropriate asset allocation for your risk appetite.

Once you have your baseline, you can then decide how to tilt your portfolio based on your read of the situation. I think Scenario 1 is more likely, so I tilt to bonds and cash. But I also retain my equities / gold / real estate positions, to hedge against Scenario 2.

For those who are interested, my full portfolio breakdown is available on Patron.

Closing Thoughts: Passive Investing may no longer have the same returns going forward

I wouldn’t say that this is the death of passive investing. What I will say – is that passive investing is probably less attractive going forward.

When you buy an index like the S&P500 now, you’re also buying into industrial, energy, retail, travel stocks. Not all of them are going to do so well in 2020.

Whereas when you active invest, you’re able to pick the winners, and avoid the losers. If you get that right, there’s a lot more money to be made.

I think 2020 will just be a stock pickers dream. A lot of old world industries are trading at fantastic valuations. If you can find those with a good balance sheet and resilient business model that will bounce back, there’s lots of money to be made.

But we’ll probably save that as a topic for another day. There’s just too much to cover. My advice is to not be too greedy. Optimize for survival, rather than gains. Pick companies that you think will not go bankrupt. Stay away from those with high leverage and weak cash flows, no matter how attractive they may look. The real secret to investing is to avoid losing money, rather than to focus on making big money. I know it seems counter-intuitive, but it’s correct. It’s why Warren Buffet has the rule: Rule No. 1, Never lose money. Rule No. 2, Never forget Rule No. 1.

Don’t forget this rule.

For now – My personal stock watch is available on Patron for those who are keen. This sets out the full list of stocks that I am monitoring on my watchlist.

What do you think? Is the bottom in stocks in? Share your comments below!

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