Dead cat bounce, or buying opportunity of the decade? What happens next?

Hi Mr Horse,

I’ve been a big fan for a long time, can’t afford the patron fees though but I’m very grateful for all the free analyses you put out. I’m graduating uni this year but I’m not doing anything financial related. Can I ask:

1. Do you mind quickly explain the difference in monetary and fiscal stimulus? I.e dyou mind explaining why trump’s latest stimulus won’t work?

2. I recently met someone from Temasek who recommended buying the dip and then continually buying and averaging down over the course of the recession. I understand this strategy is “safer” but would yield lower returns than “timing the bottom”. Any thoughts about this?

Hi FH,

Great article as usual. My view is slightly different for what it’s worth.

In my simplistic view, a recession is given. Simply put, there can be no economic expansion vs last year if a city or country is locked down or has significant social distancing for a few months as will happen almost everywhere. This is simple logic and no calculations are really required.

But this recession is tied directly to decreased consumer demand and a supply shock as a result of the virus so the removal of this trigger will allow self recovery of the economy to a large extent. Government measures are important mainly for sustenance of businesses and to avoid credit defaults and credit freezing and so the buy signal for me is still linked more to the state of the virus and the reactions of people to it then government economic intervention. When people feel safe or have mentally adjusted to the risk, they will go out and spend money. If they don’t, no amount of government stimulus will make them do so.

My assumption is that the outsized effect of Covid on daily life (not necessarily the economy) will be over within 2 years. One or a combination of the 3 things below will happen
1. Large proportion of population gets infected during next one to two years with vast majority recovering. People are no longer afraid.
2. Spread is slowed and people are still fearful but adapt to virus as part of life as we did with terrorism. Some norms may change like mandatory 2 week quarantine for visitors to any country which will ha e structural impact on some industries like tourism but large part of life goes back to normal. Humans will not tolerate home quarantine for more than a few months. Even during the Spanish flu, plays and dramas went on as usual with some precautions. Just look at the recovery in activity in Capitaland malls, back to 95% normal based on their data.
3. A vaccine will be invented in 1 year plus and many will have access to this.

The elephant in the room with regards to immediate disease progression and human reaction is the US. Without a functioning public healthcare system, strong central coordination and a fact based government, the disease will spread there in a rather uncontrolled fashion. The high inequality and personal levels of debt mean that many will not have access to affordable healthcare and many will have to work even when sick as they rely on the next paycheck for daily necessities. So situations of chaos, panic and lockdowns are likely. When the peak of this happens in the next 2-3 months, that for me is the time of maximum fear and also the time of entry. Why? Because the disease situation will resolve itself one way or another as stated above and as long as we don’t enter a depression, markets will inevitably recover within the next 3-5 years.

The big caveat is whether there is sufficient economic dislocation and a tight enough credit squeeze during the next 1-2 years to cause enough companies to go into bankruptcy and cause not just a recession but a depression. If credit squeeze and business dislocation is bad enough to cause the next Great Depression, we will have to wait 13.5 years to recover like last time. So don’t bet everything because the risk of this is higher than striking 4D, not negligible.

Your thoughts, especially on the credit situation?

Hi FH,
Thank you so much for your insightful sharings.

My RM recently introduced me to Equity-linked notes where l get 10-12% annual returns and buy a ELN with basket of 4 shares. He said I’m assured of the monthly returns when if market falls.

After 8 mths, if my none of the stocks goes below ‘strike-in’ price (30% from buy price), I’ll get back my Full principal and keep the returns. However, if it does fall Below strike-in price, I’ll need to buy that stock at the original price when l first entered the ELN.

Appreciate if you can advise if l should go for this product as it seems a gd deal in current choppy markets.

Thank you.

All good points. I think at the end of the day we probably need to think less about trying to buy at the bottom than to protect our downside. Regardless of whether we buy at your buy signal 1 or 3, one will make money when the market recovers eventually whenever it happens. But we must make sure we have capacity to hold when we buy and not be forced to sell if it falls further AND have the money to buy when the buy signals are reached.

On recession, there is no question we will have one. Businesses assess their monthly performance vs previous year by making adjustments for days closed due to public holidays. Even a couple days difference makes it difficult to show year on year growth. When you have a month or two of sales gone, whether it is car sales, property sales, hotel, airline, restaurant etc. you cannot grow for the year. But recessions can be caused by exogenous or endogenous factors and their recovery differs based on cause.

I agree with your assessment of the credit cycle which I need to weigh more in my thinking. Selling equities on the bounce makes sense, I have been doing this as well. Teh Hooi Ling whom I respect seems to hold a different view in today’s papers which I also need to think about. The big danger of selling to buy back later is lacking the guts to buy back when it is time to do so. During the depths of the financial crisis I was telling everyone to buy bank ETFs because while individual banks may fail, banking as an industry could not because it would destroy modern society but still I did not buy myself and take my own advice because of fear. So the head may be rational but the heart may overrule at the time of action and that is a real danger.

I have two important follow up questions

1. Would you also sell bonds – BBB and BB+ at this time?

2. Where would you keep all the liquidated assets? In cash, gold or govt bonds? I was not surprised to see gold down this week. My analysis of how gold reacted during financial crisis which I did before all this happened was that it fell for the initial months before recovering and outperforming the market in the middle stages so my conclusion was that it is not a safe haven in the early stages contrary to what many believe.

I am not FH but I would urge great caution with this. You are basically selling the bank a put option to sell you those shares at strike price after 8 months if the prices fall more than 30%.

With the market behaving like this, what do you think are the chances of this happening?

So if you buy, you should be ready to accept the very significant risk that you will have substantial capital losses in excess of 30% and consider if the juicy 12% yield compensates you sufficiently for this risk.

Remember, the bank is out to make money for themselves and not for you by structuring such products. You can do something similar by just selling put options directly on the market and save the large spread the bank is earning from you by structuring this note. They have put all the risk on you and earned a hefty fee for themselves in the process. If shares prices don’t fall 30%, they make money selling the put and paying you only part of it. If they fall more than 30%, you are responsible for the loss, not them. Either way, they win. You win only in the first scenario but you win a lot less than if you simply sold the put directly yourself.

I fully agreed with your analysis and I like your game plan! My only deviation from you is dollar cost averaging based on my game plan. Since everyone’s situation and financial goals are different, there isn’t a “one plan fits all”… Good luck to you and all FH readers. BTW, I read your blogs weekly without fail, thanks very much for sharing your thoughts:)

I am 30% cash right now and planning to go to 50% by selling assets that are not down much like bonds or can be sold at a significantly lower profit than peak but still not at loss , e.g. sold Keppel DC because price had gone up so much previously and current yield of 3.3% does not justify current risk which shows it behaving totally like stock subject to 7% falls in a day. Started crisis at 25% cash because I had been anticipating one for last few years. Means I could have profited more from last year’s equity rally but also means I don’t have to panic sell now so there are tradeoffs.

Reason why I want to go to higher cash level is so I will have guts to buy when the time is right. If I have 50% cash, I will hopefully feel confident enough that 20% can last me a few years to deploy 30% back into the market. Key to coming out ahead here is to deploy more back than you take out when it is time to buy. Otherwise, you have only locked in your losses or lower profits.

I didn’t sell any shares during dotcom bust or 2008 Financial crisis and both cases worked out well so not selling is also a good strategy. Each time something like this happens, we always worry about Great Depression but so far it hasn’t recurred.

This time I am selling some because unlike previous 2 major crises where one could not predict when upturn would happen, here it is somewhat predictable that it will not happen in next month or two as virus disease pattern is predictable. So selling now is not a big risk. The big risk is not buying back later and it is indeed a real and substantial risk. My mistake in 2008 was not buying when I had the chance to do so. I hope not to repeat that mistake but we never know until it actually happens. Everything else is theory. It is hard to buy when the world seems to be crashing and no one can predict if your job is stable in such situations no matter how well you perform and how strong your company is.

What’s your target equity allocation now? Down from 30% I assume?

Hi,

Are you still holding on to your REIT positions? Last we chatted, your strategy was to hold on at least for reit.

To sell on panic (= market timing) seems never an appropriate approach to investing. Investing to retail investors should be made up of good (=well diversified), large and very cheap passive indexing stock ETFs bound and a bit (5-10%) physical gold for crisis. Bonds or bond ETFs seemed dangerous and/or expensive for a long time now.

Holy crap that article. 8 billion USD of ELNs in the Korean market betting on low volatility, sold to elderly people. 8 billion!

Hi Frankie,
You are absolutely right and just buying ETFs and holding is the best strategy without trying to time the market.

In this case, I don’t consider selling now to be timing the market but acting on information before the market does. Bear with me. Previous crises like 2008, 2001, 1987 were caused by economic reasons like subprime crisis, dotcom overvaluation and automatic trading so the direction of the market and when it would rebound was unpredictable.

This time the crash is caused by a real world problem whose evolution is utterly predictable for those who are scientifically trained and we should look to the doctors and scientists to understand this rather than the economists and fund managers who can’t get into the details of this. The virus is expected to increase the number of people infected by ten times every 19 days if spread is not controlled. The problem is not the mortality rate but the ICU rate overwhelming the healthcare system. Between 5-15% of patients infected will need ICU care. There are 45000 ICU beds in the US of which 30000 are usually taken up at any one time. The disease has been spreading uncontrolled in the US so far due to lack of testing. Within a month or at most two, the US will be in the same situation as Europe with health systems under severe strain or overwhelmed. There is no way to stop this now short of severe social distancing measures. Economic activity will be severely curtailed when this happens on a scale not seen in recent memory. Yet the market is down less than 20% after the Friday rebound. So while we can’t predict when the sustainable rebound will happen and there will be unpredictable intermittent rebounds, we can predict with a pretty high level of confidence that the real world situation will get a lot worse in the US, the most important market before it gets better and markets will follow this so markets will go down a lot more before they recover. In this real world rather than financial market induced crash, follow the science and whats happening in the medical world rather than the finance experts. The financial analysis is frankly less relevant than the medical analysis.

The market is still behaving in a schizophrenic fashion because fund managers and traders havent decided yet how bad things will get. But the infectious disease experts and epidemiologists already know the answer to this.

Guess the Fed move on Sunday has just proved my point. Unfortunately, now market will plunge on Monday and likely too late to sell anymore so now just have to hang in for the ride.

FH, one other thing you can do is short the market with a 3x leverage fund. I am doing this now. But get out after a month because after that we dont know if exponential increase in US cases will continue.

I would advise against short selling using an inverse fund, ESPECIALLY a leveraged one. Remember that even in a bear market, the trajectory is almost never downwards. A massive relief rally, like what happened on Friday can destroy your position. I know this because I was actually holding some SDS on Thursday into Friday. Managed to get out of that position before being burned though. If you do want to take up a short position, I would strongly advise using Put options, at least a couple months out and fairly close to the money. Make sure the IV isn’t too high when you buy in, if not the premiums just are not worth it. You can actually use a relief rally to strengthen your short positions since the premiums on puts will decrease.

Hi FH,

Thanks for your great sharing of insights!

Prices of REITs are battered down by more than 20% from their high, and yields are getting very attractive.

I am looking at US office REITs where properties are mainly freehold and with long leases.
No doubt that their performance will be affected by the stability of their tenants during this crisis – which is very hard to predict.

What is your personal views on REITS with long leases (eg. office REITS) in the current situation?

Hi Andrew,

Thanks for your sound advice on shorts. I have always been a long investor so this is new for me. As mentioned, I have never thought one could predict the market direction except in this case given it is driven by a predictable real world phenomenon.

FH,

Just read Ray Dalio’s Big Debt Crisis book and it is terrifying. Looks like this real world crisis is likely to lead to a financial crisis and a non-beautiful deleveraging. This silly Fed keeps surprising the market even after the nice rebound on Friday and their sudden, unexpected actions only stoke fear rather than send relief. Credit markets have frozen because of them, hope we dont see bank runs soon.

So, lets assume a depression is coming. The scenario Ray described about being overly indebted and central bank out of ammo has occured.

What are your next moves now?

Hi FH,

Read in detail the section in Ray Dalio’s book on the Great Depression and my conclusion at the is that the chance of this happening is pretty low. Both 2008 and Great Depression had in common bank failures and I think we are still some ways away from that although most worrying part of Fed announcement was waiving of Bank capital requirements. Great Depression also had complexity of gold standard and inability to print money. Whole process took a few years to play out so we still have time to react.

Liquidity challenges probably caused by lots of people moving to cash at same time but hopefully impact of QE will loosen this in a week or two. It did when it was applied during Great Depression.

Anyhow, recession is much better than depression. I laugh at those economists or analysts surprised by China’s 22% drop in retail for Jan and Feb and who projected -1%. This comes from looking too much at Excel models and not thinking. If place is locked down, of course drop will be severe. It was probably much worse in Feb if one takes apart the numbers.

Danger is still deleveraging at end of long term credit cycle but virus induced effect will be relatively short lived. For me short lived means 6 months to 2 years. Either most will get it or mankind will adapt. Probably countries who manage to contain keep borders open only to other countries who manage to contain or whose population has developed herd immunity from widespread infections that have resolved. Worse period probably in next couple of months as it soars towards peak in the US and Europe.

There is actually a relatively simple solution to all this. The world just needs to coordinate a 3 week period where the entire population stays home except for essential services. Then virus will be almost completely stopped. Practically speaking don’t think politicians will be able to pull that off so it will be a longer drawn affair country by country.

Anyhow, I view this as overall a great opportunity to rebalance my portfolio towards all those great companies which were too expensive to buy previously once they have been appropriately discounted by 50-70%.

The inflationary recession you mention in EM could play out as a repeat of Asian Financial crisis of 1997 if companies can’t pay USD debt and Asian currencies depreciate.

Reading the book in detail, I understand why the Fed did what they did and think they are good moves but the way they announced it leaves much to be desired. Always bad to surprise investors on a weekend and just scares them.

What about once things stabilise a bit? It looks like this time we have really reached the end of a long term debt cycle. While we may not enter into a depression, it is sobering to think that it took 25 years for Dow to recover that time.

With all the unwinding that still needs to happen, even without a depression, there is a fair chance we end up in a Japan type slowdown in the US which could also last decades. Japan’s stock market hasn’t gone back to its peak since.

In this situation, it may not make sense to buy equity even after things stabilise. Just hold on to cash and as things deflate, they get cheaper. All the negative interest rates, QE etc. hasn’t done a thing to change the trajectory for Japan.

Ray Dalio’s book talks about what governments should do in an unwinding, not so much individual investors.

Thoughts?

True unless there is no inflation but deflation like in Japan. It is hard for us to understand since we only experience it in theory and not practice but my Japanese friends were experiencing flat pay or pay cuts every year and were still better off in real terms because of deflation and were not complaining. After 30 years, the Japan equity market has still not reached its previous peak.

It’s a strange world with negative interest rates. Now Japan, Europe and US have negative real interest rates. Hard to make sense of this new world.

From Ray’s book, it seems that ingenuity of humans could not beat the greed of humans and massive debt write offs had to take place every 50-100 years from Jubilee year of Romans to Imperial China, whatever the culture. Japan handled their asset bubble with 3 decades of deflation, maybe the western world is next. Perhaps we need to look more closely at equity market of China where there is still lots more growth needed to bring GDP per capita to developed world status. On the other hand, US internet giants are making the whole world their market and no one can compete with their scale.

Definitely not Singapore real estate in any case. We are in the middle of our own asset bubble here and we will hear a big pop by 2022/23 if not earlier.

FH
Looks like your buy signal 3 came before buy signal 1. So which one will you follow?

So does that mean you are not buying yet? What’s your latest thinking on entry timing? I am starting to nibble very selectively and in small quantities while keeping my war chest tightly locked and monitoring ratio of cases to ICU beds available in the US. Looks like severity of situation has sunk in for everyone now so can’t be certain market will definitely fall further like I was last week.

But if ICU beds overwhelmed and people end up in hospital corridors without treatment, panic could ensue. At this point, think that is still more likely scenario.

Anyway, thanks for the article on 3 actions to take reminding us to relook portfolio allocation and make sure we were comfortable with it. It helped spur me to actually take action instead of just telling myself to take action which helped save me a tidy sum assuming I have the guts to put it back in market later. I have a bad habit of predicting what will happen and what to do fairly well but not actually taking the actions that I say I should take and suffering the consequences. Inertia is strong.

After the week that we’ve had. I really look forward to your weekly post tomorrow!