B. Chase Chandler, FRM, CFP | March 11, 2020
We have been warning investors about rising risk since January. Most people have mistakenly presumed the pandemic situation was a problem to be solved by medical and healthcare professionals. Not so. Certainly treatment and vaccination are medical, pharmaceutical, and generally healthcare related problems. However, the spread of the virus (given so many unknowns) is a complex math problem requiring an understanding of advanced probability in non-linear (non normally distributed) systems. The following is our third update since the end of February.
These types of situations are where decent investment managers shine, and a quintessential example of why we are willing to hold cash and trail during incessantly rising, highly valued, exuberant markets. In certain market conditions we are made to look smarter than we are, while in others we appear to have lost our marbles. We prefer the former. Investing should be boring most of the time. Big outperformance often happens in flashes, seemingly coming out of nowhere. Blow-ups also happen in the snap of a finger and with no advance warning. In each case, those who were overly reliant on recent history get the wrong end of the stick.
"The air goes out of the balloon much faster than it went in."
Howard Marks
I am surprised how many have been (or are still) assuming COVID-19 is just a "bad flu." Even many healthcare professionals have been imprudently spreading this view while Americans in South Korea and Italy are reporting draconian measures in what feels like the "end times." The virus has already spread at conferences in California and CPAC. Meanwhile, most of the U.S. has been in denial about both the health and economic impact COVID-19 will bring.
The negative economic impact will be large. Many sectors are already feeling the pain (e.g. travel, retail, dentistry). The extent of damage will be determined over the next 30-60 days. If the masses begin to take this seriously we could see some version of what China so far appears to have pulled off --- an intense but short period of mass quarantine. It will have to be self-imposed in the U.S. and the populous may not take it seriously until it has spread far and wide, touching people they know.
"Evidence-based" thinking is dangerous in these situations. Real time statistics are not all that useful, as Rutgers probability researcher, Harry Crane, has pointed out. The case count of most countries is not the officially published numbers. Most countries have not been aggressively and proactively testing. In fact, many have been preventing testing. The only way to have a sense of the real numbers is by modeling various scenarios. Johns Hopkins did this in January with the Chinese data and found that, given the estimated spread rate, cases were far higher than being reported. China revised their case count significantly upwards in early February.
We learn in markets that we absolutely must see things as they are, not as we wish them to be. This means observing and assessing what influences markets to find the truth. Not to predict but to figure out what is happening and what the potential outcomes could be. We cannot abide by the status quo when it comes to seemingly "small probability" risks that might not occur. Those who fail to avoid being fooled by the past will not make it in investing. What happened in the past does not tell you what the risk was, until it's too late.
It has been difficult to get people to fully grasp why COVID-19 is a big deal. These numbers should persuade those still convinced the flu is more dangerous. The R0 (spread rate) has been between 2.2 to 2.5. We created a simplistic model to assess the potential spread (shown below in Figures 1 and 2). We conservatively assume an R0 starting at 2.2 in the U.S. and declining over time. The is compared to a constant influenza R0 of 1.3. Bear in mind all of this is for example purposes to show how and why COVID-19 could be a massive problem.
We assume we are somewhere in the yellow shaded area (G5-G7), given complete testing. The spread rate (R0) is assumed to be 2.05 (G7) and declining by a rate of R0*.99. We also assume half of each group enters quarantine or isolation, and is no longer spreading, after a lag of three periods. In other words, G(0) was the first group of 100 carriers. G(0) passed it to G1 at a rate of G(0)*2.2. G1 then passed it to G2 at a rate of G1*2.18, and so on. At the fourth period (t4), half of G1 is goes into isolation and is subtracted from the "cases" column because we are interested here in the multiplicative spread. Figure 2 shows the same information in graph form.
We hope our numbers have some glaring error that we are currently not seeing. Obviously it cannot grow exponentially forever, but a significant percent of the U.S. and global population is expected to contract the virus. Given the case fatality rate is likely at least 10x larger than the flu (0.1% vs. 1%), it makes little sense to act as if things are just fine. As of now, COVID-19 cannot be contained (stopped) other than by mass self-quarantine and travel restrictions. Hence, President Trump's travel ban on those coming in from Europe is not overly drastic --- it is required. The risk is far too great to not take the apparently over-the-top steps now.
Figure 1
Figure 2
Impact on Markets
Credit spreads have been surging. Credit Default Swaps have spiked. A liquidation rush has already started. Correlations are moving towards one. Conventional asset allocation has stopped working. Jonathan Golub of Credit Suisse says the market hasn't priced in the full impact to earnings.
Berkshire Hathaway just issued $1 billion in 2025 senior debt at... 0%. Lenders are giving Berkshire $1 billion simply because they believe Berkshire will be able to return in in five years. Years of low interest rates have created major capital distortions in credit markets. Many non-viable companies have taken on debt and been able to survive to this point due to miniscule interest costs.
Economic conditions will recover, but it may be a rough road to get there. We will continue to be patient until such time that most are fearful. It's what people are not properly worried about and not focused on that can cause problems. When the commentators and others switch from complacency to fear, then we will turn aggressive.
“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get."
Charlie Munger