It is impossible to look at the prognosis for COVID-19 and not conclude that the global economic sudden stop is a negative for the equity markets. But as always, just looking at the surface and making strong conclusions from the news might not be the best way to make investment decisions. In the current market environment of extremes, conventional wisdom may not be the most effective way to make profitable investment decisions.
Three different types of viewpoints are currently being expressed about the prospects of the economy and the markets. The first, optimistic, view is that this is just a shock correction, and as soon as the peak of the pandemic passes, the markets will rebound smartly. The second, more neutral, view is that a structural change has occurred whose consequences are impossible to forecast, so markets will be in a new environment of uncertainty and volatility. The third, pessimistic view is that we have not seen the extent of the damage yet, and before things turn around, the markets will make new lows, e.g. the S&P 500 will yet fall below 1500 (another 30%-40% below current levels).
In “The Affluent Society”, John Kenneth Galbraith introduced the concept of “the conventional wisdom”:
People approve of what they understand. We adhere, as though to a raft, to those ideas which represent our understanding. This is a prime manifestation of vested interest. Vested interest is more preciously guarded than any other treasure. In the field of social ideas familiarity is the touchstone of social acceptability. Acceptable ideas have great stability – they are highly predictable. I shall refer to these ideas as the “conventional wisdom”.
As investors, our task is to ascertain which one of the three opinions is likely to win out in the formation of monetary and fiscal policy, and thus influence the actions or inactions of government authorities. In the immediate future, the participation of the government as player/referee will determine the course of financial markets, because today only global government balance sheets are large enough to counter the fear embedded in markets.
For the optimistic group, who are attached to the idea that this is just a short term correction, the best suggested course of action for the government is to stay out of private markets. This group will likely be most supportive of temporary, reversible government action that only addresses economic issues but not private company operations.
For the second group, which holds that we have entered a phase of volatile and uncertain markets, the best suggested course of action would be for the government to provide a backstop, but stop short of taking control of private companies. In other words, they would like the government to be there as a guard against further deterioration, but not to the degree that would result in transfer of ownership of equity to the government. This point of view would prefer that the government to be a potent provider of insurance which draws a line in the sand below which it will not let markets fall.
For the third, pessimistic, group, the lack of aggressive government action would mean staring at the abyss, perhaps even a depression. This group would encourage maximum government intervention, including encouraging taking equity stakes in companies, and socializing national champions.
Classifying US companies in these three groups is not particularly hard, because based on their initial conditions, i.e. cash and liquidity situation, they will likely self-select. More importantly, which direction they are likely to move will be driven by where they expect to see most immediate benefit for themselves; i.e. their vested interest, served.
For example, companies like Apple have massive cash hoards, and until the recent debacle were engaging in large buybacks of their own stock. Under any scenario where the government takes an equity stake in a company such as this, it is likely that buybacks would be put on hold, which would not serve the vested interests of its shareholders. So, these companies are firmly in the first group and would likely want to see the government stay out. In any case, with interest rates at zero, and the government ready to buy corporate bonds, financing costs are kept low. Thus, for companies like Apple, any return of stability will likely re-start stock buybacks with low financing costs courtesy of the government’s bond purchases. This is just one of the unintended consequences of trying to lift all boats.
In the second group we have banks. Since the banking model depends on steep yield curves, leveraging and trading of securities, banks would naturally benefit from volatile market conditions. News from the last quarter showed that banks such as JPMorgan Chase & Co. made record profits from buying and selling securities to frenzied investors driven by greed and fear (Source: Bloomberg). Thus as long as the bottom does not fall out (which it obviously can), banks would prefer the government to stay at a distance but bail them out if the losses started to become extreme. This is what happened in the global financial crisis after the first wave of losses morphed into bigger waves of losses. In other words, banks would want the government to promise that there would be no Lehman moment in this crisis.
The third group consists of national air carriers such as Delta, American and United. Without policies that would enable them to survive, the consequences of a loss of passengers means no revenue, and a stock price that rapidly plummets toward zero. Since there is little revenue at the moment, the practice of spending free cash flow to buy back stock, as these companies did over the last few years, is probably over for now. Facing the grim reaper, they would now prefer that the government not only take an equity interest, but also mandate pricing and surcharges that would enable them to stay in business. In other words, these national air carriers become utilities run by the government.
We should not forget Boeing. As a supplier to the airlines, Boeing is a national champion, and until recently had a cash situation like Apple. But the sudden stop to travel demand has crushed its stock, and if there is no airline demand, then there is no demand for Boeing’s jets. However, given its importance to the economy, I suspect that it (and companies similarly situated) will be bailed out without too many strings attached.
So where do we come out of all of this? I don’t have a crystal ball, but I do think the framework above suggests where the tilts should be. My key assumption is that the door to government ownership of private companies has already opened. Which means that there are two categories of companies: those who will need to fall into the bear hug of the government, and those who try to stand their ground and operate independently. While the first group will be safer, the prospective returns will also be lower. The second group is likely to be more volatile but also reward their holders better over the long run.
As always, picking winners and losers is a gamble for investors and for the government. When the government is involved in making markets, as it is today, vested interests and lobbies will drive stocks. To me, this is therefore a time to be selective, rather than throwing money at the whole market. And just to be clear, for my money, right now, I would place my bets where the government is providing cover. But I will be quick to change my mind if the situation changes.