Investing in the Midst of COVID-19

Transcript:

How would you describe the current market conditions?

So what we think what we are in is an event-driven bear market with some cyclical elements to it. It’s very important that we get this diagnosis right. So if you look at the history of the stock market, there’ve been approximately 20 bear markets since the inception of the Dow Jones Industrial Average some 120 years ago.  It’s not a large sample set but there are three very distinct kinds.  There is an event-driven bear market, which we are most certainly are in, given the nature of what’s going on. There is a cyclical bear market, the last one of those was really the 2000 to 2002 bear market and then there is a structural bear market, so those would be things like what happened on 2008, 2009, the Great Depression and you could argue the very poor real rates of return in the 1970s was a structural bear market.

So we think this is an event-driven bear market. So the good news with even-driven bear markets is they are faster in and faster out, but let’s not confuse this with a correction. Corrections are short, kind of violent storms in financial markets, where if you went on vacation and came back four months later, you’d hardly know anything happened based on where stocks were priced in your portfolios.  Bear markets aren’t like that. Bear markets are destructive acts, wealth does get destroyed and some of it doesn’t come back and that is the nature of it, but you also get a lot of displacement, a lot of disorderly selling. People don’t think very clearly during these processes and you get what is essentially what is some form of myopia where people are selling stocks for the wrong reasons or for mechanical reasons and that is what potentially leads to really outsize gains as you finally exit from one of these.

What is the Shallow Market Hypothesis?

About a year ago, we published a piece called the “Shallow Market Hypothesis“. This is a piece that I authored and it detailed some of the features of the current market environment which are different from the market that I grew up in many years ago.  The core of the Shallow Market Hypothesis is that there are far fewer active investors as a percentage of the total, than ever before and they have been replaced by more automated forms of investing.  So these include indexes, ETFs and quantitative strategies just to name a few. The difference between the market and the market of 20 or 30 years ago is that you do not have a great deal of depth to the price discovery process for stocks and that in times of stress, the provisioning of liquidity and the efficiency of that price discovery is considerably worse than it has been historically. We are seeing powerful evidence of that on display right now.

A recent study by JP Morgan showed that market liquidity for S&P 500 Futures has decreased 1/12 to 1/14 its normal level in the current market sell off. That doesn’t make a lot of sense until you start thinking about how thinned down the market structure has truly become now that thought can either be a scary thought in terms of well what if this gets worse? But it also can be an exhilarating thought in terms of what kind of opportunities present themselves to active manager who actually apply some thoughtfulness and discipline to their stock picking.

In light of current conditions, how is Cambiar evaluating businesses?

What we’ve tried to do is assign stocks to one of three buckets.  There are companies that are going to experience almost no disruption to their earnings or their overall business. So that can include pharmaceutical companies, utilities, maybe consumer products like food.  Those we see almost no disruption to their business.

There are other companies where there’s going to be a medium amount of disruption so this could be higher velocity industrial products, things like semiconductors and computers and cellphones. You may see some very wild variances in their earnings in the short term, but we think by the time you get to 2021, and assuming we get some kind of containment the virus problem, you’ll see their earnings snap right back to whatever track they used to be on.

There’s a third bucket, which is companies that are going to have more powerful disruptions to their business. So this is very obviously things in the travel and leisure space.  There are some casualties, we’ve seen in the oil market simply crater.  There’s a lot of materials that go into that market that will also be negatively affected.  Some of those businesses will recover, we’ve tended to see a commercial aviation, for example, recover actually quite rapidly following 9/11 even though there was a brief period where hardly anybody was flying anywhere.  Those you’re going to see more extreme stock price compression and it may be appropriate in some situations to go ahead and nibble, but this is where timing becomes very important. We need to feel that we’re very close to the end of the bear market before that happens and given that it’s event-driven, that that means seeing some kind of peak and decline in the rates of infection and right now, we’re not there yet.

How should investors navigate through event-driven bear markets?

When you’re thinking about what to do as an investor, appreciate that it’s in these times of market stress where you have to become as unemotional as you possibly can. We are seeing stocks that are down, 20, 30, 40 or more percent where we don’t see material business disruption beyond a very short window of time in 2020. If you’re describing that circumstance to somebody, from a different planet, they would think that this was incredibly irrational.

But having been around markets for a long time, this is what happens when you have a lot of correlation and a lot of fear and a lot of selling pressure simultaneously. There are two event-driven bear markets that a lot of people, hopefully listening to this are familiar with, one is the 1987 stock market crash, the other was the few weeks following 9/11.  That was a down leg in the context of what was a cyclical bear market. But in both cases, panicking after the selling had happened, and going the wholesale liquidation was a truly terrible portfolio management or personal capital decision.  You really wanted to think more about buying maybe not all right away but a bit over time. That was the correct response and that’s the approach that we are taking.

One last point, I’ve been through a lot of violent bear markets. They are not fun to go through, but we do have a lot of experience and frankly, a lot of scars at this organization around these kind of events. So it is clearly part of our plan to apply that experience here. We do have an overall plan in terms of thinking about risk buckets and we are going to be allocating capital to all of those buckets.  Hopefully in a timely manner but we don’t want to try to rush too aggressively into things.  So far, we’ve been easing in in a way that seems very sensible to me.

We don’t welcome the virus, obviously, but we welcome the challenge.

Brian M. Barish, CFA

Brian Barish is the President and CIO at Cambiar Investors and is responsible for the oversight of all investment functions…