My grandfather, my mother’s father, Charles H. Magill died in the flu pandemic of 1918. Ironically, he did not die from the flu. He died from an overdose of drugs administered by a doctor. There was no Food and Drug Administration (FDA) in those days. Doctors had to decide for themselves the appropriate dosage. My mother was three years old at the time.
Now we are visited upon by another virulent contagion. The world is much more populated now than in 1918 by a factor of about five. Science and communications make the spread of the virus much more anticipated. However, because it was not anticipated, there is no vaccination for the current outbreak, labeled COVID-19. Nor is there a remedy, aside from contracting the virus and surviving.
The effect on the stock market has been pandemonium. There is an old adage on Wall Street that markets take an escalator going up, but the elevator going down. Program trading has exacerbated this. In 1987, program trading caused the stock market to fall 25 percent in a day. So far, the market has fallen about 33 percent from its peak February 19, 22 days ago.
The problem with program trading is that it assumes there is someone on the other side of the trade. This is technically known as liquidity. When liquidity dries up, and there is no one to bid or offer at the last trade price, look out below. Markets used to be supported by specialists and banks trading their own accounts. Specialists were supposedly made obsolete by computers, and banks were told to curtail their support of markets as the act was deemed “too risky.” In effect, the risk was transferred to the investing public. Add to this mix, the usual investor who buys a stock with borrowed funds, or margin, and the downward pressure on stock prices begins in earnest.
The COVID-19 virus can only be controlled by reducing the number of human interactions. As I write this, we are midway through America’s longest enforced holiday. Everyone who can is to stay home. Hopefully, this will reduce the rate of spread of the virus, and (also hopefully) warm weather will cause it to hibernate until fall.
This period of economic inactivity is unprecedented. Never before have both demand and supply been depressed at the same time. The Government is trying to revive economic activity through various legal measures. Most have not been tried before on this scale. The idea is to buy time for the period of inactivity to reduce the cases of infection so that our health care system does not become overloaded.
So far, programs totaling $4 Trillion are being proposed. No one is saying how this will be paid for, although the Treasury announced it would be selling more long-term debt presumably to help fund the programs.
Historically, event-based market corrections are short-lived. There is a period of time, usually, 3-9 months, when the lost ground is recovered. This time may be different. As people realize the precariousness of their positions, there may be an effort to create a cash cushion in the event of such an event again. Collectively, this will reduce consumer demand. Since about 70 percent of our GDP is consumer spending, this will have an impact going forward.
Somewhat offsetting this are payments made by the government for Social Security and Medicare. As the number of retirees increases relative to the total population, the percentage of citizens who can spend Social Security funds will go up as well. This government spending is impervious to the economic cycle and is demographically driven.
Like the flu pandemic of 1918, we will get through this virus and go on from there. The investment question is, what will the investment world look like, and how will it change.
Economic activity is in free-fall. With the government impaneling everyone they can into their homes, unemployment may reach 20-30 percent.
Most, but not all, will return to work once this is over. There is an estimate that as many as 30 percent of all restaurants will go out of business. The hospitality industry, which employs about ten percent of the workforce, has been suspended. Airlines are cutting back domestic flying by 60 percent, and international flying has been put on hold.
Getting these sectors back to work will help to reduce unemployment. The unknown is the disposition of the consumer to spend. If spending is not robust, the recovery will take longer.
Inflation is the factor left out of consideration at this time. This will make it a future shock to the economy, and the market should it return.
A $4 Trillion plan to revive the economy will increase the size of the national debt by about 17 percent. Add to this the structural deficit which generates $1 Trillion per year in additional debt, and pretty soon you are talking real money.
Panic has driven interest rates to historic lows. Once the panic subsides, the realization that the Treasury will need to sell so much debt in short order to finance the above government programs will send interest rates higher. Just today, the announcement that the Government was considering 50-year bonds had interest rates tracking upwards.
Aside from any changes in the economy, the biggest upshot from this crisis will be to focus on the level of government debt and the deficit. Like market liquidity, the debt doesn’t matter so long as there is someone around to purchase it at low rates. If this assumption ceases to be valid, this could be the seed of our next calamity.
The Stock Market
A stock market built on cheap and plentiful money is not on a solid foundation. Last year, the earnings of the Standard & Poors 500 Index was almost unchanged. It was higher valuations, in the form of higher Price-to-Earnings multiples, that caused the market to expand as it did. Easy come easy go.
No doubt, the market will recover. Whether it goes back to its former level in a brief amount of time remains to be seen. History tells us that the leaders of a market advance have a one in five chance of leading the next upward move. While this market is still fluctuating heavily, there will be a time soon to get back in.
As for reducing the fluctuation, both up and down, two ideas come to mind. First, to tax security transactions. The tax amount does not have to be large (one cent per share), but the amount will be material to the hedge funds who trade in and out of shares several times a day.
A second idea is to tax the income of hedge fund managers as ordinary income unless positions are held for more than a year, when it becomes taxable at capital gains rates. Right now, hedge fund investors can get a tax break on the interest they pay to borrow stock. The average person can deduct this too, so long as he or she has taxable income on the investments. Hedge funds require no offsetting income, calling it carried interest.
Most stocks should come back in short order. However, this is a time to separate the wheat from the chaff. If the environment changes, the portfolio should change with it.
Warren M. Barnett, CFA
March 23, 2020
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