The first quarter of 2020 will go down as one of the most volatile quarters for financial markets in U.S. history. We had the fastest decline into bear market territory in history. It only took 16 trading days for the market to lose 20%. This was a quicker start to a bear market than 1929 or 1987. The average stock is now trading at their price levels of 2011-12. The total decline in the average stock from their highs was 50%. A barrel of oil declined from $63 in January to $21. Most of that decline in oil happened in one day when OPEC broke up. The Fed injected trillions into the financial system to try to calm the markets. They also cut interest rates to zero on the short end. The reason for this mayhem: a virus called COVID- 19.
We started hearing about COVID-19 in January. After numerous discussions about it at work and its potential impact on the economy, we decided it would not be a major factor to our investments. We were wrong. We didn’t assess this situation correctly in the short-term and it cost us. We are deeply sorry for that. We will outline below our logic for holding on during this market break. In this letter we will also go into detail why we passed on selling, what we think is going to happen next, and how this may be the end of a 40-year deflationary cycle.
When the news came out about the problems China was having with this new virus, we became concerned. We read numerous web sites, newspapers, magazines, Chinese research papers and blogs to get information about how they were dealing with this. We also called doctors, researchers who had worked on Ebola and hospital administrators to get a better feel for this. We went back and studied previous pandemics and virus out breaks. In no order, they were SARS, H1N1, Ebola, MERS and the ordinary flu. At that time, it was our opinion the COVID-19 virus most resembled the SARS virus. Even though H1N1 was labeled a pandemic and killed around 12,000 people in our country, we thought how the markets and OUR governments treated SARS would be the best test case (no one died from SARS in the U.S.). As we have stated above, we were wrong in how we thought the world would deal with this virus.
The SARS virus started in December of 2002. During that time the stock market was in a serious bear market. The credit markets were in horrible shape based on the bankruptcies of Enron and WorldCom. The U.S. economy was still in weak shape. With all of that as a backdrop, the stock market bottomed in March of 2003 and took off. The SARS panic went away in July of 2003. Using that data as our base case, we then applied it to what we were looking at economically in January and February of this year compared to 2003. The economic stats were very strong in 2020 vs. 2003. The credit markets were very healthy. The stock market made a new high on February 18. That high was one month after China had reported to the WHO that the virus didn’t spread person to person. This proved to be a lie, but we don’t blame them for our losses.
We have been fully invested in the stock market since the Great Recession of 2008. Our guiding principle for those 12 years has been if there is no inflation, the federal reserves of the world will be able to print money to bail out financial investors in stocks and bonds. It was our opinion in February that, with commodity prices low worldwide and inflation low, and if we were wrong on the virus’s impact, the central bankers of the world would print money to raise asset prices. As of this writing, it appears, they will print an unprecedented $2 trillion this month in the U.S. alone. We thought this likely money printing would blunt the market declines to less than 20%. We were wrong on how severe this market would break even though we got the Fed response right. Why did the markets respond more severely this time than the last 12 years?
We did not see the governments of the world shutting down their economies by keeping people at home to the extremes they did. We thought some form of self-isolation would occur but not to the extent it was implemented. When something new occurs, like forced shutdowns of the world’s economy, the standard response for some investors is to sell first and ask questions later. We thought this selling would be contained at around 15-20% correction because the world’s central bankers would flood us with money. The S&P 500 was down around 35% as of this writing, so we missed that. Later, we will talk about where we think this market goes from here.
What we would like to do now is go over our top five holdings and explain what we thought about them in February and what we feel about them now. We think most of these companies will benefit from this, economically, though their stock prices aren’t showing it today. The next paragraphs will outline why we feel this way.
We have written in the past about how cheap Berkshire Hathaway is versus the market. Warren Buffett has recently been viewed by Wall Street as out of touch with today’s economy. He was criticized for sitting on roughly $150 billion in cash which represented 27% of his market cap. It was our opinion that if a bear market occurred, he would not only be an aggressive buyer of the market but also of his own stock. Last quarter he was buying back his stock (1.5% of the float) at over $205 a share (it’s $170 now). We think that the investments he is making for us today in this bear market will cause Berkshire to have record earnings and cash flow in 2021. We think the discount that Berkshire has traded at versus the market will now disappear as he will appear one of the big winners of this pandemic. For probably the last time (he’s 89), we had the world’s greatest investor sitting on cash going into a market panic. We can’t wait to see what he bought for us in this decline.
CenturyLink is the largest provider of bandwidth in the U.S. (using ethernet circuits as the yardstick). In December of 2019 the company announced a strategic partnership with Zoom. As travel restrictions have been put in place, video conferencing has exploded. Zoom is the biggest winner economically in this pandemic and CenturyLink is their preferred bandwidth and voice provider. CenturyLink also has “only” $1.2 billion of debt due this year (April 1). They have projected for this year $3.25 billion in free cash flow; $1 billion of that will be paid out in dividends, with the rest to be used to pay down that $1.2 billion in debt coming due. This leaves them with a cushion of $1 billion if times get tough. They astutely restructured most of their debt maturities by January of this year to limit their yearly debt payments (up to 2026) to about what their free cash flow is today minus the dividend. We don’t see any reason for them to go to the credit markets currently to borrow money. We see the demand for bandwidth exploding this quarter as schools, hospitals and business go online. They reported in the last week of March that traffic on their network was up 35% this month. We expect that trend to help cushion the blow of some small customers who can’t make it through this panic.
BGC Partners benefits when the financial markets are volatile. We anticipated them reporting higher earnings this quarter than they projected in February because of March’s market volatility. On March 26 they did confirm that they would outperform street expectations this quarter with record sales. Having rising earnings and sales in this market is very unusual right now. However, they then said they are having trouble conducting business during the last two weeks of March. They have 5,200 employees. We are ASSUMING they are having problems getting their workers (and their clients they sell to) to their desks because of the quarantine. Their three main trading floors in the U.S. are in New York. Their fourth largest trading operation outside the U.S. is in London. Because of the uncertainty of when they will have everyone back (and their clients have everyone back), they cut their dividend to increase their cash on the balance sheet. Here is how they stated that dividend cut in the 8k. “The Company took this step SOLELY out of an abundance of caution in order to strengthen its balance sheet as the world faces these difficult and unprecedented macroeconomic conditions.” The phrase “solely out of an abundance of caution” means to us a more positive view than we are in dire straits. We don’t blame them for conserving cash until they know the status of when their workers can return in these two cities. We don’t expect this virus to damage the business model of the company. We believe long-term it will help it. The CEO of this company lost 90% of his work force in 911. After that event, he then rebuilt the company and grew it to record profits. If he thinks this is what he must do in the short-term, we support him. As for what happens next on the dividend, they said this: “The Company and its Board of Directors intends to review and reassess its policy with respect to dividends and distributions as global conditions become more clear.” We are hoping the word reassess means the dividend could be coming back when the world is clearer. We will know more in May at the latest.
We think, in the short-term, that Apple Inc.’s earnings will be impacted by this pandemic. They are the only company of our top five that we think will have a revenue or earnings impact from this. We held the stock because they were sitting on $207 billion of cash at the end of the first quarter. In the fourth quarter of 2019 Apple bought back 1.5% of their stock. We expect that number to go up materially this year. There have been rumors they are interested in buying Disney. We don’t see that happening, but it is possible they use their cash to increase their media content to compete against Netflix. Tim Cook has been a good steward of the money. We think he will increase the value of Apple in this downturn.
Our last stock has been on a real roller coaster this quarter, Royal Gold. On March 16, with gold trading up for the day, Royal Gold’s stock traded down to 59 (a decline of 15%) before going up 37% for the day to close at 81. That’s a year’s worth of trading in one day. If you are a big believer that the central banks of the world are going to print money to devalue the dollar, you need to own some gold. This is our bet that the central bankers of the world are going to create inflation again by unlimited money printing to monetize our fiscal debt. As of this writing, our central bank is going to increase the Fed balance sheet by over 30% in one week. One week! We have continued to hold this stock because of our belief that when the secular bull market in financial assets (stocks and bonds) finally ends, this stock will be leading the way up. What’s our view for the next 18 months if you think gold will eventually be the asset of choice at some point this decade?
For 12 years our guiding philosophy on a macro view has been to be long financial assets (almost always stocks) until there is inflation. Each market decline during that period was met by the central banks of the world printing money. This eventually helped our accounts go to new highs each time. It allowed us to buy the flash crash in 2010 when the market lost 8% in 10 minutes. That view was tested in 2011-12 during the European financial crisis. When Greece defaulted, our market had three 15% plus corrections in 12 months. Our macro view was our guiding light in the breaks of August 2015, February of 2016 and finally the 20% stock market correction in December of 2018. Today’s decline of 40% (Value line composite) in one month is the worst one we have dealt with in the last 12 years. As we stated above, it also caused the central bankers of the world to flood the markets with more money than we could imagine. We believe the pattern of money printing and rising financial assets is not broken. We think within 18 months the markets (and our accounts) will be trying to make news highs. We understand this view is a minority one after a decline of this magnitude. The playbook of the last 12 years is being put to the test. We think it’s still valid.
If we are wrong on the market going back up substantially, we hope that the five stocks that are our largest holdings will overcome the markets downward pull should it decline. We think that’s possible for our stocks based on what we stated above. We do not believe, however, the path the market is going to take is down. The last time we predicted a bull market like we are now, was in our yearend letter of 2012. It’s on our website (trendmanagementinc.com) if you wish to critique it.
The doomsday scenario: What does concern us? How would the end of a central-bank-induced bull market end? It would start with fiscal irresponsibility at the federal level. The bailout today of the economy/market will raise the debt to GDP of the U.S. economy to its highest level in the last 50 years. Our debt to GDP has been moving up for the last 12 years without inflation showing up so far. This time we think it’s different. We are reaching an inflection point in how much debt we can pile on our economy. Once we go over 120% of debt to GDP, we think it creates real problems that are not solved easily. The following scenarios we think will play out over the next market cycle as we switch from deflation to inflation.
In previous market crashes where the Fed stepped in, it is our guess that 90% of that money went to supply credit to businesses. In 2008 a preponderance of the money went to banks and financial institutions. Most of this money didn’t “circulate”; it stayed on the financial companies’ balance sheets to keep them afloat. This time the epicenter is not the financial markets (banks) as much as it is “the real” economy and workers. It appears that around 50% of the money being printed in the $2 trillion stimulus bill is going to end up in the pockets of the public, whether they were working or not. This money is going to be spent. It won’t be saved, it will circulate. When the public spends this money, it is going to widen our trade deficit with the rest of the world. A wider trade deficit will put immense pressure on the dollar to go lower to offset the U.S. spending too much money.
It’s our belief at Trend that one of the main causes for the lack of inflation the last 40 years is a decline in world population growth coupled with the deflationary effects of free trade. For the next year we are willing to predict that world population growth will have a spike in nine months. With the world shut down for about a month, there are increased odds that people will find other things to do than watch Netflix. In the 1977 New York black out that lasted only one day, it was reported there was a 35% spike in births nine months later. When you have kids, spending goes up. This is not the main reason inflation may come, it will just help it along.
Over the last 40 years there have been numerous trade pacts signed to help lessen the wage pressures of U.S. workers while lowering the cost of products. We see that reversing under this administration or a Biden administration. It’s a trend that isn’t going to stop no matter who gets elected. Under this pandemic the U.S. woke up to find out that most of their pharmaceutical drugs weren’t made in this country. Ventilators and masks were easier to find in China than in the U.S. This type of news, when you pay the highest health-care costs in the world, are not going to go over well with the American public once this ends. The same goes for anything made in a foreign country that can be disrupted by the next virus. We think the days of creating a widget in Silicon Valley and shipping the manufacturing of that widget overseas is going to slowly reverse. It will take time, but we think it’s going to occur. When it does, the wages of U.S. workers will accelerate compared to what we have seen for the last 20 years. Before the market crashed this year, wages were up 3.2% for U.S. workers. This was the highest increase in wages compared to inflation in quite some time. What allowed the Fed to print money THIS time “to save us” was the dollar was strong and commodities were very weak. We think when the economy returns to growth (Q3), wage pressures are going to accelerate along with commodities worldwide.
To sum up, the economic data that would cause us to lighten up on stocks, you need a declining dollar, higher inflation and a budget deficit that can’t be funded by the Fed buying bonds. We are not sure how many years it takes for that scenario to hit, but it’s closer now than it was six months ago.
We have included charts at the end of this report to help you see what you just lived through. They are dramatic visuals of what was one horrible market. We are sorry we had to live through this. We have given our logic for why we have stayed fully invested. If you would like to call us, please do. Our number is 417-882-5746.
Sincerely
Mark Brueggemann IAR Kelly Smith IAR Brandon Robinson IAR