Monday, March 16, 2020

When you throw in the kitchen sink and the market still falls 12%

Well, Houston we may have a problem.

** Thanks again to everyone that came back and shared the blog. If you find it interesting, pass it along to your friends and/or enemies :)

A couple of quick observations:

I believe the reaction by US leadership will eventually slow the spread of the virus in some parts of the US (I do worry about reports I'm hearing from some states that don't seem to be reacting at all). 

Unfortunately, this means our lives our going to be severely disrupted for 4-6 weeks in ways that we've not experienced in our lifetimes.  However, I also want to reiterate that I feel that this complete shutdown of our society is unnecessary. 

We could ask people at risk - principally those 70 and older or those with severe immune deficiencies to self-isolate and the virus would spread throughout the US quickly.  Most of us would get sick (perhaps 200 million+) and a few would have serious complications but our world would not end. 

However, our current approach seems to be geared to mitigating liability and the only way to do that is to  shut everything down. I believe we should be learning to live with this virus, not trying to hide from it for 6 months. 
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Today was a perfect example of the Fed losing credibility.  They've thrown everything they have at the markets, but the markets keeps saying this isn't an interest rate issue.  This is a debt/solvency issue and the Fed doesn't appear to have the tools to deal with this problem.  Think about how fragile our system was that it requires near 0% interest rates, $700 billion of quantitative easing, $500 Billion in nightly repos, 4 weeks after all time highs and the market is still crumbling. 

I still think this will be a very challenging week for the markets because the headline risk is so significant.  Hospitalizations and deaths are going to soar in the next 7-10 days in the US but that will be countered by a steady flow of "STIMULUS" news.  A $1,000 in everyone's mailbox?  A payroll tax holiday? Deferred mortgage or utility payments? If there is a crazy idea out there, it will probably get floated in the next 48 hours.

The market is sitting on a precipice with ledges roughly 10% lower, then 15% lower and eventually another 30% lower.  It's worth noting that despite the thrashing stocks have taken in the last four weeks, they need to fall roughly another 50% just to get back to historical norms.  

Okay, so it's time to sell everything and retreat to a bunker?  

Well, here's the funny thing, I suspect that at some point we'll get numb to the bad news and everyone with a lobbyist is lining up to getting a bailout so the set up exists for an explosive rally.  The potential is there for a 20-30% rally in a very short time frame.  None of this is advice, just observations given that so much of our market is driven by technicals we need to be aware of the charts. Some will see this (if it happens) as a sign that the worst is behind us and they will probably take a victory lap.  That would be the wrong reaction but be prepared for it.
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If we want long-term financial stability in our markets and for our industries, we should strive for better capitalized companies with less debt.  The debt bubble of the past 12 years is the real villain in this story.  The virus was merely the pin which popped that bubble. It's okay to be upset with the hits we've taken over the past month, but direct that toward the real bad guys here - the people that told you that our economy could go on gorging on debt forever. 

Speaking of bad guys....the airlines, Boeing and the casinos all started begging for bailouts today. 

The five largest US airlines - Alaska, Delta, United, American and Southwest spent a combined 96% of their free cash flow from 2010 to 2019 on.....

debt reduction?
capital investments?
employee retention?

Nope - they spent it buying back their own stock.  Consider this simplified example - if a company has 20 shares outstanding and their stock is trading at $100 they are worth $2000.  If they take $200 from their cash flow and buy their own stock, now they have 18 shares outstanding but they are still worth $2000 so each individual stock is probably going to be worth ($2,000 divided by 18)...$111.  It's like MAGIC!

So why would a management team want to push up a stock price if it doesn't change the overall value (remember the company in our example is still worth $2,000 in total)? Well, that gets back to our old friend - stock based compensation.  Options, warrants and bonus pools are often driven by share price, thus management of the airlines actively pursued policies to enrich themselves while leaving their companies with excess leverage and ill-prepared to handle a downturn. 

The airlines will not go away if we allow nature to take its course.   The existing airlines will probably go bankrupt, the equity holders would be wiped out and the debt holders would get a haircut, but they would reorganize like they have done many times before and re-emerge.  If you bailout the airlines, you are endorsing the reckless behavior of the past decade.

Boeing has spent a little over $100 billion in the past 5 years on its own stock. It sure would be nice to have that money now instead of coming to Washington with their hat in hand.

Finally, the casinos are going to make some sort of ridiculous pitch that they are critical to the survival of the neon industry or something but they probably will have a sympathetic ear in the White House since he knows a thing or two about casino bankruptcies.

Again, the economy going to grind to a halt in the next few weeks.  The real test will be how we chose to stimulate our way out of this mess.

Cheers!

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