“We’re through the looking glass here - black is white and white is black.”
-Kevin Costner, from the Oliver Stone film JFK.
What caught my eye today was the dismal April employment report and the bullish reaction to it in the stock market. The popular narrative being offered to explain this apparent disconnect is that the market had already "priced in" an even worse report. Bad means rally. Less bad means more rally. Onward and upward.
After today's rally the market is within 13.5% of its all-time high of 3386. That's astounding to me. What's even more astounding is that the market could make a new all-time high in just three days. But it probably won't.
It would take three consecutive days of 5% gains to get back to the previous high water mark. We've had many 5% days since February 19th, but the market has calmed down considerably recently. Look at this chart of the VIX market volatility index.
Volatility peaked at 83 on March 16th. It's now down to just 28, not far from its long term average. I expect the market to continue this low volatility ride, punctuated with the occasional 3% up or down move as headlines either scare or soothe investors.
With daily moves now of 1% to 2%, compared to the recent string of 5% to 9% moves, we have transitioned from a hair-on-fire market to a kinder, gentler market. The trend is still higher, but the velocity of the rally that began on March 23rd has changed from warp speed to grind mode.
Even the most optimistic and dedicated dip-buyers now recognize that a significant portion of the market gains off the bottom have already been achieved, and the gains from here on out will be hard-fought and dependent on just about everything going right.
What can go right?
First and foremost is a continuation of the "curve bending" we've seen recently in the number of cases and deaths from the pandemic. That could continue, and if it does, it will bolster the resolve of investors. But curve bending is not in our control, it's in the hands of biology and epidemiology. It's up to Mother Nature to decide where the curve will go next, not us mere mortals.
Another thing that could go right is a successful reopening of the economy. That brings us to the idea of "herd immunity." This is the resistance to the spread of a contagious disease within a population that results if a sufficiently high proportion of individuals are immune to the disease, especially through vaccination.
The level of vaccination needed to achieve herd immunity varies by disease but ranges from 83 to 94 percent. (Dictionary.com)
Countless articles and think-pieces on the COVID-19 virus are making the argument that, albeit potentially risky, achieving herd immunity could be one response to our crisis. Many of them frame herd immunity as a preventive strategy that may stall the tidal wave of disease so many are predicting.
But note well: herd immunity without a vaccine is by definition not a preventative measure. (sciencealert.com) And based on what I've read, an effective vaccine is at least 6-12 months away.
Another thing that can go right is a massive return-to-work by furloughed employees. If that were to happen, businesses could quickly return to profitability and earnings would recover to their previous levels by mid-2021. This is what's driving the current market rally. Investors are looking past the deep chasm of unemployment and depressed earnings, and they see the dawn of a new era just ahead.
What can go wrong?
There are many things that could go wrong, starting with a second wave of cases and deaths that would bend the curve higher. As I said, Mother Nature controls the curve, not us.
Another risk is that the recession may drag on for longer than the optimists believe. That would mean more layoffs, more failed businesses, more dividend cuts, more lowering of earnings expectations. lower stock prices, lower consumer spending, and more people giving up and leaving the labor force.
Even in the best-case scenario where businesses reopen and rehire their employees, it will probably take many months before consumers are willing to risk their health and go to hotels, restaurants, bars, cruises, casinos, concerts, and their office cubicles.
What's most likely to happen?
Masks, gloves, and social distancing will be with us for a long time, regardless of how quickly businesses reopen. Be prepared for stubbornly high unemployment, lower economic growth, lower earnings, and a stock market that will have pockets of downdrafts while it tries to grind higher from here.
The central banks globally are using their 2008 playbook and have jumped in very quickly to the rescue. That is why even Warren Buffett is sitting holding his 130+ billion dollars of cash. But no one is calling to offer him great deals that he got in 2008 because the guys who need the cash have now got it from the central banks in some roundabout way.
Compare this with what the Indian government and RBI has done for the industry – practically nothing. And unless some significant measures come in, India is going to have to pay for the consequences for a long time.
The Way Forward
I am of the opinion after speaking to a large number of business owners over the last few weeks that the next 1-1.5 years will be extremely tough. The level of uncertainty is only going to go down as and when a vaccine is found and is delivered to the masses and is effective in preventing a further outbreak. Till then we are going to be wary of the circumstances. The more the duration of the lockdown goes on and the more social distancing norms gets mainstreamed, the more persistent behaviour changes are likely to be. The scars of this event will be there for a fairly long period in my opinion.
The urban salaried and business class are likely to be badly affected with reduced income from salaries or businesses. This is likely to have a negative impact on discretionary spending. So, sectors like real estate, both residential and commercial; 4 wheelers, luxury items, leisure travel are likely to be hit much longer than people are currently factoring in.
Another area of concern for me is how the startup space will play out. The “thin-air” valuation model is likely to come under severe scrutiny and make way for more profitable and cashflow oriented business models. The concern is that in the last few years, the bulk of incremental jobs in India, especially at the lower end of the spectrum, has come from these “non-profitable” enterprises (the likes of Oyo, Swiggy, Zomato, Ola, Uber, Flipkart, Amazon, Paytm etc). Impact to such businesses would mean a chain reaction and lead to joblessness.
Civil Distress
History tells us that severe economic contractions most of the time lead to social unrest, civil wars and even full-scale wars between countries. I am not suggesting we would have it this time around, but we need to be aware of such an outcome. Already social tensions have started rising and with more duress in daily life, it is likely to escalate. The government does have a significant role to play in this through various social schemes.
Silver Lining
Some areas which give me comfort is that a very large section of Indians depends on agriculture and that has been the least impacted in the crisis. With, hopefully, a good monsoon, we should be able to see rural demand coming back.
Another silver lining is the reset in labour laws that states are now resorting to. Times of crisis such as these are great opportunities for policy reset which is particularly difficult to get done during normal times. Labour and land reforms are the two most critical issues that have been holding back Indian industry and any progress on these should be welcomed.
In times like this, it is better to remain cautious. There are 3 positions an investor can take in the market at any time – i) be a buyer, ii) be a seller and iii) wait outside.
Now seems a good time to be waiting outside.