• Samuel Zavaletta

Where is the floor?

Updated: Mar 24, 2020

The single most important question that investors around the world are grappling with is: where is the floor? In order to answer the question, it's important to understand the market's fundamental motivation in selling off so precipitously. That is to say, why should this pandemic be of any concern? In the last few days, several revelations have come to light which, in my view, clarify why this selloff has been so fierce.

First, the data emerging out of Europe indicates that the virus is far more dangerous to the young and healthy than previously suspected. The old and the sick are not the only demographics at serious risk. Second, areas within which "community spread" has taken hold - places like Northern Italy and New York City - are showing us that despite a low fatality rate, the prevalence of individuals suffering severe symptoms is far higher. Those individuals require advanced medical intervention, and in sufficient quantities this alone is enough to overwhelm local medical systems. I believe this is why POTUS activated the emergency preparedness plan of every hospital in the nation. Third, it would appear that the market has finally started to grasp (a) the type of policy responses that are necessary to halt the spread of the virus, and (b) the fact that such policy responses are somewhat anathema to American sensibilities. As a republic made up of diverse peoples with great attachment to personal freedom, there is a distinct possibility that swift and coordinated action will be delayed. We've started seeing the kind of hash measures that are needed (multiple states have shuttered non-essential business activity, an unprecedented move), but these measures have not been instituted in a coordinated and comprehensive manner. Fourth, as it was stated in a White House briefing several days ago: wherever we believe we are along the growth curve of the virus, that perception is actually weeks behind reality. When viewed in light of (a) the proven existence of asymptomatic shedding, and (b) the continuing insistence that "not every American needs to get tested", it becomes clear that we are still playing catching up to the virus.

The most basic, universal measure of valuing an enterprise is the price-to-earnings ratio. The velocity of the drop that we have seen in the "price" component of the equation is virtually unprecedented. Levels of implied volatility reflect that intense selloff. Initial reports indicate that this drop has manifested for good reason. Both the actual projections for global & domestic growth and the confidence interval of those projections have deteriorated substantially. Forecasts are shifting substantially, first from a "quick V" shaped recovery to a slower "U" shaped recovery, and now I believe from a slower "U" shaped recovery to an actual recession. That is all to say, the "earnings" component of the equation is suffering substantial deterioration and uncertainty. Combine that with the earth-shattering forces exerting themselves on specific hard-hit industries - such as restaurants, hotels, and the like - and the result is truly unknowable at this point. Even the pro's are stumped and scrambling. I do not believe that "Mr. Market" has sufficient clarity to see through this occlusion.

The severe selloff in stocks, the bid up in treasury yields, the widening of spreads between corporates and treasuries, and the rise in the dollar index all reflect the resurgence of risk-aversion and the increased demand for cash. Based on the historic behavior of these and other forward-pricing mechanisms, pessimism has not peaked. At these valuation levels, the intrepid investor might begin allocating to carefully selected longs, but buyer beware. There is a high probability that the floor is not in yet.

25 views0 comments