The Depth Report - It's Not Too Late
Three weeks ago, we wrote a piece, Net Short, in which we disclosed that we had a large cash position and had gone short against the market through options spreads. Since then, the market has fallen 20%. Last week, we wrote a piece, Even More Net Short, in which we explained that the corona virus situation was worse than the market expected, and that we had increased our short position. Since then, the market has fallen almost 9%. We continue to believe that the situation is getting worse and that it’s not too late to switch into a short position.
The Virus is Not Under Control:
The official corona virus case count in the US has risen to just under 3,000, but as we’ve discussed previously, that number is understated due to a lack of testing. There are positive tests in 49 states, and thousands of Americans are crowding airports as they rush back to the US ahead of the announced European travel ban. Packed airports, customs lines, and airplanes are ideal for spreading a contagious virus, but even without that coming problem, conditions in the US are worsening. New York City has declared a state of emergency and closed the nation’s largest school district; the National Guard has been deployed to New Rochelle, NY; and Hoboken, NJ has instituted a curfew. The governor of New Jersey is considering a statewide curfew and other “more draconian steps.” Some are calling for President Trump to deploy the National Guard or the army to help enforce a quarantine and keep order, and others are warning that any action along those lines would indicate he’s a hostile dictator. At this point, any action by a mayor, governor, or the president is going to be criticized and be used to instill the fear that the government is either not doing enough, or on its way to declaring marshal law.
We believe that the act of deploying the army or declaring marshal law will cause the market to fall. Even without that, we’re still facing a minimum of several quarters of severe economic disruption. As things stand now, we’re in the early stages of shutting down some of the nation’s transportation infrastructure. People are afraid to go to work, and anyone who can is working from home. Bars, restaurants, and other service industries are shutting down for the season or going out of business. People are slowly starting to realize that the corona virus does affect people under 70, and that the fatality rate is probably much higher than the 1% - 2% we had initially anticipated. Right now, the only places Americans are congregating in large numbers are supermarkets, Costco, and Walmart.
Stafford Act – Possible Act II:
On Friday (March 13), President Trump invoked the Stafford Act and declared a national emergency. In doing so, he released funding to help slow the spread of the corona virus. As of tonight, we’re both hearing and reading rumors that the president will invoke the Stafford Act a second time and declare a two-week nationwide quarantine. It’s difficult to tell at this time whether the administration will take this action, or if this is a rumor being spread by people who don’t realize that a national emergency was declared on Friday. While we would view the suspension of civil liberties as a serious act not to be taken lightly, we do note that similar measures seem to have been effective in China, have been effective in South Korea, and are being implemented in Italy.
A quick non-legal reading of the Stafford Act shows that Title VI provides for the government to be expected to control traffic and panic, and control use of civil communications. Title VII provides the president the authority to determine any rule or regulation that may be necessary to carry out the powers that he is given in the Act. It may be within the president’s legal authority to declare a limited-time national quarantine.
We’ve spoken with Phil Kessler, a Co-Founding Partner of the law firm Hoffman & Kessler, and also a member of the Deep Knowledge Investing Board of Advisors. Phil questions the legal right of the government to suspend certain key constitutional rights. However, he further notes that any legal challenge would take longer than the potential two-week quarantine and as a result, by the time the action could be declared unconstitutional, it would have already been completed. Whether the president has the legal right to take this action or not, he has the power to execute it.
We would expect a suspension of constitutional rights and a nationwide quarantine to have a negative effect on the market.
Over-Reaction Trading Theater:
On Thursday, the market traded down 9.5% due to disappointment that President Trump didn’t declare a national emergency. When the president reversed course and did so on Friday, the market finished up 9.3%. We think people are giving the government both too much credit and too much blame. This is a situation where government action can make things better or worse, but right now, asymptomatic people are still spreading the virus, and more businesses and institutions are closing every day. The reality is that the situation is deteriorating and decisions by each of us to exercise an abundance of caution and practice “social distancing” are going to be more effective than government policy. On the positive side, the extreme volatility is creating some attractive trading opportunities.
The Federal Reserve Just Fired All of its Ammunition:
Earlier today, the Federal Reserve cut rates to almost zero, and announced $700 billion of quantitative easing. The futures promptly traded limit down. It’s hard to criticize Fed Chairman Powell here as he’s doing the best he can with the tools he has available. That said, consumer demand is down because people are afraid of becoming sick, and there’s no interest rate or level of QE that will change that. We think the Fed will not succeed in stimulating demand right now, but they have unintentionally scared the markets by signaling they know we have a tough road ahead of us.
Hard Assets Decoupling from Virtual Assets:
We’ve read a bit lately about the price of physical gold diverging from the price of the GLD ETF. If that’s the case, it would signal a loss of confidence in the financial system. We’ve tracked the relationship of these assets for years, and the long-term R-Squared is 99.8%. Since March 2nd, the R-Squared is 92.6%. On the other hand, the ratio of the price of the GLD ETF to the price of spot gold has hovered right around 94% for the past few months. Our belief is that the recent lower correlation is due to a shorter time frame and smaller data set, but if any of our readers have an alternative opinion on that, please email us. We’re open to another point of view.
What to do Now:
For the reasons described above, we still advocate being net short. We continue to hold a substantial cash position, to slowly buy companies we like where stock prices are down a lot, and to over-hedge equity exposure. In recent pieces, we’ve disclosed that we were short the market using put spreads. Last week, due to an increase in pessimism, we explained that we stopped using spreads and simply owned naked puts on the S&P 500. Because the VIX spiked into the mid-70s last week (indicating that the price of the puts we owned had become very expensive), we sold those puts and started hedging by shorting the S&P 500 (ticker: SPY).
As always, we’re happy to speak with subscribers in more detail. Other than that, we wish all of you, your friends, and family good health. We’re hoping that all of you are both careful and lucky.