Satan's apple

Investing by the broad view is alluring. When performed in hindsight, it’s inevitably profitable, and requires far less work than sweating through the details.

Navigating the 1990s? Be aggressive. Productivity gains from technology advances plus subsiding inflation will combine to create a great bull market. Beginning the New Millennium? Retreat. When an index’s price/earnings ratio hits 80, as did that of the NASDAQ 100, nothing good will happen.

Sadly, anticipating the future is more easily said than done. What’s more, because stock prices reflect consensus beliefs, it’s not enough to see what others perceive. Entering the 1990s, US equity investors knew that inflation had been tamed and that technology was rapidly improving. However, profiting from that knowledge required realising that events would be even better than expected.

Recognising this difficulty, I had never invested on the big picture. Perhaps that was because my introduction to the financial markets came in late 1987, when dire predictions of impending doom, uttered after Black Monday’s crash, proved wholly false. The economy chugged along, with equity prices gradually recovering their lost ground. The pundits had failed. Better to emulate those who never claimed to possess such understanding, such as Fidelity Magellan’s Peter Lynch, who would later write, “If you spend more than 13 minutes analysing economic and market forecasts, you’ve wasted 10 minutes.”

(Which, by the way, is a peculiar quote. If you spend 13 minutes analysing macroeconomic data, fine. However, if you spend 14 minutes on the task, then you have wasted 10 minutes, which means that the sensible limit is 4 minutes, rather than the original 13 minutes. But geniuses are often inscrutable.)

Taking a bite

This March, I broke my long fast. The stock market had already plummeted, but I believed that it had further to go, because the economic consensus appeared to be overly optimistic. For example, on March 16, the UCLA Anderson School of Business forecast called for a 6.5 per cent second-quarter drop in US gross domestic product, with a resumption of fully normal business activity by the fourth quarter. That same month, Oxford Economics (a private firm, not the university department) published a “downside scenario” of a 2.5 per cent GDP decline for calendar year 2020.

Such outcomes struck me as utopian. Surely the economic damage caused by the coronavirus pandemic could not be so easily contained. If the US imposed drastic measures, the second quarter’s GDP slide would be far worse than 6.5 per cent. And if the government took a gentler approach, then the coronavirus would linger, thereby harming the economy for the foreseeable future. Either way, those GDP projections could not be met.

For the first time in my investment life, I possessed conviction. I felt, strongly, that I recognised better than other observers the economic problems that COVID-19 would inflict upon the United States. These struggles, presumably, would further depress equity prices. I resisted the drastic step of selling stocks, but I did spend 2 per cent of my portfolio on stock-market puts. From my perspective, I had become an honorary member of “The Big Short,” while looking less silly than did Brad Pitt.

Right but wrong

My economic intuition was correct. The second quarter’s GDP decrease was a whopping 33 per cent, the largest US quarterly decline ever recorded. The calendar year is of course not yet completed, but when it finishes, its results will also trail expectations. For example, the recently published “upside case” for this year’s GDP from economics researcher The Conference Board is worse than that of UCLA Anderson’s previous “downside scenario.”

None of which benefited me in the least. The stock market immediately and (from the perspective of three-month options) permanently reversed course within a few days of my transaction, leading my puts to expire worthless on 30 June. Easy come, easy go. Or at least, easy go.

The problem was, my thesis was only half correct. My skepticism about the length and depth of COVID-19’s effects was warranted. What I had missed, however, was that unlike in 2008, the contagion would not spread. When this year’s panic arrived, the banking system was well capitalised; the Federal Reserve immediately instituted strong countermeasures; and Congress promptly passed a stimulus bill. These strengths convinced equity investors to overlook the current bad news.

Those items were not impossible to foresee. Had I thought harder and longer, I could potentially have anticipated their effects. When I made my trade, Morningstar’s banking analyst, Eric Compton, had already noted that banks had addressed their previous deficiencies. Predicting the government’s response would have been trickier, but I could have considered that policymakers would have been desperate not to repeat 2008’s systemic failures.

Practical difficulties

These items, however, are clear only in hindsight. At the time, it was very tough to perceive that of all the factors that might affect the next few months’ equity prices--1) COVID-19’s spread; 2) the pandemic’s near-term economic effects; 3) the banking industry’s health; 4) Congressional acts; and 5) the Federal Reserve’s actions--those five would prove to be the most important. Nor was it easy to realise that the latter three items would dominate the first two.

Even that discussion oversimplifies the analysis, because it overlooks global issues. No matter how the US had reacted, if (say) Western Europe’s bourses had remained at their March levels, American equities would be trading well below today's prices. One tends to talk of the US stock market in isolation, to streamline the research, but that is not how equity prices behave.

Once burned, twice shy. I won’t invest on the big picture again - at least not until the memory of this year’s debacle fades.

John Rekenthaler ([email protected]) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.