Gundlach, Marks, Rogers All Agree: It’s Going To Get Much Worse

“We’re going to have the worst bear market in my lifetime,” in the next year or two.

That’s the message from billionaire cofounder (with Soros) of the legendary Quantum Fund, Jim Rogers, who told Bloomberg this morning that the impact of the virus on economies “will not be over quickly because there’s been a lot of damage. A gigantic amount of debt has been added.”

Rogers is far alone in his alarm. As Bloomberg reports, the fund manager overseeing the fortune of the Lego billionaires says equity markets remain too volatile to justify any bargain hunting.

“This is not the time to be brave,” Soren Thorup Sorensen, the chief executive of Kirkbi Group said in an interview on Tuesday,

“Volatility is at historic highs.” As a long-term investor, the best response is to “sit still and weather the storm,” he said.

Bond King Jeffrey Gundlach said similar things during his webcast last night,

“I think we’re going to get something that resembles that panicky feeling again during the month of April,” Gundlach said as economic uncertainty in April will rise further.

He added that stocks won’t hit their recent highs for a long time:

“It won’t be back to where it was prior for a long time to come,” he said, “particularly on a real basis.”

But it is yet another legendary investors,  OakTree Capital’s Howard Marks, who really laid out the case for not ‘buying the dip’ here in a 10-page note which can be summarized simply – “sell, don’t hold… worse is coming.”…

“In the Global Financial Crisis, I worried about a downward cascade of financial news, and about the implications for the economy of serial bankruptcies among financial institutions.  But everyday life was unchanged from what it had been, and there was no obvious threat to life and limb.

Today the range of negative outcomes seems much wider… 

Social isolation, disease and death, economic contraction, enormous reliance on government action, and uncertainty about the long-term effects are all with us, and the main questions surround how far they will go.”

While Marks suggests that assets were “fairly” priced for an “optimistic case,” he warns that this “didn’t give enough scope for the possibility of worsening news.”

Marks concludes on an ominous note, saying that he expects asset prices to decline.

“You may or may not feel there’s still time to increase defensiveness ahead of potentially negative developments. But the most important thing is to be ready to respond to and take advantage of declines.”

Below is Marks’ summary of the “Negative Case”:

I always say we have to be aware of and open about our biases. I admit to mine: I’m more of a worrier than a dreamer. Maybe that’s what made me a better credit analyst than equity analyst. On average I may have been more defensive than was necessary (although somehow I was able to shift to aggressive action when crisis lows were reached during my career). Thus it shouldn’t come as a surprise today that my list of cons is longer than my pros (and I will elaborate on them at greater length).

I’m very worried about the outlook for the disease, especially in the U.S.

For a long time, the response consisted of suggestions or advice, not orders and rules. I was particularly troubled last weekend by pictures of college kids on the beach during spring break, from which they would return to their communities. The success of other countries in slowing the disease has been a function of widespread social distancing, testing and temperature-taking to identify those who are infected, and quarantining them from everyone else. The U.S. is behind in all these regards. Testing is rarely available, mass temperature-taking is nonexistent, and people wonder whether large-scale quarantining is legal.

• The total number of cases in the U.S. has surpassed both China’s and Italy’s and is still rising rapidly (and is likely understated due to under-testing).

• The number of deaths doubled from 1,000 to 2,000 between Thursday and Saturday.

• From a recent tweet by Scott Gottlieb, MD, former commissioner of the FDA: “I’m worried about emerging situations in New Orleans, Dallas, Atlanta, Miami, Detroit, Chicago, Philadelphia, among others. In China no province outside Hubei ever had more than 1,500 cases. In U.S. 11 states already hit that total. Our epidemic is likely to be national in scope.”

• The U.S. is under-equipped to respond in terms of hospitals, beds, ventilators and supplies. Under-protected doctors, nurses and first responders are at risk.

I’m concerned that the number of cases and deaths will continue to rise as long as we fail to emulate the successful countries’ actions. The health system will be overwhelmed. Triage decisions – including who lives and who dies – will have to be made. There will be a point where there doesn’t seem to be an end in sight. I’m afraid the headlines are going to get much uglier in this regard.

The economy will contract at a record rate.

Many millions will be thrown out of work. People will be unable to patronize businesses. Not only will workers miss paychecks and businesses miss revenues, but businesses’ physical output will tail off, meaning essentials like food may run short. Last week, 3.3 million new unemployment claims were filed, versus the previous week’s 282,000 and the weekly record of 695,000. Prior to the government’s actions, expectations included the following:

• unemployment would return to 8-10%, and citizens would soon run short of cash;

• businesses would close;

• second-quarter GDP would decline from the year-ago level by 15-30% (versus a decline of 10% in the first quarter of 1958, the worst quarter in history);

• some forecasters said the combined earnings of the S&P 500 companies would decline 10% in the second quarter, but that seems like a ridiculously small decline. At the other end of the spectrum, I’ve seen a prediction that S&P earnings would decline by 120% (that’s right: in total, the 500 companies would shift from profits to losses).

Government payments plus augmented unemployment insurance will replace paychecks for many workers, and aid to businesses will replace some of their lost revenues. But how long will it take to get these funds to recipients? How many should-be recipients will be missed? For how long will the aid continue? ($3,400 to a family of four won’t last long.) What will it take to bring the economy back to life after it’s been in a deep freeze? How fast will it recover? In other words, is a V-shaped recovery a realistic expectation?

It will be very challenging to resolve the conflict between social isolation and economic recovery.

How will we know whether the disease merits the cure? The longer people remain at home, the more difficult it will be to bring the economy back to life. But the sooner they return to work and other activities, the harder it will be to get the disease under control.

First, the growth in the number of new cases each day has to be reduced. Next, the number of new cases has to begin to decline from one day to the next (that is, the growth rate has to turn negative). Then new cases have to stop appearing each day. (Of course, we’ll need increased testing and mandatory quarantining for these things to occur.) As long as there are new cases each day, there are people who are infectious. If we send them back into the world and into contact with others, the disease will persist and spread. And if we seize the opportunity provided by a decline in the number of new cases to resume economic activity, we risk a rebound in the rate of infection.

For the most part, we have companies whose revenues are down and companies whose revenues are gone.

They can reduce their expenses, but because many of them are fixed (like rent), they can’t reduce expenses as fast as revenues decline. That’s why second-quarter profits will shrink, dry up or turn negative. Revenues may come back relatively soon for some industries (like entertainment), but less rapidly for others (like cruise lines).

Many companies went into this episode highly leveraged.

Managements took advantage of the low interest rates and generous capital market to issue debt, and some did stock buybacks, reducing their share count and increasing their earnings per share (and perhaps their executive compensation). The result of either or both is to increase the ratio of debt to equity. The more debt a company has relative to its equity, the higher the return on equity will be in good times . . . but also the lower the return on equity (or the larger the losses) in bad times, and the less likely it is to survive tough times. Corporate leverage complicates the issue of lost revenues and profits. Thus we expect to see rising defaults in the months ahead.

Likewise, in recent years, the generous capital market conditions and the search for return in a low-interest-rate world caused the formation of leveraged investment entities. As with leveraged companies, debt increased their expected returns but also their vulnerability. Thus I believe we’re likely to see defaults on the part of leveraged entities, based on price markdowns, ratings downgrades and perhaps defaults on their portfolio assets; increased “haircuts” on the part of lenders (i.e., reduced amounts loaned against a dollar of collateral); and margin calls, portfolio liquidations and forced selling.

In the Global Financial Crisis, leveraged investment vehicles like Collateralized Mortgage Obligations and Collateralized Debt Obligations melted down, bringing losses to the banks that held their junior debt and equity. The systemic importance of the banks necessitated their bailouts (the resentment of which contributed greatly to today’s populism). This time, leveraged securitizations are less pervasive in the financial system, and their risk capital wasn’t supplied by banks (thanks to the Volcker Rule), but mostly by non-bank lenders and funds. Thus I feel government bailouts are unlikely to be made available to them. (As an aside, it’s not that the people who structured these leveraged entities erred. They merely failed to include an episode like the current one among the scenarios they modeled. How could they? If every business decision had to be made in contemplation of a pandemic, few deals would take place.)

Finally, in addition to the disease and its economic repercussions, we have one more important element: oil.

Due to a confluence of reduced consumption and a price war between Saudi Arabia and Russia, the price of oil has fallen from $61 per barrel at year-end to $19 today. The price of oil was only slightly lower immediately before the OPEC embargo in 1973, and in the 47 years since then it has only been lower on two brief occasions. While many consumers, companies and countries benefit from lower oil prices, there are serious repercussions for others:

• Big losses for oil-producing companies and countries.

• Job losses: the oil and gas industry directly provides more than 5% of American jobs (and more indirectly), and it contributed greatly to the decline of unemployment since the GFC.

• A significant decline in the industry’s capital investment, which recently has accounted for a meaningful share of the U.S.’s total.

• Production cuts, since consumption is down and crude/product storage capacity is running out.

• The damage to oil reservoirs that results when production is reduced or halted.

• A reduction in American oil independence.

As recounted above, the negative case encompasses rising numbers of infections and deaths, unbearable strain on the healthcare system, job losses in the many millions, widespread business losses and mounting defaults. If these things arise, investors are likely to shift from the optimism of last week to the pessimism that was prevalent in the rest of March. Contributing factors may include:

• negative psychology surrounding the combination of threats to the economy and life itself,

• fear of more, and 

• a very negative wealth effect that depresses spending and investing.

The TL;DR version:

Bull case: everything opens in 6 weeks. The unemployed can go back to old jobs or as true Americans, bootstrap. Economy back to normal within 6 months. 2T $ in PE dry powder, low gas prices and 0% interest rates pour fuel onto on the economy. The roaring 20’s mean the 2020’s now.

Bear case: Unemployment goes to 20%+. Everything does NOT go back to normal before at least a year or two, and in the meantime, there is a huge demand shock. The effects of the lockdown on businesses as well as the oil shock create depression-like conditions.

Trade accordingly.