Although it’s only been a little over a year since our last 20% market correction diagnosis—which everyone forgets occurred, and we covered here—we turn to the 2008/2009 financial crisis for lessons of thinking through the noise. It’s not easy to forget the pain inflicted, but it is easy to overlook how the equity market’s bottom formation occurs long before any semblance of improvement in fundamentals. Blame for today’s dislocation falls squarely on the shoulders of COVID-19 contagion fears, further exacerbated by a political cycle anxious to assign blame and an oil pricing war stemming from OPEC defections. As before, globally coordinated efforts to resolve the source of the current disruption will be required. However, we are confident that the ultimate magnitude of the required COVID-19 solution will pale in comparison to the trillions of dollars that were needed to bolster our financial institutions' foundation post-financial crisis. We're even more confident that an equity market bottom will form far sooner than a recovery in the underlying causal data, as was the case during March 2009. In the final analysis, we conclude that the current set of unique challenges are not insurmountable based upon available evidence.
What Led Up To 2009
To dust off the cobwebs to what the market faced while marking its March 2009 bottom, consider the dominoes falling long before Secretary Paulson forced government capital down the throats of major bank CEOs in October 2008. Throughout 2007, serious fissures began to form across the sub-prime real estate complex, leading to the ultimate demise of players like National City Bank, Countrywide Financial, and Washington Mutual. At the turn of 2008, the Federal Reserve responded with rate cuts while President George W. Bush signed the Economic Stimulus Act into law. Non-performing loans ("NPLs") and foreclosures soured irrespective of the early accommodative initiatives. The Fed responded again in March with a Term Auction Facility while simultaneously guaranteeing Bear Stearns' bad loans and later ushering its sale to JPMorgan. More rate cuts and auction facility increases ensued across April–June 2008, while the Office of Thrift Supervision stepped in to stem a run on IndyMac Bank (which was spun from Countrywide in 1997), shuttering it July 2008. The FDIC was forced to raise its guarantee limits in an attempt to restore depositor faith. Fannie and Freddie were placed under conservatorship by the US government. Lehman triggered bankruptcy, BofA bought Merrill, and the Fed propped up AIG with an $85 billion bailout.
All these events defined the setup to March 2009. Just four days after AIG reported the biggest quarterly loss in US corporate history—at $63 billion, coupled with $165 million in executive retention bonuses—the market determined that the pill fix had been taken. However, symptoms of contagion would persist long past its March 6th bottom formation.
Nerves of steel were required to come off the sidelines in March 2009. Every market prognosticator was barking that downdrafts of this magnitude would require over a decade to recover. A land-swell in bank NPLs continued deep into 2009. Before the contagion, NPLs averaged sub-1% of total loans—they climbed to 5.8% by December 2009. Residential mortgage NPLs persisted above 8.0% through March 2013. The largest component to most US families' net worth, their primary residence, also faced sustained headwinds into 2010, with foreclosures topping out at 2.9 million properties for the year. Home prices didn’t hit the bottom until March 2012. Investors also had to overlook the auto sector contagion, including the US government's bailout, and the bankruptcy filings of Chrysler and GM.
Much warranted anxiety was derived from a fragile banking sector that required organic and artificial means to heal. Trillions of dollars had to be raised to shore up tier one capital ratios from their current sub-7% levels. It took until 2014 to get this ratio north of 12%, a solid six-year effort. The Federal Reserve also needed to throw trillions of dollars at the problem, causing its balance sheet to tip $4 trillion by December 2013, while its European Central Bank counterpart later hit the €4 trillion mark in March 2017. Any investor eyeing these institutions for the "all clear" sign likely missed the +50% move off the bottom that arrived by August 2009 as well as the +97% move that unfolded by February 2011.
Fast Forward to Today
Although identifying the precise "all clear" signal will be just as challenging, we are confident that the magnitude of response is unlikely to require anything close to the trillions of dollars needed for the last major downturn. Instead of tracking NPLs and housing data, we turn to the World Health Organization ("WHO") for proxies. Even though China's experience may not be analogous to the democratized developed world, WHO data show new daily cases peaking on February 12th in China, with its daily occurrence dropping to 103 as of March 6th (see Chart 1 below). Total confirmed cases stand at 80,924 in China, representing 0.006% of its total population. Given China is ground-zero for COVID-19, it's plausible that the aggregate number of confirmed cases could be under-reported, as early testing resources were at best unavailable or worst, suppressed. However, this would make COVID-19's mortality rate lower in relative terms, given the upside bias to its denominator. As South Korea draws the short straw to battle the virus next, we've seen a peak form in its daily incidence. On February 28th there were 813 new cases—by March 9th, it fell to 131 new daily cases (see Chart 2 below). With arguably more modern healthcare resources at its disposal, South Korea has also been experiencing 1/5th-1/6th the mortality rate of WHO-published China results, placing it much closer to parity with the common flu.
The real challenge may not be how we manage contagion of COVID-19, but how we manage the contagion of fear in a world where platforms like Facebook, Instagram, YouTube, WeChat, and Whatsapp garner over a billion users each. A health risk factor that was non-existent in the eyes of the masses a year ago is now plastered across the world's news feeds, walls, and DMs. This is a dynamic and evolving situation with incidence in North America in its infancy. As equity investors, we must always draw conclusions based on imperfect information. Even though the epidemiological risk may be immaterial at the broader population level, it very well may become a self-fulfilling prophecy. Consumer confidence responds to perceived levels of elevated risk rather than actual risk. Consumers curtailing vacation and entertainment spend, canceling flights and hotels, avoiding gatherings, and stocking up on non-perishables will undoubtedly have economic impacts.
If any of the early WHO incidence curves are indicators of how and when subsequent countries will get over the hump of new daily cases, a plausible scenario is that rational minds will prevail in weeks or months, not quarters or years. They also will be regaining consciousness to a world with cheaper gasoline (via low-/mid-$30s per WTI crude barrel), a cheaper stock market (now 15.5x forward-P/E on the S&P 500), and a plethora of discounted travel and leisure options.