March Newsletter Title
“A great book seeks to explain causality, not correlation. It works to point out the circumstances in which it works, and where it doesn't. And in so doing, it is broadly applicable.”
- Clayton M. Christensen
March came in like a lion. I am of course referring to the hit Netflix series, “Tiger King” which broke records for streaming content and emerged as both the top-rated and most watched series in the United States. It’s almost as if people had nothing better to do than sit around and watch a colossal train wreck of poor judgement, borderline criminality and terrible risk management. We hope this isn’t an analog for our current global policy responses. Hopefully you’ve had the opportunity to read our recent thought piece, “Policy in a World of Pandemics, Social Media and Passive Investing”. We are gratified with the response so far and look forward to sharing more thoughts on a regular basis. As March ends, we are also excited with the launch of the Logica Absolute Return Fund in April – our first commingled product. Please reach out to Steven Greenblatt (Greenblatt@logicafunds.com) for further information.
It wouldn’t be unreasonable to extend the chaos of Joe Exotic to the performance of the S&P500 which managed to deliver one of the worst monthly returns in the past thirty years and by far the fastest bear market drawdown from an all-time high.
Is It Different This Time?
We are experiencing an unprecedented event. There is no published account of any experience in which a society has intentionally shut down its productive capacity to slow (not eliminate which is impossible) the infections and deaths associated with a pandemic. While comparisons are often made to the 1918 Spanish Flu epidemic that killed over 500,000 Americans and nearly 50 million worldwide, the steps taken for COVID-19 dwarf any attempts at mitigation from that period. As researchers demonstrated in 2007, attempts at mitigation in 1918 did not end the pandemic, they merely slowed its progress. For a disease that targeted the young workers and soldiers, society made the choice to keep going on the factory floor and the battlefield.
Early implementation of certain interventions, including closure of schools, churches, and theaters, was associated with lower peak death rates, but no single intervention showed an association with improved aggregate outcomes for the 1918 phase of the pandemic. These findings support the hypothesis that rapid implementation of multiple NPIs can significantly reduce influenza transmission, but that viral spread will be renewed upon relaxation of such measures. – Hatchett et al 2007
In 2020, a very different decision is in play. Globally, the focus has been on preventing an overburdening of healthcare systems and to do so we have shut nearly all “unessential” businesses. These decisions have been made with very little consideration for the rapid innovation that occurs during times of systemic stress. For example, the frequently cited ICU and ventilator shortages have been addressed with the establishment of field facilities (e.g. the Javits Center in NYC) and the extension of ventilator capacity to serve multiple patients (an innovation demonstrated nearly 15 years ago) that roughly quadruples the existing capacity. Retired and inactive medical personnel have willingly volunteered to address expected labor shortages with over 76,000 volunteering in New York alone, a surge of roughly 15% of total capacity including home health aides; if we exclude this subspecialty, it is nearly a 30% increase in capacity.
Medicine has triumphed in modern times, transforming the dangers of childbirth, injury and disease from harrowing to manageable. But when it comes to the inescapable realities of aging and death, what medicine can do often runs counter to what it should. – “Being Mortal”, Atul Gawande
Likewise, we must consider the impact of the shutdowns on those who would be otherwise unaffected by the virus. A timely study from October 2019 identifies the long-term impact of entering the labor force during recessions. Historically, it was believed that these effects were mostly economic and faded over a 10-15 year period, but Schwandt et al 2019 note that “unlucky” labor market entrants experienced persistent adverse outcomes on mortality and behavioral health. This past week we began to get the data on the impact on the economy – it isn’t pretty with unemployment posting dramatically higher among the less skilled workers who bore virtually all the pain. This suggests that the loss of productive workers is simply the beginning of a dramatic “own goal”.
The current economic consensus seems to be coalescing around a decline in economic activity that has never occurred in the modern era for advanced economies. Goldman Sachs is leading the charge in estimated GDP decline with -9% in Q1 and a staggering -34% in Q2 (both in annualized numbers), before recovering in Q3 and Q4. These numbers would imply a trough in US real GDP in Q2-2020 at $17.2T, a level equivalent to December 2014 and suggesting a decline in GDP/Capita of nearly 11%. In contrast, the Global Financial Crisis saw rGDP/Capita decline by only 5.3% in the US.
The GS forecast is heavily dependent on a key assumption that GDP can be accurately forecast by a variation of Okun’s Law. As they note, “Normally, the coefficient for Okun’s law is thought to be about 2, meaning that a 1pp rise in the unemployment corresponds to a 2% hit to real GDP. During this crisis, however, a more appropriate Okun’s law coefficient is likely to be closer to 1… Our current estimate of a roughly 12pp increase in the unemployment rate implies a roughly 12% peak decline in the level of GDP.”
Replicating this analysis is quite straightforward and of course we get a similar answer to GS given the assumption of a 12% increase in unemployment rate (to 15.5% by Q2). However, there is interesting information generated by providing the historical relationship as seen below. Since 2002, the historical relationship has clearly broken down. Expecting an Okun coefficient of 1.0 (11% GDP decline) seems quite arbitrary with the range of GDP outcomes from positive to -45%. In other words, we simply don’t know. Pretending otherwise would be foolish.
What we do know, however, is that the stimulus programs to this point have focused on one very clear objective – providing incredible support for the large corporates in the United States. As the early information on unemployment in the United States makes very clear, the job losses have been concentrated in the ranks of the unskilled and the multiple job holders. Perhaps they will spread aggressively to the white-collar salaried ranks currently working from home, but there is reason to be skeptical. The large corporate sector has availed themselves of lines of credit and many of them have used their large purchasing power to unilaterally “negotiate” extraordinary terms, e.g. Cheesecake Factory announcing suspension of rental payments. With trillions in stimulus at play, it seems difficult to imagine a scenario in which large corporates do not emerge with less competition and more pricing power. That this occurs against a backdrop of growing political unification in favor of massively increased government deficits and support for diversifying supply chains away from China seems likely to drive even further consolidation. It is tempting to refer to one of the greatest movies of the 20th century, “Demolition Man”:
Demolition Man not only forecast casual dining consolidation, but also predicted a future toilet paper shortage. At Logica, we have no such forecasting skill. We do not know how this will ultimately play out. Given this uncertainty, it seems odd that most of the focus is to the downside. One simple observation is that the longest historical equity index dataset, the Dow/Gold ratio, has again moved below trend. Excluding dividend yield, the DJIA is only up 0.9% per year for the last 100 years. Since the trough of the GFC, price gains are only 5.7%/year despite huge buybacks. Is it possible that the large US corporate sector is “cheap”? In all seriousness, only the future can answer this question.
Regardless, Logica remains committed to expressing this humility in our trading strategy. As volatility begins its inexorable retreat, we are again looking to deploy capital and convert our option rich cash balance back into risk positions. In both Logica Tail Risk and Logica Absolute Return we understand that we cannot know the future, but that there are phenomena that do not appear to have run their course – namely the passive sector continues to take share from the active manager segment. One piece of evidence supporting this thesis is the continued outperformance of momentum strategies. If salaried employment (and hence 401Ks) is supported by stimulus, we believe there is a very good chance that currently vindicated bears will again be running for their caves due to the impact of passive share gain. If we’re wrong, our downside is always protected.
“Everything serious in the world is well approached by humor. It's a powerful and often quite subversive tool. I suppose there is an argument that could be made against me for being frivolous, but I do think a laugh is a very generous thing to give.” Beeban Kidron, House of Lords
“Public health interventions and epidemic intensity during the 1918 influenza pandemic”
Richard J. Hatchett, Carter E. Mecher, Marc Lipsitch
Proceedings of the National Academy of Sciences May 2007, 104 (18) 7582-7587; DOI: 10.1073/pnas.0610941104
“A Single Ventilator for Multiple Simulated Patients to Meet Disaster Surge” Neyman et al 2006
Bienvenu, O., Gellar, J., Althouse, B., Colantuoni, E., Sricharoenchai, T., Mendez-Tellez, P., . . . Needham, D. (2013). Post-traumatic stress disorder symptoms after acute lung injury: A 2-year prospective longitudinal study. Psychological Medicine, 43(12), 2657-2671. doi:10.1017/S0033291713000214
“Socioeconomic Decline and Death: Midlife Impacts of Graduating in a Recession” Schwandt et al, 2019