Updated: Nov 3, 2020
This is not investing advice. Seek a financial professional before making important financial decisions. This article is for informational purposes and should not be interpreted as a recommendation to buy/sell/or trade any security.
Investors who bought cruise lines in late March were brave. But despite a rapid development of vaccines, cheap refinancing options, and an economy that has rebounded to within 97% of its peak...these investors have made almost nothing. Investors since March have nearly all lost money. Catching a falling knife is hard, but if you do it right it can be very profitable.
In this post we explain why we are buying stocks hit hardest by the pandemic on Monday at the close. We argue that the threat from COVID19 is largely psychological, and list the catalysts that we believe are about to change investor psychology toward these stocks.
This new reopening trade goes hand in hand with our short on the pandemic. Our last strategy piece focused on the election and our expectation that the second wave of the virus and lack of cheap options for hedging the election would lead to a selloff in stocks. We shared our first Periscope reiterating our call the day before Friday's selloff. We plan to keep these shorts on SAR-CoV-2 stocks like Zoom and Teledoc, but now wish to pair these against long positions that would benefit from a reopening.
In this piece we lay out our strategy starting with our reasons for believing the pandemic bubble has popped, why we think that now is a good time to bet on the re-opening, and our strategy for executing this trade. We take each in turn...
Pandemic Bubble Pop
Timing the Reopening
Hardest Hit Industries
Pandemic Bubble Pop
Companies most closely associated with benefiting from the pandemic are underperforming the broader stock market for the first time since March. This has been the case since early September, but accelerated this past week. The trend up broke in September, The trend down was signaled yesterday. This is evident from the online retail ETF "ONLN"...and to a lesser extent the large tech ETF "QQQ". But the real bubble is not in companies like Amazon or Apple...
Online Retail (ONLN)
Big Tech (QQQ)
The Pandemic Bubble is in companies like Zoom, Petoton, Teledoc, Wayfare, and other companies you can view on our Portfolios page under "COVID19 Short". These compnies tanked on Thursday when the stock market rose. Then they tanked again on Friday as the stock market fell.
The narrative today is all about the second wave ... so why would these companies lose so badly when the market is down...presumably because of the pandemic?
Because its not about the pandemic.
These companies did benefit from the lockdown and some effects will be sticky, but the run-up in price left reality a long time ago. You can see it in the price...but even more you see it in the volumes.
Peloton (PTON) is a good example. This company charges people $39 a month do access streaming workout videos that seem indistinguishable to us from free videos you can watch on YouTube. They also don't make any money. On the flip side...they are growing at about 100% a year and has been since at least 2017. The company had its IPO at a price of $27 where it stayed more or less until the pandemic. After an initial selloff, Peloton soared to a high of $140 equating to a market capitalization of $40 Billion. Despite falling nearly 3% in two weeks it is still trading at double its 200 day moving average, and we would argue...potentially even higher above its intrinsic value.
American Movil (AMX) is currently valued at $40 Billion...the same as Peloton two weeks ago. But that's about all these two companies have in common. AMX trades as a price-to-sales of 0.84 compared to PTON at 17.5. For paying about 25 times more per dollar of revenue, investors in PTON get zero dividend...whereas those in AMX receive 3% annually or about four times a Treasury Bond. América Móvil is the leading provider of integrated telecommunications services in Latin America, and has more wireless subscribers than any company in the world outside of China and India. Peloton offers a bicycle that doesn't go anywhere.
AMX fundamentally performed well during the crisis as customers continued to pay for their wireless services. As a result...revenues and profits rose relative to 2019. And for this...investors slashed their valuation on AMX from $18 at the peak to just under $12 today...or 30% down.
Investors should be asking why a company like Peloton is valued anywhere close to American Movil. And the answer is pretty simple. We have been living in the same narrative for eight months, and that narrative benefited Peloton and hurt American Movil.
Since March the narrative that has been nothing but non-stop COVID COVID COVID every time you turn on the TV, put on a mask, and talk to friends on a screen. That narrative says that we are all moving online forever, that we will never take a cruise again, and we will all now and forever more work from home.
Investor narratives say interest rates will now stay low forever because of debt and the permanent damage to the economy, that emerging markets like those in Latin America will fall apart, experience rampant inflation, and currency devaluations. Brick and morter is dead because we will all now buy everything online. As a result...investors sold pretty much everything except for US and Chinese tech stocks that we needed to get through the lockdowns.
At this point...astute readers will recognize that there is some truth to these narratives. We don't pretend to know the extent to which behaviors will change. We don't need to. All we need to know is that the narrative is about the change.
Timing the Reopening
We plan to start buying on Monday at the close. In this section we explain why...but the short answer is that we believe tomorrow is "Peak Fear" day. We first explain why we believe the threat of COVID19 is largely psychological. From here we explain why we believe investor psychology is about to turn positive...or at least move on to a new narrative that isn't centered on COVID19.
An big criticism of our timing would be the now obvious second wave. New lockdowns are popping up in the news. Many reading this might think we are a bit crazy for thinking that now is a great time to buy stocks like cruises and airlines. And they would be right...if this were the Spanish Flu. But this isn't the Spanish Flu...this is COVID19...and the threat of COVID19 to the economy is largely psychological.
The Spanish Flu was devastating to the economy because it killed over 2% of infants and nearly 1% of working adults it infected. In contrast, the average age for a COVID19 death is about 75 years of age. Fatality rates are less than 1% and falling because of rapidly improving treatments.
We forget that 1918 was a very different time...where economies were largely dependent on physical labor and lacked the technologies we have today. Many have suffered during 2020. Millions lost jobs. Domestic violence and drug abuse rose dramatically. But to draw comparisons to the 1918 Spanish Flu is quite absurd. In reality, this was a cakewalk for the vast majority of high income households that got to work from home while the Fed showered the economy with enough money to actually raise wealth and income levels. The top 50% of households drive 80% of consumer spending which in turn drive 70% of the US economy. We aren't saying this is good or bad. We are simply stating facts.
The reality is that the threat of COVID19 to the economy to the point that it effects behavior. If it scares politicians and consumers into lockdown then it will hurt the economy. We are seeing this play out in real time. Google Trends show that searches for "Lockdown" are on the rise again for the first time since the Spring.
But notice that searches for "Pandemic" and "COVID Symptoms" is not surging...at least not yet. This seems to reflect the lack of surging deaths in the US. We are watching Google Trends carefully because they reflect sentiment...and how people feel is what matters.
We see three catalysts that we believe are about to change how people feel about COVID19.
We see several catalysts for a quick rebound in stocks hit hardest by the pandemic over the coming days and weeks. Reopening catalysts include...
Election "Risk Event"
Slowing Death Rate
The Election is a known "Risk Event". Stocks tend to have outflows before a big known risk like an election. The psychological reason for this is a generally overweighting of known risks. By over-pricing we mean that known risks are, on average, given a greater weight then they deserve relative to the severity of the known risk. Elections are a great example. Below you can see the average outflows before elections going back to 2004. These outflows are almost immediately followed by inflows...even when the risk event worrying investors occurs, such as Trump's victory in 2016. Our short position is timed to get ahead of this outflow and cover before the inflows.
The importance of the election is magnified this year by all the anxiety in 2020 from the pandemic as well as Trump's attempts to undermine faith in the election process as well as his unwillingness to state plainly that he will accept the outcome of the election should he lose. All the anxiety investors feel today is clearly evident from the high levels of cash held in money market funds ...
And the cost of put options as measured by the VIX which is currently higher than any point in 2019. Of course, bad things could happen after the election. We discussed tail risks in our Election 2020 strategy piece. What is different today is that the high VIX and market selloff is telling us that many bad scenarios are already priced in.
The second catalyst we see is a slowing death rate. The second wave is clearly evident from rising confirmed cases which have already surpassed summer highs. Hospitalizations are rising as well, but are still below summer highs. Will these infections translate into deaths?
We have had rising confirmed cases for seven weeks and rising hospitalizations for five weeks. Despite this second wave arguably starting a month an a half ago...death rates only started to rise two weeks ago, and failed to reach a new high this past week.
Could death rates continue to rise next week?
Yes...that is our expectation...but it seems clear to us that mortality from the virus has continued to fall as we employ ever better treatments and the most deadly strains of the virus fail to reproduce.
The third a final catalyst we see is the vaccine. Current expectations put a vaccine being available to 25 Million sometime in 2021Q1. There is a 90% expectation that this will occur before the end of 2021Q3. We fully expect that by the time a vaccine is announced that prices of the most beaten down stocks held back by the pandemic will have already started to recover because too many insiders will have access to this information for it to be fully kept quiet from the public.
In conclusion...we expect the near term catalysts of the election, potential for falling deaths despite rising cases, and expectation of a vaccine announcement to propel beaten down stocks starting Tuesday.
Why Tuesday? ... because Monday is "Peak Fear" day making Tuesday the first day of the rebound.
While we can't time the peak in deaths...or the vaccine...we all know the election is Tuesday and the election is key.
The election is key because COVID19 has been used as a political tool by both parties. Trump is using the fact that he recovered quickly from COVID19 as a reason people should stop letting it impact their behavior, and in turn not blame him for the damage it has done to the economy. Republican's as a group have been less likely to wear a mask for this reason. Democrats rightly point out that Trump is largely responsible for the USA having one of the highest infection and mortality rates in the world. But if Biden wins we expect that Democrats will also start to acknowledge the falling mortality rates, the damage of keeping schools closed, and other Republican talking points ... because if they are in power it will be more politically convenient to do so.
Incidentally...if we are right on our timing it would be a good case study on why people with strong political views tend to make bad investing decisions around elections.
3. Hardest Hit Industries
People, places, and industries have been affected by the pandemic positively and negatively. We are looking at a few areas that have been negatively impacted and discussing whether or not it will go completely back to normal once there is a vaccine announced. The things we are going to discuss are restaurants, cruise lines, hotels and resorts, gyms, commercial real estate, and airlines.
Dine-in restaurants were definitely negatively impacted during the pandemic. This chart from calculatedriskblog.com shows the 7 day average of people going to seated diners from online, phone, or walk-in reservations. There was a huge crash when the pandemic hit and that number has been going up and down according to death rates from covid.
Restaurants are probably one of the first things to go back to normal once there is a vaccine. And since everybody will still need to eat it will probably go right back to normal with no noticeable impacts from the previous pandemic. Bankruptcies across smaller non-public restaurants will probably help profit margins for years to come.
Cruise lines are another area that have been negatively impacted by the lockdown. Shares of three major cruise lines had gone down 70 to 80 percent from the beginning of 2020 to April. Here’s a chart of the percent decrease in revenue of three major cruise lines.
There will probably be an increase in cruise line occupancy once a vaccine is announced. But things may not go completely back to normal since people may still be scared of going back on a cruise because when you go on a cruise you can’t escape. And if someone on the cruise gets sick, you aren’t able to leave the ship. So while we will probably see more people on cruises once a vaccine is announced we may not see things going completely back to normal for the cruise line industry.
Hotels and Resorts
Hotels and resorts is another big area that was negatively affected by the pandemic. Here’s a chart from calculatedriskblog.com comparing hotel occupancy in previous years to 2020. The chart shows that hotels have gone down 31.7 percent so far and is worse than in 2009 which was the worst year, based on hotel occupancy, since the Great Depression. Hotels and resorts will probably go completely back to normal since people will want to go on vacation and there wouldn’t be any reason to be fearful about getting COVID-19.
Gyms were greatly impacted as well from COVID-19. Here’s a chart from a report on COVID-19 impact of gyms that shows the amount of gym visits in Alabama, Georgia and Texas.
Gyms will probably get a lot more people going to them once a vaccine is announced. But whether or not it goes completely back to normal depends. People may have found great youtube fitness channels and don’t see a reason to go to the gym when they can work out at home. And with gym equipment, many people have been touching the same things and that may bother some people after trying to be sanitary. But some people may really enjoy having a lot of different kinds of equipment at their expense and just love going to the gym. Gyms will probably get a lot more visitors once a vaccine is announced, but will it go completely back to normal?
Commercial Real Estate
The amount of people going to the office dropped significantly when COVID-19 hit. Here is a chart from kastle.com of the average occupancy rate in ten cities in the United States. Almost all office buildings have been empty or with few employees actually working at an office building. Once a vaccine is announced it doesn’t mean that everything is going to be completely back to normal. Many companies have announced that they are going to allow their employees to work from home. So while the occupancy in commercial buildings will probably increase, things might not be the same as before.
Airlines were affected by the pandemic for various reasons, but two stand out. One, there hasn’t been a vaccine yet so people are afraid of getting COVID-19. And two, 12% of airline passengers are for business reasons and a lot more people are working from home. Also, 75% of profits gained from passengers are for business since companies want to make sure their employees are comfortable on their plane rides because if an employee shows up tired, they won’t be able to do their job as well.
Here is a chart comparing the number and percentage of people traveling on planes in 2019, compared to 2020. As you can see, there was a tremendous drop, but it may not bounce back to normal once there is a vaccine. The reason why is because it is likely that more people will be working from home rather than going to the office. This would mean less plane trips needed for business which is significant because so much of the profit for airlines are coming from business passengers.
Airlines will probably go up because a vaccine eradicates the first reason why people wouldn’t want to go on cruise lines, because they are afraid of getting COVID-19. But they probably won’t bounce completely back because more businesses are getting comfortable with their employees working from home, which would result in less business passengers. Also because a vaccine in America doesn’t necessarily mean a vaccine internationally so not all countries may be allowing any people traveling to their country.
We now turn to the reopening portfolio where we combine the analysis above with insights from steeply discounted stock and ETF prices.
4. Reopening Portfolio
We begin our search for the reopening portfolio by looking for stocks that seem best poised to do very in a world no longer dominated by fears of the pandemic. So what does that world look like?
Six months from now we expect benchmark interest rates to rise as inflation expectations pickup from broad based increase in consumer spending. This should hurt Treasury bonds and perhaps even investment grade corporate bonds, but junk and leveraged loans should benefit from tightening credit spreads. We expect the VIX to fall as hedge funds scale back their demand for insurance against falling stock prices and embrace the bull market. We expect investors that sat on the sidelines through 2020, some of which sold at the March lows, to throw in the towel and buy into rising prices. We expect fears of the pandemic to slowly subside which should hurt stocks tightly associated with COVID19 and drive higher earnings expectations for stocks hurt by lockdowns.
Growth stocks could potentially get hurt by this new environment even if they were not direct beneficiaries of the pandemic. The reason would be higher interest rates. Even a modest increase in the 10 Year Treasury yield from 0.86% on Friday to 1.2% sometime in the next six months would meaningfully reduce the present value of future cash flows from growth companies we own such as Tesla and Materialize. That's one reason why these companies were selling off this past week harder than the S&P 500.
So who wins in this future environment?
We screened for ETFs that fit the following criteria as a first step in our selection process...
Down over 20% year to date
Negative earnings per share (EPS) in 2020
Price to Sales under one (considered low)
Positive EPS and revenue over the past five years
Positive dividends over the past 12 months (which includes pre-crisis)
These criteria revealed some expected and some not so expected ETFs that we use to identify broader trends in the market. We then ranked these ETFs using a formula that looked for the most extreme matches. For example, the Brazilian small cap ETF (EWZS) had one of the biggest drawdown despite having relatively high EPS and Revenue growth over the past five years. The 20 top scoring ETFs are listed below.
These ETFs generally had one or more of the following criteria...
Small and Micro Cap Value
Mid Cap Low Beta
Financials, Aerospace, Defense, and Oil/Gas Industries
Domiciled in Brazil and Russia
We then overlaid these criteria with some judgment calls based on our analysis of the fundamentals. The reason here is that we believe some of these ETFs sold off for good reasons so we wish to avoid value traps. For example, we don't think the oil & gas industry is going to do well in coming years because of the transition to electric. Russia is heavily dependent on oil and gas so we don't want that.
We then added stocks that we believe to have a strong correlation to the pandemic narrative. These include stocks that ...
Investors are scared to own like cruises, airlines, commercial real estate, and hotels
Have lots of cash on balance sheet to get them through at least 2021
Have fewer competitors post crisis because of bankruptcies and mergers
Had generally rising stock prices before the pandemic.
We added these new "Reopening" strategy positions to our existing portfolio as shown below. Note that these positions are subject to change without notice.
Here are the long positions broken out by strategy...
Here are the offsetting short positions we have retained as part of our "Short Pandemic Bubble" strategy explained in our last strategy post...
Here is a breakdown of our strategy and asset class weights. Note that these weights often overlap...
We don't expect the outcome of the election to have tremendous implications for markets. Six months from now we are likely to have a vaccine, but even if we don't we are likely to have much better therapeutics for fighting COVID19. As we return to "normal" we expect investors to broadly turn toward a new narrative.
We don't know for sure what that narrative will be, but we are pretty sure that six months it won't be about the pandemic. Next Spring we expect children to be going back to school, families going on vacations, planes in the sky, and cruise lines sailing the Caribbean. There will likely be some permanent changes in behavior. Many people will be working remotely one or two days a week. But for the most part we expect office buildings to be largely re-occupied and many business people to start flying again.
It's hard to imagine what life was like before the pandemic. But we think we will start to remember shortly after the election...