Markets’ Worst Tail Risk Belongs to a Furry Mammal

1 week ago 33
Points of Return

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Uncertainty, Pre-Vaccine and Post-Vaccine

The post-election world is growing a little clearer, even if it is still not, alas, the post-Covid world. Thursday offered the inspiring online spectacle of three powerful central bankers — Andrew Bailey of the Bank of England, Christine Lagarde of the European Central Bank and Jerome Powell of the Federal Reserve — undergoing a grilling from my former colleague Roula Khalaf, the editor of the Financial Times.

Three days after the exciting news of the Pfizer/BioNTech vaccine results, they made it plain that the virus was still their greatest concern: "We do see the economy continuing on a solid path of recovery, but the main risk we see to that is clearly the further spread of the disease here in the United States," said Powell. "With the virus now spreading, the next few months could be challenging."

That was interpreted as a reminder that the Fed expected to have to keep intervening to keep rates low, and bond yields dutifully fell. The problem is still with us; and as an anxious New York City parent facing the prospect that schools will be closed to in-person lessons again any day now, I can see all the reasons for caution.

The most revealing answers came when Khalaf channeled another old colleague, Martin Wolf, who wanted to ask what most frightened the central bankers. Answers all centered on the virus.

Powell focused on the "base case" — of enduring effects on particular groups, including women, the young, small businesses, and those made long-term unemployed. It is still hard to discern how deep the economic "scarring" effects will be. But there will be wounds, which will serve to worsen divisions in society that were already dangerously wide a year ago.

Lagarde was worried about distinct "tail risks" — the hubris and stupidity that can lead to war and, more specifically, the case of the Danish mink. For the uninitiated, the virus has shown the ability to jump to the animals, mutate, and then come back to humans. This is just what epidemiologists hoped wouldn't happen. Among the many potential repercussions, it is possible that vaccines may not protect against the mutated virus — although Anthony Fauci, the top U.S. infectious disease official, suggested this was unlikely.  

So, there are tail risks. What is the base case? It is definitely worse than it appeared a few weeks ago, even if Covid remains far less deadly than appeared possible in spring. I strongly recommend the intellectually rigorous and honest pandemic updates from former hedge fund manager Whitney Tilson of Empire Financial Research. Having supported the theory that the disease reached an effective "choke point" when about 20% of the population in a given area had been infected, he suggests in his latest bulletin that the current wave is "likely to be somewhat worse than  I estimate." He also, however, says that the broad outlines of the theory, which I've discussed in several past newsletters, still stand. First of all, while cases (positive tests) in the U.S. are off the scale, deaths remain far below the spring high. The critical measure is the number hospitalized, which is its highest all year: 

In New York City, where a 10 p.m. curfew starts Friday, total hospitalizations have doubled over the last two months:

However, they don't compare with the horrific levels witnessed in April:

This tends to fit with the "choke point" notion, that once a certain proportion of people have caught the disease, it will be far less deadly. There are limits, though. Without a vaccine, mask-wearing and avoiding large gatherings still make sense.

The three states worst affected — Montana and the two Dakotas — had all avoided a serious outbreak until now. That left them vulnerable. These are the charts for Montana. Those for North and South Dakota are virtually identical:

Yet look at Harris County, which includes the city of Houston. Like New York, cases have picked up again but remain at a far lower level after a serious outbreak earlier this year:

This helps to explain the issues for the U.S. The vaccine isn't going to arrive in time to avoid what Joe Biden has called a "dark winter," in which economic activity will be considerably limited.

Globally, many places still haven't had their first outbreak. Cases continue to rise (in a way that can only partially be explained by more testing). And the global death rate is, again, at its highest level yet. This summary chart was produced by Deutsche Bank AG:

The more people are worried, the less they will move around, so the prevalence of the virus is bad news for the economy. Government responses are also important. There shouldn't be a need to return to lockdowns as tight as the one that covered much of Europe in the spring, but government policies are becoming stringent, amid much more anger and disappointment. This chart is from NatWest Markets. None of the lines on it, covering the main European economies, is likely to come down this side of Christmas:

After Monday's vaccine excitement, the world's two most important financial markets came close to important landmarks but balked and retreated somewhat Thursday. The S&P 500 neared its all-time high from September, while the 10-year Treasury yield approached 1% before sliding back.

That seems reasonable. We have several more months before the vaccine can help. After that, as Powell said, we will discover how deep the scars are. The plight of the Danish mink reminds us that tail risks remain. The vaccine has taken markets as far as it can for now.


Vaccines: Architecture and Morality

It looks as though at least one technology for vaccinating against Covid-19 basically works. This is great news. Two critical issues remain. Borrowing from the title of one of my favorite albums, they are Architecture (how to arrange the massive logistical operation of getting the vaccine to people) and Morality (the difficult ethical questions in building that architecture).

The logistics of distributing vaccines are daunting, particularly for the Pfizer Inc. version, which requires sub-freezing temperatures. Supply chains are stretched. As the vaccine cannot arrive all at once, that will create moral choices. Who gets it first? Can people be compelled to take it? Scott Duke Kominers and Alex Tabarrok even argued for Bloomberg Opinion that a vaccine lottery might be the fairest method. You could also read this important piece in Science magazine, led by Ezekiel Emanuel, who will be on Biden's Covid task force, or my own lengthy essay from August.

I will be discussing the ethics of Covid vaccines in a livestream with my colleague Sarah Green Carmichael on Monday. Questions in advance are welcome — just email me or Sarah.


Price of Everything, Value of Nothing

Oscar Wilde defined a "cynic" as someone who knew "the price of everything and the value of nothing." Many these days are cynical about the prospects for value investing. That's understandable after a dreadful few years. In the U.S., Monday's vaccine news was enough to help the Russell 1000 Value index outperform Growth. The value/growth ratio, as measured by Russell, is above its 100-day moving average for the first time this year. Previous times when value appeared to have perked up also saw a tick up in bond yields, such as the end of 2016 when people were excited about Donald Trump, and in late 2018 when the Fed seemed serious about plans to keep cutting its balance sheet on "auto-pilot." When yields came down, so did value. Value's latest upturn has also come amid rising bond yields. Can it be sustained this time?

The debate has been going on for a long time. Rob Arnott, founder of Research Affiliates LLC and one of the godfathers of quantitative value investing, said in an email Wednesday that even if this is not the turn, the prospects for value over a slightly longer period look good:

Over the last two days, U.S. value stocks have beaten their growth counterparts by 8.6%. Yesterday alone, the Russell 1000 Value Index outperformed the Russell 1000 Growth Index by 6.0% (4.1% vs. -1.8%), the highest daily excess return over the past ten years. Has the turn happened, or is this just a temporary blip? Time will tell. Too many investors focus on short-term thinking. We have no clairvoyant ability to consistently predict catalysts and market turns. Recall that year-to-date through its trough on September 1st, value stocks lagged their growth counterparts by 41.4%, representing the largest meltdown since 1931. Catalysts are, by definition, surprises. That said, when valuations are extreme, turns become inevitable, and a small shift in sentiment is often all it takes to initiate a swing of the pendulum from extreme fear to extreme euphoria. Was yesterday's news of the effectiveness of Pfizer's vaccine the catalyst we've been waiting for? Will the Biden win restrict the supply of carbon-based energy, boosting energy prices? Perhaps. My preference is not to guess.   We've long advocated focusing on when long-term market prospects are at odds with market perceptions, and then responding in a disciplined, contrarian fashion by averaging into out-of-favor markets and away from the expensive, beloved markets. The results over the last few days have been quite encouraging. It also bears mention that the valuation spread of value versus growth stocks continues to remain at a breathtakingly wide level. Long overdue for a reversal, value stocks are still priced to offer compelling return prospects, relative to their growth counterparts.

It's hard to fault his logic. The debate over why value has done so badly for so long is fascinating. You can watch here a vintage round table on "value for the long run" featuring four value-investing megastars — Cliff Asness of AQR, Mario Gabelli of Gamco Investors Inc., Jeremy Siegel of the Wharton School at the University of Pennsylvania, and Josef Lakonishok.

In maybe the most significant development, one of the most respected quantitative value investment firms, Aronson Johnson Ortiz in Philadelphia, decided to wind itself up and return money to investors a few weeks ago. Jason Zweig of the Wall Street Journal told the story here. Ted Aronson, the founder, explained:

Our recent performance sucks. And our record over most of the last five years has been so sucky that even if we outperformed mightily over the next five, we would still have—at best—a drab return looking back over those 10 years.

When the AJO news broke, I wondered whether it would go down in history like the value managers who were forced out of business shortly before the dotcom bubble burst. Perhaps more to the point, with fewer value managers leaping on the most attractively priced stocks, the returns for those who remain should be that much greater. It's best not to be cynical about this.


Survival Tips

This is a stressful time of year, with a lonely holiday season ahead for many. So let me recommend the televisual equivalent of comfort food: The Great British Bake-Off (known outside the U.K. as The Great British Baking Show). It's scarcely undiscovered.  But its format remains uniquely relaxing. If you haven't seen it before, there are several seasons on Netflix.

As for the current season, Netflix is releasing episodes in the U.S. at the rate of one a week. Rather than binge-watching, the family gets together on a Friday night (regrettably always spent at home these days), and watches the latest instalment. The kids think this is a great way to watch TV, and it makes me feel about 94 to explain to them that it used to be the only way. Releasing the episodes this way encourages everyone to treat TV as more of a shared experience again. Enjoy, and have a good weekend.

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