“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1” Warren Buffett
Unless you’ve been hiding from the Coronavirus (COVID-19) by living in a cave for the past month, you know that virtually everyone is violating Buffett’s rules. This includes the “Oracle” himself, who’s Berkshire Hathaway is down over 20% in the past month. Nearly every investment across the globe has lost value since the beginning of the year. China’s economy has been partially shut down. Italy’s economy has been almost entirely shut down. The US economy is grinding to a halt. Supply chains have been disrupted all over the world. And no one knows just yet how bad the effects of the coronavirus will be. One thing we do know, though, is that this disease is a danger to fragile people. It’s a danger to fragile economies, too.
Who’s At Risk From the Coronavirus?
For most people, the so-called “Coronavirus” is nothing more than an unusually bad flu. The CDC states that: “Reported illnesses have ranged from mild symptoms to severe illness and death for confirmed coronavirus disease 2019 (COVID-19) cases.” Symptoms include “Fever, Cough, and shortness of breath” anywhere from “2-14 days after exposure”. The symptoms for most individuals may be indistinguishable from the cold or flu without some official test, which most probably won’t bother getting.
But the CDC continues by outlining what is most concerning: “Older people and people of all ages with severe underlying health conditions — like heart disease, lung disease and diabetes, for example — seem to be at higher risk of developing serious COVID-19 illness.” The “serious” part is the dangerous part. In other words, if you have a strong immune system, you’re probably fine. If you have health problems already, however, the Coronavirus could be lethal.
I won’t pretend to know more details beyond that, as opinions regarding the nature of the illness vary wildly. Very little is known about this new biological threat, and much of the CDC’s informational website could best be summarized with the familiar acronym: TBD. But what I want to point out is this: fragile systems are always more susceptible to damage from external stresses. To put it another way, if your body is already under stress, your immune system is weak.
The irony here is that this applies as much to economies as it does to our bodies. Economies that have strong “immune systems” are more resilient to external shocks like the Coronavirus. If, for instance, the US economy had a lot of savings, a growing working population, low levels of debt, and fairly-priced asset markets, then the Coronavirus would pose very little threat. That doesn’t mean panic wouldn’t cause a short-term decline in asset prices. It surely would. But that sell-off and any economic slowdown would be short-lived and relatively mild. The economy would be “back on its feet” in no time, so to speak.
Fragile economies, on the other hand, are incredibly vulnerable to external shocks. When an economy has very little savings, massive amounts of debt, and asset price bubbles everywhere, it doesn’t take much to plunge into a recession. The Coronavirus, as it turns out, isn’t just especially dangerous to fragile people. It’s especially dangerous to our fragile economy as well.
Unhealthy amounts of debt
One of the “underlying health conditions” of the US economy is our strangely naive affinity for debt. We just can’t help ourselves. Below is a graph showing the contrast between the growth of corporate debt and the growth of corporate earnings.
Since 2005, corporate profits (red line) have increased by 22% while corporate debt has grown by 120% (blue line). In other words, for every dollar corporations have generated in new revenue, they have added almost $6 in debt. This is clearly not sustainable. Without revenue growth and savings to weather economic slowdowns, many of these companies are sickly already. They simply don’t have the ability to service the debts if their revenues slow down. As I discussed last year, even a mild recession could push as many as 40% of existing corporations into insolvency. An underlying heart condition can make the common flu life-threatening. Similarly, our massive corporate debt load could make an otherwise mild recession a very bad one.
Another underlying health condition is the extremely over-valued assets in the US stock market. Even after the recent sell-offs have taken US equities down 25-30% from their peak, prices are still extremely expensive by historical standards. As a point of reference, the Buffett Yardstick suggests the market is still nearly as expensive as it was near the top of the bubble in 2007 – before it plunged over 50%. Even after the recent sell-offs, the metric remains in the range of 110-120%.
There is a reason this metric is so useful. Corporate profit growth and stock prices typically go hand in hand. From 1950-2010, corporate profits increased at around 6.6% while the US stock market grew (net of inflation) at around 6.5%. The notable exception was the few years leading up to the Dot.com bubble in 2000. In the late ’90s, stock prices increased much faster than corporate profits. This was followed by the stock market dropping nearly 50% from March of 2000 to September of 2002. From 2002 to 2010, the two metrics once again had a high correlation.
Since 2010, however, the growth rate of the US stock market has been well over 10% per year while corporate profits have grown at just over 2% per year. Intuitively, we know this can’t last. No one pays ever-higher prices for assets that are not growing their cash flows comparatively. For these two measures to realign, as they did at the end of the Dot.com bubble, stocks would need to lose another 40% from this point. This means that the recent fall of 30% in the US stock markets may be just the beginning. The Buffett indicator is once again likely to see a ratio in the range of 70-80%, with the S&P 500 at about 1500.
Thomas Paine once wrote that times like these “try men’s souls…what we obtain too cheap, we esteem too lightly.” The next few years will likely be a difficult economic period. We have obtained much paper-wealth through the issuance of additional money and artificially low-interest rates. The Federal Reserve has inflated asset prices in stocks, bonds, and real estate to all-time highs. Many who have ridden this debt-party to the top have esteemed the good times too lightly. Easy come, easy go, as they say.
On the positive side, though, there are some asset classes that were cheap before this meltdown began. Those assets are even cheaper today based on their long-term earnings. The important thing for investors to remember is that their future returns will be based on the price they pay today. If you buy on sale, your future returns will be high. If you overpay, your future returns will be low. It really is that simple.
One last note
If you have any of the symptoms mentioned above, it’s probably a good idea to get tested and quarantine yourself. Similarly, if your portfolio is feeling sick, you might want to get it tested as well. It has become common for people to insist “the markets always come back”, so there is nothing to worry about. On the contrary, the US stock markets have had periods of 10-20 years of no returns before. Some asset prices take decades to recover from bubble peaks. Some, like the Nikkei 225 in Japan (their equivalent to our S&P 500), never recover.
You are likely to survive the Coronavirus, so let’s make sure your retirement portfolio does too. It’s one thing to experience dropping prices on healthy assets that you bought on sale. It’s quite another to experience dropping prices on sickly assets for which you paid too much. Besides, healthy assets are likely to recover from this crisis. The fragile ones will not. As you think about how to protect yourself in the midst of this crisis, consider Plan Financial as a resource to test your portfolio’s health. We’ll make it easy for you – far easier than washing your hands for 20 seconds. So give us a call!