Coronavirus May Mean Recession: Have Cash, Watch

Buffett, Own Berkshire

seekingalpha.com/article/4330202-coronavirus-may-mean-recession-cash-watch-buffett-own-berkshire

Jim Sloan March 6,

2020

Summary

I buried the lead in my article explaining my sale of emerging markets ETFs; the proper
headline was reducing asset allocation 5% while harvesting a tax loss.

Estimating COVID-19 impact involves a denominator problem; we know how many die or
have serious cases, but we don't have good numbers for total infected, and may never
know.

The coronavirus has probably pulled forward a mild recession which would have
eventually happened anyway: you might still sell a little, especially if you can harvest a tax
loss.

Berkshire, banks, and selected industrials remain good bets as Biden's re-emergence
takes several major risks off the table, while munis remain cheap against other
alternatives.

1% on the 10-year Treasury suggests caution, be wary of companies with heavy debt,
and pay close attention to Buffett's actions and words.

I buried the lead in my previous article, "The Coronavirus And Emerging Markets: What I
Did And Why." Writing out of a sense of responsibility after recently recommending
emerging markets (I still do), I failed to focus on the core reasons for the action I took.
What I did was trim about 5% from my equity allocation in response to economic and
market uncertainty. Tweaking my allocation was the main thing. But there was another
factor. I reluctantly sold positions I continued to like (emerging markets ETFs) with the
consolation that it was a rare opportunity to bank a tax loss.

There are important facts that we don't know yet about COVID-19, and some we may
never really know. The key number is the denominator. Deaths and serious cases are
easy to identify, but the number of total cases is not. Mild and asymptomatic cases are
invisible. Because we lack an accurate denominator we can only make educated guesses
about mortality rate and level of risk.

Actions taken as a result of the spread of the coronavirus - deriving both from
government policies and simple human fear - seem likely to trigger two consecutive
quarters of zero to negative growth both domestically and globally. This is the standard
economist's definition of a recession. This particular recession may have some quirks.
One particular quirk is the fact that it will start with a supply shock rather than a demand
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shock. Consumption will first be damaged by lack of things to consume. There is a fair
chance that this first shock will serve as the trigger to pull forward the long-awaited first
recession since 2007-2009.

It's hard to get a handle on economic damage without knowing basic facts. For the
present, COVID-19 is having an impact like a reverse beauty contest. It's not how bad it is,
it's getting an estimate of how bad everybody else thinks it is going to be. My reading of
this so far is that the estimates of others are projecting enough economic damage to pull
forward a recession of moderate size.

Neither the recession nor the accompanying bear market, if they do indeed eventuate, is
likely to have the scale or the duration of the 2007-2009 downturn. The major imbalance
in the economy will derive from the one-time disruption in trade, travel, and
consumption. The disruption may be sharp, but it is likely to be brief and leave few
lingering effects. In fact, it may reset the clock for future economic growth. The risks
include a policy mistake by the Fed or an election outcome unfriendly to business.
Surprises which might deepen the recession would include discovering a lot of short-
term mismatches of corporate revenues and corporate debt.

As is the case with every economic downturn, it will be important for the individual
investor to pay attention to which stocks and sectors show strength in the face of the
market decline. These are generally the leaders when a bull market resumes. Because of
the quirky nature of this event, however, some of the biggest losers in the travel, trade,
and leisure area might also present wonderful bargains and bounce back strongly. It's a
good idea to plan on having some cash on hand when the economic world turns back up.

The Fidelity Business Cycle Model And Its Limitations

In a recent issue of Fidelity Viewpoint - a publication I receive regularly because I keep
one IRA account there - there was an article on "cycle investing" built around the
following table:

The Business Cycle Approach to Sector Investing (PDF) provides details on how you
can potentially take advantage of opportunities that arise due to the relative
performance of sectors in each phase of the cycle:

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This is a fairly common way of approaching business cycles. Technical analyst Martin
Pring represented business cycles by a sine curve matching phases of the business cycle
with changes of market leadership among bonds, stocks, and commodities (in that
order). Fundamentalist Sam Stovall has also used a similar model for the sequence of
market leadership among sectors similar to the above. In my sixty years of market
experience, models like this have been broadly accurate but there have been quite a few
exceptions.

Today market commentators like Jim Cramer often draw from this sort of model
anecdotally giving advice like, "Hey, the next month or two look rocky, better hide in
health and consumer staples like Bristol-Myers (BMY) and Clorox (CLX)." For a utility he
might throw in something like Southern Company (SO).

My real problem with these models and Cramer's anecdotal advice is exactly how one is
supposed to implement them. My problems with implementation include the following:

1. Am I the only person who has to pay capital gains taxes? Am I actually being told to
sell one sector and pay the taxes in order to buy a different sector?
2. Am I the only person left who actually tries to be a long-term investor? See #1
above for one reason I rarely trade.
3. There's an old market-correction adage which goes this way: "When the cops raid
the cathouse they take all the girls and the piano player too." When markets
correct, the defensive sectors often go down with the rest of the market; they just
don't go down as much. Where's the advantage in trying to play that?
4. Meanwhile, the defensive sectors of the market today are bond substitutes highly
correlated to incredibly expensive Treasury bonds. If the conditions which have
made bonds expensive reverse, especially on the way out of a recession, the
defensive sectors such as utilities and staples could be crushed.
5. And finally: to do well in the sectors specified it would be necessary to implement
the strategy with a lead time so that you buy them before the cycle turns. I don't
think I can do that with consistency. Can you?

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In short, I don't have much belief in the idea that I can do well by turning over my whole
portfolio or a large part of it in anticipation of shifts in the business cycle. My only real
use of the above chart is reverse engineering it to think about the business cycle itself.
Where are we within the big picture?

And what are some strategies that may apply?

Sell A Little, Especially If You Can Harvest Tax Losses

The importance of this strategy should have been the core of my previous article. At
some point every year I sell everything in my portfolio which shows up in Vanguard's Cost
Basis table in red. In recent years there have been slim pickings for things to sell at a loss.
At times I have ended up selling a tranche or two of reinvested dividends during a
downturn.

One of the oldest market adages is to sell your losers and let your winners ride. This
accords with Bayes' theorem according to which you begin with a premise and
strengthen or weaken it depending on new information. For those of you who operate
on Bayesian principles this is a helpful statistical way of making a decision. Your prior -
the premise you started with - was that the security you bought would go up. If it goes
up, the probability that you made a good decision is affirmed and you either hold or buy
more. If it does go down - I have heard smart investors say this all my life - accept the
fact that you were wrong. Your prior - the initial premise - is called into question.

Because I am a long-term investor I don't often take an action of any kind in the very
short term. When it came to my emerging markets ETFs, it was too soon to modify my
premise, especially as the immediate cause of their market decline was an exogenous
event having little to do with their actual value.

The complicating factor was taxes. Every now and then I do build up a resolve to sell
something despite the fact that I hold capital gains in it. The current candidate for a
haircut has been Wells Fargo (WFC), which has gotten so many things wrong in such a
persistent way that my original premise for owning it has been seriously degraded. To
trim my WFC position without getting billed for cap gains by the taxman it was helpful to
harvest a tax loss. Additionally, I had a desire to trim my overall asset allocation by a
small amount - creating a little more cash available in case the market took a truly large
hit (so far, in my view, it hasn't). The only way to do this was by selling emerging markets
ETFs that I fundamentally like for the long term.

The next action I am likely to take is to buy them back after the 30-day wash rule period
or buy ETFs which are similar. But let me explain the things I am not selling and the
reasons I am not selling them even if they appear to be in the wrong column of the above
Fidelity chart.

Many of the following sections review elements of my Jim Sloan Positions for 2020 piece
written for SA at the start of this year. Here's an excerpt from that piece:
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 The biggest risks probably lie in future events we don't have any inkling of at the present
moment, even if it turns out that there are no aliens or menacing interstellar objects hidden
just behind the sun (the sort of worry the internet has introduced into our culture)."

The aliens that arrived without warning were a small virus with little ball-tipped spikes
which readily attach to healthy cells.

Berkshire Hathaway Is A Buy

I haven't sold shares of my largest holding, Berkshire Hathaway (BRK.A)(BRK.B), because
from the earliest days of buying it Berkshire has confirmed and upgraded my prior on a
regular basis. My original premise was that Berkshire is a wonderful company with a
unique structure of operational decentralization with centralized capital allocation, good
internal diversification involving best-of-breed subsidiaries, managerial excellence, and a
supporting culture founded on high principles. It has an extraordinary leader, but it also
has a deep bench.

The Berkshire premise has only been strengthened by Berkshire's performance over the
years, with the result that it has grown to be a huge overweight in my portfolio. A few
days ago I received a query from an MBA student wanting to know my views of
Berkshire's reporting for a paper he was writing. He was apparently weighing the
criticism Berkshire has received in recent years for the lack of detailed information on
the operations of its subsidiaries. The reasoning in my previous paragraph led to my
basic answer that Berkshire's free admission of mistakes over the years had built a lot of
credit. I have never seen reason to doubt its reporting. It has been at pains, for instance,
to detail the distortions presented by regular inclusion of market prices in its portfolio in
reported earnings whether they produce an increase or a decrease.

Although many of Berkshire's acquisitions in recent years have been industrials, they
have been stable businesses with consistent revenues and profits during economic
downturns and thus safe havens during bear markets. Because of my very large
overweight I can't really add, although I did so as recently as December 24, 2018, but my
son has added a bit during the recent market weakness and has also bought Berkshire
with funds a daughter saved from a part-time job bartending while a college student.
That's conviction. Berkshire below $210 on the B shares is a bargain. It's available at that
price as I write this.

The Large Banks (Ex-Wells Fargo) Should Be Okay

Banks have been under heavy pressure during the present sell-off for an obvious reason:
low yields. The yield curve (2 to 10-year Treasuries) has actually steepened since the 50
basis point cut by the Fed. It's normally the steepness of the yield curve that matters to
banks, steepness providing the net interest margin. At the present absolute level of
rates, however, it's pretty hard for banks to make money on the ordinary forms of
lending. Banks are in for some rough times.

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That being said, my largest banks positions - JPMorgan (JPM) and Bank of America (BAC) -
have been successful in compensating for the problem of low rates with other revenue
streams. While earnings may decline quite a bit, these banks will be able to benefit more
from buybacks after their steep declines in price. It is worth remembering that both
these banks, even after paying dividends, have been able to use cash to generate a per-
share earnings increase of 6 or 7 percent via buybacks. This will continue to work so long
as their free cash flow doesn't decline significantly. For this reason, I am content to hold
them through an economic downturn even if their prices decline quite a bit more.

Industrials Should Be Okay Too, P&C Insurance Under

Pressure
The other large positions in my relatively un-diversified portfolio include Parker-Hannifin
(PH), United Technologies (UTX), Dover (DOV), Travelers (TRV), and Chubb (CB). All have
large embedded capital gains and are solid enough that I have no thought of selling. The
first two industrials will be supported by having many products which are used in a
variety of end products and have significant recurring sales. UTC will be sustained by
government business. There is not much that is immediately positive in property and
casualty insurance when rates are this low, but TRV and CB are the top companies, have
profited from buybacks over many years, and aren't going away.

Biden, Bernie, Warren, and Trump

The Jim Sloan Positions piece had Biden versus Trump as the default prediction for
Presidential nominees. This seemed in doubt for a couple of months, but once again
seems to be the default option. The more certain this seems, the more likely a sharp
recovery will follow economic weakness. Warren posed a particular threat to banks and
buybacks, the one a case of fighting the last war and the other an attempt to get politics
involved in corporate decisions. Her poor showing has greatly reduced these risks.
Bernie had many positions that are anathema to corporate America and businesses of
all sizes. The huge rally the morning after Super Tuesday shows the extent to which this
risk appears to be receding.

Most of corporate America is happy with the majority of Trump's actions in the business
area if not particularly enamored of Trump as a person. Biden seems okay to business
leaders, if not perhaps their first choice. He probably won some appreciation for having
effectively taken a worst-case outcome off the board.

Key Indicator: Watch The Absolute Number For The 10-Year

Treasury
If the 10-year continues to trade under 1%, and especially if it continues to fall, be wary of
any apparent equity market recovery. This is simply not a healthy number for the
economy, and suggests that problems in the rest of the world have tilted the global
economy so much that we are joining in the slide. The Fed decision to cut rates 50 basis
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points on Tuesday struck me as a bit questionable. Rate cuts don't kill germs, and they
probably don't do much for the economy either when businesses are afraid to invest and
individuals are afraid to leave their houses and buy things. What a 10-year under 1%
does is attack the assumptions of many financial businesses. Think especially of those
brokers who dropped commissions and quickly merged on the assumption that they
would make it up by massive asset gathering.

Munis Are Expensive, But Still Cheap Compared To Other

Options
In early December of 2018 I backed up the truck on 5-year CDs yielding 3.55% and long-
term munis yielding over 2.5%. I was a little lucky in the timing, but extending fixed
duration to the extent I did may have been the largest shift in portfolio allocation I ever
made. At the time I had little sense of how spectacularly it would work out. It just seemed
like a good parking place for money I didn't want to hold in equities. CD yields to maturity
now reflect current Treasury rates, but my cost basis numbers at Vanguard reflect large
embedded capital gains.

Their current yield of those long duration munis is now below 1.5% accompanied by
embedded capital gains of about 10%. I'm not selling but would I be buying? That
question had barely crossed my mind when a person close to me asked what to do with a
large bonus needing to be invested or parked. It forced me to look and see that longer
duration munis were still dirt cheap compared to equivalent durations in Treasuries. I
suggested putting the money into muni money market while waiting and watching to see
how volatile Treasuries were going to be.

Be Wary Of Companies With A Lot Of Debt

Thursday, a small British airline named Flybe (OTC:FLYBF) went into administration
(bankruptcy). Be aware of the relationship between debt service and cash flow in any
company with a lot of debt. This is especially true for companies in the travel and leisure
business which may soon have to survive a period of zero cash flow.

Watch Buffett
No one has better information on the economy than Buffett. With reports from
Berkshire's roughly 100 wholly or largely owned subsidiaries, he sees what is happening
in the economy on a daily basis. His detailed information probably compares favorably
with the information available to the Federal Reserve. He also brings almost eighty years
of experience and proven judgment that are hard to match. Everything he says and does
should be taken seriously, including investment choices that include things like his one-
off structured deals, large acquisitions, large share purchases in the public market, and
Berkshire buybacks.

Buffett has often been extremely helpful in times of crisis. He wrote pieces or gave
interviews expressing his views with extraordinary accuracy before the major downturn
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in 1969 as well as the upturn in the middle and late 1970s. He was prescient in his
cautionary comments on the dot.coms toward the end of the bubble years, although he
came in for criticism at the time. His famous "Buy Stocks. I Am" New York Times op-ed
piece in 2008 provided a clear signal that the worst was over. Those were the major
turning points of the last 50 years. When Buffett gives such definitive views it has always
paid to act on them.

Watch for what he says and does. I am.

Disclosure: I am/we are long BRK,B, JPM, BAC, TRV, CB, UTX, PH, DOV. I wrote this article
myself, and it expresses my own opinions. I am not receiving compensation for it (other
than from Seeking Alpha). I have no business relationship with any company whose stock
is mentioned in this article.

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