Monetary Bazooka and Multi-Curves

This post was first published in 25 Mar 2020 but things moved rapidly and my views have changed. The updated parts are in red.

Since we last discussed COVID-19, the world has gone from bad to worse. We now have a global pandemic which is increasingly out of control. It is becoming a crisis in the same order of magnitude as the 2008-2009 Global Financial Crisis. I have been using the original thebaselab website of daily checks. It is depressing. We have exceeded 15,000 100,000 deaths with no end in sight.

Courtesy of thebaselab

To combat the virus, many affected countries have gone into lockdown mode following China's example. But they didn't do it fast enough. Some countries' healthcare systems could not handle the situation and many lives were lost. It is important not to stress the healthcare system because there are only so many ICU beds and only so many respirators. Unfortunately, we don't learn fast enough. The first lesson from Wuhan was not learnt quickly enough to prevent the tragedies in Italy, Span and Iran and New York. Hopefully other countries and cities can still save themselves by working hard now.

Meanwhile, global markets went berserk. It did not help that Opec and Russia decided to shoot themselves by not reaching an agreement on production thereby causing a huge collapse in oil prices. (They finally agreed but the damage was done) The direct link between COVID-19 and crude is not clear. There is reduced demand but it's not 40%. However oil prices fell from the 50s to the 20s. In stressful times, as we had seen during the Great Financial Crisis (GFC), market participants adopt the mentality of "sell first, talk later". Hence the correlation of different asset classes goes to 1. Everything gets sold. Even gold got sold.

So last week (19 Mar) gave us a glimpse of the confusion that took place. As markets collapsed, we saw indiscriminate selling across stocks, bonds and commodities. The USD spiked because investors sold assets in other currencies and revert their holdings to USD cash. But the US Treasuries also got sold off, because that's another way to raise cash for redemption as well. This selling will continue. In Singapore, we have seen many blue chips hitting multi-year lows. As long as the global situation remains dire and fluid, we should not expect any recovery. (Then the market saw one of its sharpest rebound in history)

Why is everything going to hell in the markets?

While some of us in Singapore probably don't feel this way, this crisis could actually be worse than the GFC. The 350,000 1.7m infections had affected hundreds of millions of families directly. They are seeing their loved ones succumbing to the virus. But as the lockdown continues, the livelihoods of billions are are now badly impacted. We are talking about millions of people being laid off. They could be in the service industries, their employers only have days of cash left before going bankrupt. They could be the small suppliers in the airline/aerospace industry and/or the oil and gas industry. The big boys in these sectors are having issues, so what are the chances that the little ones can make it? 

The situation is really, really bad. People cannot pay their bills, their electricity is being cut off. They cannot pay rent, and face eviction. They have no money to buy food. It is literally life and death, even when the virus is not nearby. Some experts have drawn parallels to war. We are at war with the virus. Hence we need the monetary bazooka to come and save the day.

Helicopter Money

Alas, politics get in the way. The politicians cannot agree how this could be done. Can we bailout the corporates with no strings attached? What if these big oils and big aerospace just use the money to prop up share price instead of saving their suppliers? What about helicopter money? This is an interesting notion Milton Friedman coined in 1969 but made really famous by the previous Fed Governor Ben Bernanke. He famously said he would get on the helicopter and throw money on Main Street in order to stop the rout during the GFC. We are now doing it because families really need that $1,000 to tide over this month. Not next month, this month. 

So the politicians need to sort this out. They probably have days. Lives are at stake. (30 Mar update: they got their act together) The saving grace is that they managed it during the GFC, so it can be done. Then we need the virus situation to subside. China managed to contain it. So did South Korea. We need the major affected economies now (US, UK, Italy and Spain) to follow the playbook. Lockdown for a few weeks, things should get better. The situation will be different for many developing countries. Hopefully their leaders are learning fast. If they don't, their healthcare systems will not be able to cope. We will see a lot more deaths. May the Force be with them.

Finally, we come back to the big question, what do we do now? Buy, sell, wait?

Like I have said many times before, it is not possible to predict what happens next. The politicians could get their act together tonight and we are done with the bloodshed. Then we curse and swear that we didn't buy enough. My base case is the selldown continues and things get really cheap. It could be close to or even below GFC levels for some stocks. Then it will be the best time to buy. But we cannot tell in advance. So we buy incrementally. I plan to buy 1/5 of what I intend to deploy fully every week or two, something like that. It is not hard math or science, so you need to figure out what works for you.

Markets have since rebounded sharply but it might be consensus that this is a bear market rally. It is quite unthinkable we will recover and exceed the previous 2019 high any time soon. The upside is capped and given the bounce, the time to buy is not now (10 Apr 2020). If there are things that could be sold to raise cash, maybe we should raise some cash to have some more dry powder. The next selldown will test the 2020 lows.

The worst case is that the COVID-19 pandemic drags on for months and we did not move fast enough. One, two or three large corporates fail and drag down some banks. 100 million or even more jobs are lost globally. Or, we see continuing rise in infections and many more outbreaks. We see waves and waves because different countries are on different curves. Some successfully flatten their curves but not others. 

In Singapore, we see a full blown community spread. The fourth wave gets us. Our healthcare system gets stressed. Then we will fall below GFC levels. It is a doomsday scenario. Maybe we won't be worrying about our portfolios at that point. We must not let this happen. Stay at home. Keep the social distance. Flatten the curve!

In short, there are many scenarios. No one knows which one will pan out. I would wait now but would look out for stocks that becomes too cheap to ignore. For example, DBS at 0.5x book with more than 10% dividend yield looks good (albeit banks may not be able to pay dividend in 2020 given the situation). Sadly, I have bought it way too early at $21. Now the stock is trading at $18. Dairy Farm breaking its all-time low at $3.30 or Ho Bee revisiting $0.90 will be interesting. Genting does look cheap at $0.50 (it has since rebounded to $0.70) but we have to assume its businesses will recover strongly once the virus is defeated. We have discussed these stocks before so click on the links for related posts if interested. 

Meanwhile, hang in there. This is a marathon. WFH is here to stay. Don't scold the kids. Avoid the spouse. Flatten the belly curve on top of the other curve. 

Huat Ah!

Look for Free Options

Those who have knowledge, don't predict. Those who predict, don't have knowledge - Lao Tzu

Investing is not about predicting the future. Predictions are usually not accurate. We heard the famous ones: Bill Gates predicting nobody needed no more than 640KB of memory, Dow Jones 36,000, who needs cars when we have horses blah blah.

Yeah, how right. So what do we do if we do not want to predict?

We want to be prepared. This post serves to illustrate how.

First we must accept that the future is unknown. It is a set of probabilities. We want to make sure that whichever future pans out, we will be okay. In mathematical terms, it means that the expected return is positive. In investing, we want to look for free options, or near-free options. In layman terms, it just means be prepared, don't anyhow bet.

It's easier to use an example, so we go back to Singapore's property market, my favourite topic. As of now (mid 2014), we can probably trace 3 paths that our beloved property market would follow in the next few years:

1. It will crash and burn, ie prices collapse, falling 30-40%, most speculators fall into deep shit and every Tom, Dick, Harry and his wife and his dog totally shun this market. That's when value investors come in.

2. It will continue to cruise along, doing nothing much at 2% rental yield or an average of $1,500 psf ie 90% of Singaporeans would not be able to afford anything any time soon and foreigners continue to nibble on some of our high-end stuff.

3. It will rise and rise as Singapore becomes the Monaco of Asia. Prices rise to $2,500 to $3,000 psf or higher and stay there forever. 99% of all Singaporeans and their children and their children's children will never be able to afford anything and have to resort to living in Iskandar.

Iskandar. Not too bad. Who wants to retire there?

I have posted in the past about why I think Singapore's property market should not continue to rally. But it's not supposed to be a prediction. It's merely a view I hold which I would attribute say a 70% probability that this future is likely to come true.

As for the other possible futures: 2 and 3 above, I would attribute say a 20% probability that our property market would do nothing and a 10% probability that we would become the Monaco of Asia and we will all have to move to Iskandar some day.

So the way to invest here is to make sure that no matter which future pans out, you would be ok. And if one of them happens to be right, you make a lot of money.

Now obviously if you have bought 5 properties on leverage and is paying interest instalments out of your salary, you are betting on Future 3. But if you believe my probabilities, then if Future 1 pans out. Good luck! See you in Iskandar, sorry I mean your makeshift cardboard at the void deck this weekend while I bring my kids to Legoland! That's way too much prediction and too little preparation.

On the other extreme, if you have sold your home and your mum's and in-laws ones as well and on top of that you go short $500k of Singapore property stocks, then you are heavily betting Future 1. But if Future 3 pans out, then jialat liao (ie in deep shit!). Not only you have no place to live, your short would probably be losing close to a million dollars. Makeshift cardboard at the void deck all over again. Again, that's not rational investing.

In investing, most of the time, it's very difficult to make free money or in investing lingo - to find arbitrage opportunities. You have to take some risk to make some good return. But that's just not very efficient. So the lesson here is really to just keep finding those arbitrage opportunities or what I would call "free options".

A free option or a near free option is a bet that would give a good payout if a stipulated event happens in the future but the cost is either free or almost zero. It could be said that one of the goals of investing would be building a portfolio of free options or near free options.

I must stressed that this is not going to be anything easy. The market is efficient and arbitrages are easily profited away by the professionals. Arbitrages are like dollar notes that fell out of people's pocket accidentally on Orchard Road. It would be picked up in a blink. So it's really not like money would fall from the sky. In investing, some of these free options are hard to come by.

But there are times when "free options" come about. We just have to be savvy enough to spot them. In the Singapore market, ironically, one example would be the property play Ho Bee. In early 2012, Ho Bee's share price fell to $1 as it was becoming clear that Sentosa's luxury properties might struggle to find buyers and Ho Bee was the Sentosa developer. It was clear that Ho Bee could have some serious issues as lower sales meant its cashflow would get tight but it had to finance its huge capex for its residential projects and its crown jewel commercial building: the Metropolis.

The Metropolis is a mega-deal for Ho Bee, at 1 million square feet of rental space right outside Bueno Vista MRT, this property alone is worth more than $2 when converted to Ho Bee's share price and even after netting all its debt, there is still $1.5 left. So when Ho Bee traded at $1, the market was saying Ho Bee's entire Sentosa plus other projects are worth nothing and its prime Metropolis could either be marked down drastically because Ho Bee might have to do a fire sale of this prized asset to survive.

Now I am doing this analysis with the full benefit of hindsight. I didn't invest in Ho Bee then and I am drawing conclusions now just for the purpose of illlustrating what's a free option.

The market is not stupid. Remember markets are usually efficient and I believed that there was a likelihood that Ho Bee needed to sell a part of Metropolis cheap to keep itself going in 2012, hence the market priced it below Metropolis valuation. But at $1, the market priced in the worst possible scenario. If it had gotten any lower, someone would have taken Ho Bee private. In fact, the management could just bite the bullet, partner with some private equity and took itself private at say 80c since the company and its management owns 70% of itself already.

So there was a free option on the table when Ho Bee was at $1. I would attribute say 20% probability that it could still fall another 20% which if it did the prudent decision would be to buy even more Ho Bee. But in another scenario, there is an 80% probability that it could rise 50% back to Metropolis minus debt at $1.5.

As things turned out, the upside was 100% and more. Today Ho Bee trades at $2.20. 

So ironically, despite my negative view on the Singapore property market, a prominent property play called Ho Bee was a free option regardless how the whole Singapore property market performed.