Updated: May 15, 2020
Photo: The upside-down house in Hartbeespoort, South Africa. While a metaphor for how we're all feeling right now, later I'll demonstrate how to flip your portfolio to hedge before a market panic.
After a 10-year bull run in the markets, we’ve all waited for the other shoe to drop.
The shoe is here, and it’s booting us all squarely in the rear with a coronavirus. Has the market meltdown ended? After all, most of us who went through 2008 are expecting another financial disaster, but no two economic disasters are exactly alike.
Belle and I have watched the lockdowns spread toward the UK and US, our home countries, with surprise. I expected a military-style readiness exercise, but both governments played a “wait and see” approach. Because China and other Asian countries contained the virus so well (using its SARS experience) it took Italy to wake the Western world up to a possible healthcare overload. Each day underscores the importance of staying at home, for those who aren't on the front lines.
Now we’re quarantining ourselves in our house. Because I work from home already, I already had an ideal setup. Belle is a nanny for a set of triplets and is on temporary leave from her job during the lockdown.
Just after the lockdown, we supported the local pub, The Holmbush Inn, by buying a roast dinner on Mother's Day, where they had "takeaway double pints". Picking up during our time slot, the proprieter gratefully said we were the last order with 43 for the day. The pub was surreal, an empty, quiet space during a normally busy time on the weekend.
We watched Boris Johnson as he delivered his "stay at home" address, which, like the US, is reluctant to use the police to enforce any measures. However, with both countries about 2 weeks behind Italy's trajectory, it's just a matter of time before the UK catches up. Now, with Boris himself having acquired the coronavirus, it's further driven this point home.
Our trips out have been put on hold, including a concert in Brixton, a house sitting engagement in France, and a vacation we planned to drive through Germany to Prague in the summer, as well as my next trip to the US. However, that’s clearly nothing compared to losing your job, or an intensive care emergency with coronavirus at a hospital which is understocked on ventilators, so we are counting our blessings.
If I was still in the airline industry, I’d likely have been furloughed or taken a severe pay cut. I recently saw one of my former flight attendants take a selfie on a Southwest flight with only seven passengers. The business model can’t continue for long!
Remember that guy, Bill Gates, who once predicted that people would have personal computers in every home, and people laughed? The same guy, who warned in a 2015 Ted Talk, that the next danger to humankind was not nukes, it was a pandemic, and nobody listened? He’s still here, trying to get the US organized with COVID-19 testing. He recently hosted a Q&A which is very insightful.
Looking back through history, is there one situation comparable to what we’re facing today? Many are comparing to 1918, when Spanish Flu is estimated to have killed 50 million out of a global population of 1.8 billion (2.8% of the global population, infected or not), but is that the right comparison?
With 500 million infected, the fatality rate for Spanish Flu seems much more severe at approximately 10%, which is closer to the SARS outbreak in 2002. SARS, which is also a coronavirus, was successfully stopped due to containment.
The issue facing the Western world is that we didn’t live through a SARS outbreak, so complacency has set in. Even after having the early warning offered by watching the new coronavirus outbreak and the successful “gold medal” performance of countries like Singapore, the US and the UK are both behind the curve when it comes to testing, quarantining, and contact tracing.
We should take COVID-19 seriously, even though it doesn't have such a high fatality rate as either Spanish Flu or SARS. Why? See why COVID-19’s rapid spread is unprecedented among coronaviruses in these charts. As of writing this article, the USA tops the world in active cases, an outcome predicted by health experts due to a sluggish federal response.
The difference with the coronavirus is that it kills even healthy individuals at rates 10-30x higher than the seasonal flu, has a contagion level 2x the rate of seasonal flu, and has no option for a vaccine (yet), while common flu permits vaccinations. Also, it’s possible to spread the virus while not showing any symptoms.
Pandemic risk prevention requires the coordination and willingness of a government to move quickly enough to contain it. China has imposed the equivalence of martial law, but other countries may not be willing to enforce such a quarantine. South Korea used testing and technology brilliantly - a tactic that we should have employed early on.
In the modern age, we have more tools and knowledge to fight an epidemic, but the speed of air travel and more people living in cities results in spreading the virus more quickly. While we can manufacture vaccines, it's likely that by the time they are implemented, the virus will have run its course. In the end, I expect the severity of the human losses will be far less (in percentage terms) than the last pathogen-of-the-century, but more globalization supply-chain dependencies will cause more economic damage, with the added complexity of an oil price crash.
Simulating the Future
The Brookings Institute ran a simulation of a COVID-19 pandemic based on previous pandemic scenarios and coronavirus information, and even in the lowest simulation there were 15 million human losses worldwide. This included 236K losses in the USA (compared to 55K from seasonal flu).
However, they estimated 2.8 million losses in China, while China (with 1.3 billion in population) as of March proved strict quarantining is effective and already peaked in infections with just over 3,000 losses. This is a long way from 2.8 million! Once other countries catch up with containment measures, it shows that the virus can be controlled and most predictive models like the Brookings Armageddon scenario are too extreme because they don't factor in humanity's response accurately.
The simulation included shocks to the economy due to loss of workers, a decrease in demand for vulnerable sectors like travel, and an increase in cost due to pandemic management. However, these kinds of losses can be avoided if governments take strong action to prevent its spread, as containing the virus swiftly has a more long-term positive effect on the economy than the short-term effects of a shutdown.
Unless the initial shock exposes debt cracks in the economy for corporate and consumer debt, once the spread has stopped, the economic recovery should be attainable once production is restored.
With that in mind, if you’ve sold out of your investments or hedged, once the spread of COVID-19 begins to peak and moves in the direction of containment, I believe it will be a perfect situation to reinvest at a discount from a formerly expensive market peak.
The Market's Response
What will happen to the stock markets? In Buffett's words, "you only find out who is swimming naked when the tide goes out." The Coronavirus and oil wars are just the straw that broke the camel's back. The real reason for the recent large correction is not the virus. It’s that markets have been overpriced by every metric for years now. Something had to give.
Beware of bulls in a bear market. Remember Jon Stewart versus Jim Cramer? Despite toxic mortgage evidence permeating the market, Cramer recommended buying Bear Stearns just before it tipped into bankruptcy, claiming "intuition" as the reason. Unwittingly, Cramer had buried himself in his own video evidence which was aired during the Daily Show interview.
Intuition? What happened to doing your homework? Watch out for people making statements and using "intuition" to try and predict what will happen with the markets. In a bear market, you need a bear market expert. Also, people guessing at stock directions with no view of the bigger picture when it comes to a pandemic might as well place their bets on a roulette wheel and try to use intuition to guess the next number.
To see if the market is overpriced, the metric I prefer is Robert Schiller’s CAPE because it's frequently updated and functions best over long time periods. I used CAPE (Q-Ratio and Market Cap/GDP are similar) to determine that the markets were overpriced last year. To confirm an upcoming recession, wait for the inverted yield curve, which has signaled before every recession for the past 50 years.
Using these tools, I hedged my investments completely against a market drop.
Above is where Q-Ratio was in December 2019 - the market as a whole had nearly revisited the peak during the 'dotcom' bubble.
It might seem strange that the market ignored the new coronavirus as it began spreading, but remember that the market counts votes in the short run and measures value in the long run. It also looks 6 months ahead of the news, so because the votes for economic damage finally overturned the market’s bullish view (overpriced), the market begin to drop quickly as the market repriced to reflect reality. It took Apple's earnings warning on February 17th to wake the U.S. markets up.
My investments have overall gained during the crisis, which I credit to “Roundabout Investing”. I’ve adopted this strategy from billionaire hedge fund manager Mark Spitznagel (Nassim Taleb’s protégé) after reading his “Dao of Capital”. He is what I'd call a bear market expert.
The essence of his Roundabout strategy is explained in this predictive Vanity Fair interview here in February 2020, but I will explain my simple use of Roundabout Investing in this article.
The basic idea of Roundabout Investing is that, like the famous Arc De Triomphe traffic roundabout in Paris (see video below), you sacrifice a small loss of efficiency now for a large gain of efficiency in the future. Another analogy is the martial artist who reverses momentum to use his opponents’ weight advantage against them.
Similarly, you use a hedge and the force of the market’s downward move to build up cash and market buying power, which Mark describes as the “dry powder” you deploy explosively while the market is discounted, strongly positioning for the next phase of the market’s upward trend.
How to Invest for a Pandemic
How do we invest for a pandemic? This is unlike other crises in that global supply systems are disrupted at the same time consumer confidence is dented. The usual investing options are Number 1-4, but I propose that there is a 5th option for Roundabout Investing:
Do nothing (Novice)
Dump everything in favor of cash (Intermediate)
Dump everything and buy safe havens (Expert)
Gamble on the market’s fall (Professional)
Roundabout Investing (Intermediate)
Do Nothing (Novice)
All those red numbers in your index-tracking portfolio? They aren’t losses if you're not compelled to sell. Warren Buffet does not sell all his stocks during every downturn, and still has more than doubled the market’s returns. If you’re losing money because of bad bets on single stocks, that‘s another story. But for those of us invested in market indices, you’re already diversified and the US market will recover just as it always has. You simply stay on the roller coaster, avoiding taxes and complication until it eventually starts going up again. This is the safest option for the “set it and forget it” investor.
Bottom Line: This is Warren Buffet’s “buy forever” technique and it’s also recommended by the Golden Goose Guide for the novice investor.
Dump Everything in Favor of Cash (Intermediate)
This is an attempt at market timing. This is difficult to succeed, because the only way this works is if you time the market top perfectly to catch only the short-term downturn. Moving to cash should only be done if an investment isn’t working out or has reached its full potential, preparing your portfolio for the next stage. This shouldn’t be used after the index has already crashed, because it results in realized losses. Also, if you wait too long to re-invest, you can potentially lose much more in gains than from timing the market drop.
Bottom Line: This requires caution because exiting the markets completely can result in lost opportunity and realized losses.
Dump Everything and Buy Safe Havens (Expert)
This has the same timing issue as dumping everything for cash, but has more upside as safe havens are investments which tend to go up when the stock markets are going down. This doesn’t work for your everyday or even intermediate investor, because they don‘t want to keep on eye on the economy and the markets at all time, waiting for the first one to blink like an old-fashioned pistol duel. This also has downside, in that you can lose out on potential upside once the markets resume business as usual. However, for expert investors, you can use the market downturn to raise more cash and invest it during the downturn, giving you more upside later.
Bottom Line: This is only recommended if you use safe havens with Roundabout Investing. The only true safe haven right now is the U.S. Dollar because it’s the world’s reserve currency. Even traditional havens like gold are volatile when markets crash.
Gamble on the market’s fall (Professional)
To get this right, you have to guess not only the timing of the top, but the short-term direction of the entire market. This requires the most number of planets to align to win, so it's something only worth doing if you're a professional investor. Also, if the markets continue moving up, your protection loses money instead of making money. In the long-run, the US markets will continue to go up.
Bottom Line: This is not recommended because the stock market increases with the expansion of the economy over time.
Roundabout Investing (Intermediate)
Roundabout Investing protects your portfolio with a hedge prior to the market crash. It can “immunize” your portfolio from a market panic like the coronavirus and you can accomplish it with only two investments:
1. Low-cost stock index mutual fund (core portfolio)
2. Hedge investment (portfolio insurance)
Because the market has already crashed in 2020, Roundabout Investing is only useful in preparing for the next crash (i.e., you can’t buy home insurance after your house catches on fire.)
Bottom Line: Now that the market is already crashing, investing during the height of the panic in a low-cost stock index mutual fund is recommended as a low-risk investment. The hedge should not be purchased until you have overpriced market indications and there is a strong signal for a downturn.
How to Invest the Golden Goose Guide Way (and not just during a pandemic)
Only one thing is for certain among all this uncertainty, and that's the eventual recovery of the U.S. market, given it's position as the world's largest empire (by GDP), free market economy, world's reserve currency, strong demographics, increasing productivity due to technology, and plentiful natural resources.
Notice that the Golden Goose Guide recommends purchasing a low-cost stock index mutual fund for your core portfolio, not an exchange-traded fund (ETF). Here are the main reasons why:
The #1 rule for the Golden Goose Guide is Ownership. Your core portfolio should have ownership in physical shares.
ETFs are not direct ownership of the index, they attempt to track the index, whereas most mutual funds give you complete ownership of the shares (you can read the prospectus if you're not sure).
As an ownership example, you can find an S&P 500 index mutual fund for annual expenses as low as 0.02%. This is as cheap (or cheaper) than an ETF alternative.
A simple example of a hedge is an investment which tends to go up while the rest of the market goes down. Although I don’t recommend ETFs for your core portfolio, ETFs do offer good hedge investments in the form of derivative ETFs which require very little capital to create a hedge on the rest of your portfolio.
The hedge needs to provide protection from a market implosion. Can the novice investor buy this kind of insurance for his or her portfolio? You can. A good example of a Roundabout Investing hedge is the VIX Index. It’s an index of market volatility (also known as the fear index) which is actually designed to be a hedge for market crashes like the one we’re experiencing now. Unlike selling stocks, you can hedge using the VIX without crashing the market or worry about being unpatriotic.
For example, if you had invested 2% of your portfolio in a leveraged VIX fund in February 2020 near the low at $40 when the coronavirus was already spreading beyond China, your hedge would be worth about $700 in the middle of March. This fills the gap by offsetting 35% of index fund losses in your portfolio!
The hedge protects this portfolio's value during the crash
The tradeoff for more leverage in the VIX is that its value decays quickly over time (called ‘contango’), so it's not suitable for the long term. After this explanation of the hedge, now you can see why you can’t buy home insurance after your house catches fire. Because everyone’s house is on fire, the price goes up! Ideally, you buy the hedge when you see smoke on the horizon.
If your insurance has shored up your portfolio, how do you know when to reinvest in a market panic? I go by Warren Buffet’s maxim: “Be fearful when others are greedy, and greedy when others are fearful.” In that sense, you can get a fairly good idea of whether people think the world will end based on news and social media.
This is a unique investment situation, so rather than trying to project when the economy will be restarted, I’d look at the number of infections as the world begins to successfully quarantine the new virus during the first wave after the ensuing lockdowns. When the lockdowns reach their peak, the market reprices to assess the economic impact. Pandemics go in waves, so it will take time for the market to recover completely.
You might ask, what about pet projects? People like to buy their favorite companies, though they should buy only strong investments in sectors they are experts in.
Yes, you can invest in pet projects, but I don’t recommend putting more than 10% of your stock in a speculative investment. To use another Golden Goose metaphor, don’t put all your eggs in one basket, unless you have insurance for both the eggs and the basket.
Wrapping it up in a nice tidy checklist, here’s how to use Roundabout Investing during a market panic:
Hang on to your index fund and don’t sell. You’ll only realize losses.
If you do have a hedge, at the height of the panic, sell your hedge. Keep your index fund intact.
Reinvest your hedge money in a low-cost index fund.
Don’t bother buying a new hedge right away, because bull markets last on average about 5 years and the hedge value will erode over time.
When the market is overpriced and signaling a recession, buy a hedge again with 2% of your portfolio when you see smoke on the horizon.
If you miss buying the hedge, don’t worry. Just go back to #1.
Here are some pitfalls to avoid during a market panic:
Don’t go chasing “stocks on sale” (like the airlines). The last time this happened in 2008, people kept buying GM right up until the stock was worthless, because they thought the government bailout would keep it afloat. It kept them afloat, but GM still reorganized under bankruptcy and common stockholders were wiped out when the stock was cancelled and reissued. Guess what the government got? The reissued shares.
Don’t try to guess the next biomed stock which claims to have the next COVID-19 vaccine. For every legitimate contender, there are 100 jockeying for publicity. The same goes for many other too-good-to-be-true virus investment scams, like penny stocks.
Don’t hold your portfolio in a few stocks only in one sector. For example, if all you hold are oil company stocks, you’re completely exposed to the oil wars between Saudi Arabia and Russia. Hold an index fund instead.
Don’t hold cryptocurrencies like Bitcoin as an investment, as they are more likely to drop than the stock market when there is a “flight to safety”. Bitcoin's over 30% drop along with the markets in March 2020 is the best proof that crypto is not a safe haven - not unless your government's currency is crumbling, like Venezuela.
Understandably, most are focused on protecting their loved ones during this time. Please stay safe during this time and follow the guidance of doctors and infections disease specialists who work in the field every day. Their predictions have generally been accurate thus far.
The predictions of politicians, economists, and journalists have been pretty poor in comparison, so Golden Rule #8 is this scenario is: Don't trust people who get paid to tell you what you want to hear.
Using this rule, Bill Gates, a global health and technology expert who leads a foundation aimed to eliminate diseases by giving his billions away, is a better source of information during a pandemic than politicians who make money from lobbyists or their own private business. Why? Because having stepped away from business in favor of philanthropy, he has nothing to lose.
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-Golden Goose Guy
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