The Digest #11

Published on March 4, 2020

“There are more things to alarm us than to harm us, and we suffer more often in apprehension than reality.”

— Seneca

In Today’s Issue:

  • The Coronavirus Correction
  • Daily Journal Meeting Transcripts – 2016 to 2020
  • Treasury Bonds – Where’s the Margin of Safety?

To read last week’s newsletter covering the Berkshire Hathaway annual report, Louis Rukeyser on the 1987 stock market crash, dollar cost averaging, and the benefits of walking, please click here.

The Coronavirus Correction

Financial markets have come to the realization that Coronavirus is a story that is not going away anytime soon. As long as the virus was confined mostly to China and other cases could be readily explained, markets in the United States appeared complacent. However, reports of an increasing number of cases in Europe over the past week, including some that appeared to be spreading within local communities, caused the S&P 500 to drop 11.5% last week before closing 4.6% higher on Monday.

On Tuesday morning, the Federal Reserve announced a 0.5% cut in the fed funds rate to a range of 1-1.25%. Although the Fed’s action initially caused stocks to rally, the S&P 500 closed down 2.8% on Tuesday. Perhaps the market’s initial euphoria was tempered by the realization that a cut in between FOMC meetings is rare and could be seen as a sign of panic.

At times like this, it is important to view events with a sense of perspective, both in terms of the actual impact of a pandemic and its effect on financial markets. Here are several links to articles related to Coronavirus and the markets that readers might find interesting:

  • Thoughts on the Coronavirus Correction (Rational Walk). This article, published on Sunday, attempts to put in perspective the impact of a pandemic on the underlying businesses that stocks represent and the potential impact on intrinsic value when disruptions occur. There is also a discussion regarding prospects for Berkshire Hathaway’s share repurchase program in light of the drop in the stock price last week. 
  • Who Cares What Mr. Market Thinks? (Brooklyn Investor). On Monday, Brooklyn Investor made similar points regarding the need to look at the impact of a pandemic disruption on actual businesses and the implications for intrinsic value. 
  • Nobody Knows II (Oaktree Capital). Howard Marks provides his insights regarding Coronavirus, the impact to the real economy, and the reaction of financial markets. Anything Howard Marks writes is worth reading and Oaktree maintains an archive of his past memos dating back to 1990.
  • Responding to Covid-19 — A Once-in-a-Century Pandemic? (The New England Journal of Medicine). Bill Gates is sounding the alarms regarding a potentially catastrophic pandemic:  “Now we also face an immediate crisis. In the past week, Covid-19 has started behaving a lot like the once-in-a-century pathogen we’ve been worried about. I hope it’s not that bad, but we should assume it will be until we know otherwise.”
  • Pandemics & Markets (Investor Amnesia). Jamie Catherwood’s blog on financial history devoted last weekend’s article to the impact of previous pandemics on financial markets. Everyone is talking about the 1918 Spanish Flu, which he discusses, but he goes way back to statistics from the Black Death pandemic of the fourteenth century. It’s questionable whether the behavior of financial markets in the distant past holds much relevance to what might happen now, but students of history will appreciate this article and the links provided.
  • How the Horrific 1918 Flu Spread Across America (Smithsonian Magazine, 2017). Excellent discussion of the 1918 Spanish Flu. Excerpt:  “We are arguably as vulnerable—or more vulnerable—to another pandemic as we were in 1918. Today top public health experts routinely rank influenza as potentially the most dangerous “emerging” health threat we face. Earlier this year [2017], upon leaving his post as head of the Centers for Disease Control and Prevention, Tom Frieden was asked what scared him the most, what kept him up at night. “The biggest concern is always for an influenza pandemic…[It] really is the worst-case scenario.” So the tragic events of 100 years ago have a surprising urgency—especially since the most crucial lessons to be learned from the disaster have yet to be absorbed.”

Daily Journal Annual Meeting Transcripts – 2016 to 2020

Two weeks ago, I sent out some thoughts regarding Charlie Munger and the Daily Journal annual meeting along with a link to a video showing the full two hour presentation and question and answer session. Those who prefer reading over viewing the video can now peruse a full transcript of the presentation and question and answer session thanks to Richard Lewis. 

In the following excerpt, Charlie Munger provides a sobering view of the future of newspapers:

Many of the newspapers in America had similar niches where they just made regular substantial profits in a very easy simple business to run. Of course, what’s happened is that technological change is destroying the daily newspapers in America, including the little ones like ours. The revenue goes away and the expenses remain. They’re all dying. Berkshire Hathaway owns, what, about a hundred of them, and truth of the matter is they’re all going to die. And there’s nothing that can be done with good management to save them.

It’s a sad thing because those newspapers were an accidental part of the government. They called them the ‘Fourth Estate’. And each one had come into being sort of by an accident of capitalism without any planning by the founding fathers. And the people who ran them became very powerful people due to two great American institutions. One is nepotism and the other is monopoly. (laughter)

The Latticework Investing website also has transcripts for the 201620172018, and 2019 Daily Journal annual meetings as well as a talk given by Peter Kaufman who is a Daily Journal director and CEO of Glenair. Additionally, there is a transcript of an informal “fireside chat” with Charlie Munger that took place after the 2017 Daily Journal meeting.

Treasury Bonds – Where’s the Margin of Safety?

As noted above, the Federal Reserve announced a rare 0.5% cut of the federal funds rate to 1.0-1.25% on Tuesday. The bond market has been anticipating a cut for several days with the ten year treasury note falling from 1.88% at the start of the year to settle at just over 1% on Tuesday after falling as low as 0.914% during the day.

Although U.S. treasury obligations still offer positive nominal yields, unlike the situation in many European countries, a ten year treasury note offering a 1% yield is destined to provide negative real returns if the Federal Reserve is successful in engineering inflation of 2% annually which has been its stated objective since 2012 when former Chairman Ben Bernanke formally announced that this would be the Fed’s explicit goal.

In a CNBC interview (videotranscript) on February 24, Warren Buffett had the following to say about the yields on offer for bonds:

Well, if you look at the present situation, we’ve talked about this before, that you get more for your money in stocks than bonds. That doesn’t have to be the case. I mean– but it’s usually been in the case in America. Very usually been the case. And– if you buy a 30-year bond today with yield 2% you’re paying 50 times earnings for an investment where the earnings can’t go up for 30 years. Now if somebody said to you, “I wanna sell you a stock that’s at 50 times earnings. The earnings can’t go up for 30 years,” you’d say that doesn’t sound very good. Stocks are way better than 30-year bonds. I mean, it’s–that’s clear. And–that’s one of the alternatives people h– people really have three basic alternatives, short-term cash which is an option of doing something later, long-time bonds or– long-term stocks. And stocks are cheaper than bonds.

Extending Mr. Buffett’s analogy, when you buy a ten year treasury note yielding 1%, that’s like paying 100 times earnings for an investment where the earnings cannot possibly go up for a full decade. There are clearly buyers of treasuries who are doing so on a speculative basis because the price of the bonds will rise if yields drop further toward 0% or go negative, as is the case in Europe. In addition, certain institutional investors are mandated to allocate certain percentages of assets to bonds. 

Loaning money for a decade to a government at 1% that has pledged to destroy 2% of the value of its currency annually seems like a proposition with no margin of safety. Not only will the interest and eventual principal repayment fail to keep up with inflation but a rise in interest rates between now and maturity will result in losses if the bond is sold before maturity.

Caveat emptor.

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Copyright and Disclosures

Nothing in this newsletter constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC. 

The Digest #11