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Iron Capital Insights

  • Iron Capital Insights
  • June 12, 2020
  • Chuck Osborne

Too Far Too Fast?

The market has come back considerably from the COVID-19-induced fall, and it has many people scratching their heads. The real world doesn’t look so great: COVID-19 is still here, and although it does appear that we have flattened the curve on a national basis, some areas are seeing upticks. Even in best case scenarios we are far from fully open. We have witnessed civil unrest, record unemployment claims, and a pandemic, and the S&P 500 somehow broke into positive territory for the year.

Is it too far too fast? Yes and no. The current state of the market reminds me of the problem with my industry. For too long the investment world has moved away from helping investors invest in companies and towards selling products. More and more of those products had become index-oriented. That works great in a bull market, like the one we had from March of 2009 until March 2020; that is an environment where everyone is doing well, so all ships rise on the rising tide. That environment is tough for professional investors, at least when compared to the index, because there is little differentiation and many areas get inflated prices, which professionals don’t like paying.

However, when the going starts to get a little rougher, the importance of prudent investing is revealed. Prudent investing is always done from the bottom-up, analyzing each individual investment on its long-term merits. This is always important in our opinion, but never more so than today. There are winners and losers in our current environment, and a prudent investor will wish to avoid those losers.

Airlines are a great example. As the market rally took hold and optimism started to return, many investors instinctively look to the places that were hurt the worst. Airline stocks are among that group and they have come screaming back. Does that make sense? No, and my free advice to any day trader who has been buying airline stocks would be to take your profits while you can. That is fool’s gold. It may take years for the airlines’ business to get back to where it was before the pandemic. How many travelers are willing to sit in a tube where social distance is impossible? How many businesses are going to keep their travel budget cuts and encourage more use of Zoom-style virtual meetings on an ongoing basis? These questions are unanswerable.

Might the airlines do better than expected and actually justify the optimism? It is possible, but prudent investing is not about having a crystal ball into the future. Prudent investing is about understanding probabilities. The risk-return payoff for airlines is no longer there. Seeing these stocks drop more than 10 percent in one day should surprise no one.

However, the same argument cannot be made about banks. We all need the bank, and even at the height of the crisis we were all banking. Take Wells Fargo. (As with all specific examples, this is for educational purposes and not a recommendation to buy a stock.) Wells Fargo is cheaper today on a price-to-book value basis than it ever was in the height of the financial crisis. We have plenty of other types of crises going on right now, but we do not have a financial crisis. During the financial crisis regulators allowed multiple financial institutions to go under and/or be taken over at rock-bottom prices. Wells Fargo took over Wachovia. It was not until Fed Chair Ben Bernanke finally said that they would not let another bank fail that the crisis finally ended and the stock market went on a 12-year bull run. Learning from that time, current Fed Chair Jerome Powell stated early on that the gloves are off and they were not going to let a single bank fail.

Bank stocks have been rallying up until this little blip, but did they go too far? No, not even close. Again, there is no crystal ball. These stocks could do poorly in the short run, but the valuations here are crazy low if anything, and that puts the long-term probability of success on the positive side. The risk-reward here looks much better.

The market is by definition fluid, and these relationships could change at any instant, but the lesson here is that underneath the surface it is not one size fits all. Some stocks have certainly come back too far too fast and stepping back is warranted, while others have yet to get the love they deserve, and any step back should be seen as an opportunity. Now is not the time for market generalizations; it is the time for prudent investing.

Warm regards,

Chuck Osborne, CFA
Managing Director