This week, earnings began coming out in abundance, starting with many of the Big Banks. I’ve gotten through J.P. Morgan, Wells Fargo, Bank of America, and Citigroup. Research reports will be forthcoming. I will tell you that I am incredibly encouraged. All 4 banks were profitable, despite posting dramatic and expected reserves to account for Covid-19. This was also a strange quarter in that there was a regulatory change, where they are supposed to account for all future expected losses, instead of provisioning for them as they actually develop. The banks actually haven’t seen major delinquencies or defaults yet, but they reserve ahead of time given the economic uncertainty.
While the economic data is certainly going to get worse, I expect that the banks will have to continue to enhance their loan loss provisions, but profitability should be quite strong given the severity of the circumstances. The rate of change on loan losses will likely decelerate, as this was the quarter where everything changed. That allows the natural earnings power of the companies to shine through. I’d expect that U.S. banks will pick up market share against global and some regional competitors.
The big banks haven’t been a big position for us this year, as we took profits last year and in January, after owning them for years. Now many of them trade at absurdly cheap levels once again, offering incredible opportunity for long-term investors, and we have added selectively during this downturn. Right now we are still in a fear driven market, but as the mania fades, valuations today offer a realistic opportunity for 50-100% returns including dividends, over the next 3-5 years on many of these companies. I actually think the risk of permanent losses is quite low due to the lower valuations at which they trade at, but of course we are always subject to short-term mark to market fluctuations.
The data on the virus continues to show improvement. Most hospitals seem to be holding up okay, especially outside of the most tragically hit areas such as New York and New Jersey. The effects of the “cure” must be weighed strongly. We’ve seen about 20 million job losses in just a few weeks. Many healthcare workers and medical facilities are actually seeing furloughs because most elective activity has stopped.
Suicide rates tend to go up during a recession, as well as depression in general. Of course mental health, anxiety, and crime are also heavily impacted. The situation is very tough for those who sadly face some type of abuse in their households. The models have thankfully been proven wrong (they included strict social distancing), and while the situation is still deadly serious, we have to at least look seriously at these secondary effects. The people I talk to, which is a lot all over the country, are in a stressed state like I’ve never seen, far beyond the Financial Crisis. The good thing is, we have a strong likelihood to see rapid improvement in the economy as we open things up, due to the economic strength that existed just a few months ago. Unemployment rates will stay elevated, but you will see very fast job growth, as opposed to the horror that we are seeing currently.
The point of the lock-down was to flatten the curve, which has happened. Reopening will be a tricky process, easier for some states than others. I went to the store yesterday and every single person had a mask on and social distancing practices were in full effect. This isn’t likely to change for a while. The choice isn’t simply to ignore the health crisis by ending the lock-down, versus maintaining it. Instead it is instilling procedures and practices to do so as safely as possible, knowing that we are always going to be taking some types of risks. Even with a vaccine, which will take some serious time, the virus doesn’t simply go away. Even with the flu where we have vaccines, tens of thousands die in the U.S. each year. Those of us at more risk must take more precautions. It is simply a sad time as grandparents have a tough time seeing grandchildren etc., but we will persevere because we have to.
One last note: Technology stocks have held up far better than anything cyclical. This has helped our positions in the sector but we are underweight relatively. Tech benefits from holding a lot of cash, but we must be aware that valuations are reflective of peak levels. There isn’t a margin of safety and many people are canceling subscriptions to save money. Ad prices are down, so I think some market participants are forgetting that many of these companies are economically sensitive as well. While it seems safe to own them because they hold up better under this stress, any mean reversion would create a very different scenario, and over the long-term, mean reversion is very likely. We just need everything to not just go to hell (as they have) but stay in hell for a very, very long time, to do quite well. Things will get better, we just need to let time do its thing, but I will tell you I’m far more encouraged today, than Friday, despite whatever Mr. Market does in the interim.