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McCabe Lecture Series
April 20, 2020

March Madness Erupts

By John J. McCabe '65

At end of February, the formidable US consumer-driven nation was riding high and setting records. The economy had posted 128 months in a row of uninterrupted expansion and the eleven-year long bull run was still underway. The Dow Jones Industrial Average was up over 250% and more than 160 million workers were bringing home paychecks. The puny 3.5% unemployment rate was hovering around a fifty-year low and just about anyone searching for work could land a job.

In a matter of days, much of February's bullishness turned sour. The killer Coronavirus had infiltrated the nation and freedom from harm issues were engulfing the population. Routine everyday day social and economic activities were turned upside down. To protect human life and stem the growth of the infectious disease "shelter in place" and "social distancing" mandates were forced on the public.

At month's end eighty million Americans were locked in at home. Small businesses, those carrying five hundred or fewer employees, already put the shutters up. Small business accounts for half of the US workforce and sixty percent of all new jobs. Investor confidence was also battered. It took just twenty-three days for the S&P 500 to enter bear market territory. The swift 34% pratfall eliminated over ten trillion dollars in market capitalization. By mid-March, the world's only superpower was wrestling with the beginnings of a full-blown recession.

Taking a pounding!

United States economic output so far has plummeted twenty-five percent and over twenty-two million workers have filed for unemployment benefits. How long this government-initiated demand contraction will last is unanswerable. No template or playbook exists for countering this unprecedented upheaval. The health and wellbeing of the nation is at risk and rightly so, the medical professionals are in charge. With time business losses can be recouped but a life lost can never be regained. Progress on the disease will dictate the power and timing of the economic restart. The good news is that the medical professionals all concur that the Coronavirus will be defeated.

Media pundits keep drawing frightful comparisons between today's distressed environment and both the Great Depression and Great Recession. This two wealth-eliminating reversals constitute the longest and most devastating contractions ever recorded. The ongoing reversal is a health provoked systematic event. One that broadsided the nation without warning. Before both the Great Depression and Great Recession started caution, lights were flashing. Not so this time.

Depressions are prolonged recessions that produce monstrous unemployment and lost profitability. The Great Depression lasted throughout the 1930's and some economists project that if it were not for the gargantuan labor and capital demands of World War II and the Korean War, it would have taken until the sixties before the nation got back to full throttle. In the three years between 1929 and1932 unemployment skyrocketed from 3% to 25%. Throughout the entire decade of the 1930's, the unemployment rate never dipped below twelve percent. Industrial production during this same period skidded fifty percent while GDP plunged all the way to $58.7 billion from $103.6 billion.

The social costs were mind-boggling. The Dow Jones Industrial Average from high point to low point, collapsed 89%. Real estate values sunk ninety percent. Eleven thousand banks failed, wiping out the savings of hundreds of thousands of citizens. Producer prices contracted thirty percent. Family incomes dropped forty percent causing legions of Americans not to meet monthly mortgage payments. On top of all this, over one million men abandoned their families.

Fortunately, extraordinary monetary and fiscal policy initiatives have been put in place to protect small businesses, keep the commercial infrastructure in place and put money in the pockets of furloughed and outplaced workers. It was almost the total opposite situation back in the 1930s. The Smoot Hawley Act of 1930 raised tariffs and precipitated an international trade war. The Federal Reserve Board tightened the money supply kicking up interest rates. In addition, hardly any financial assistance was doled out to displaced workers. President Franklin Roosevelt's New Deal Program did not come online until 1932 and like most major federal government rollouts, it took time to become fully operational.

Entering the 18-month long Great Recession danger signs were apparent. Subprime mortgages were being issued at a hasty clip. Far too many "Too Big to Fail" financial institutions were becoming over-leveraged. The housing sector asset bubble was overinflating and the credit rating agencies were not as sharp as they should have been. Lax lending standards were also far more prolific than presumed.

Bankruptcies zoomed. Loan defaults multiplied. Mergers for survival jackknifed and the unemployment rate raced to ten percent. The Dow Jones Industrial Average slid 54% obliterating a gigantic bucket of previously held gains. Once again, Congress and the Federal Reserve Board were forced to come to the rescue. The Fed saturated the fixed income landscape with liquidity. The Troubled Asset Relief Program (TARP) was passed by Congress in 2008 and is credited with preventing the collapse of the global financial system.

Bull Markets surround Bear Markets!

One characteristic the Great Recession and Great Depression have in common with all previous contractions is that bear markets accompany them. Since WWII the US has suffered through eleven recessions and eleven bear markets. Bear markets are defined as a 20% or greater pullback in the Dow. The average life of a bear market is approximately fifteen months while the typical recession lingers for about eleven months.

History records that post each recession, the mature, cycle consumer-dominated US economy goes on to establish record-breaking tops in GDP. Growth in productivity and labor are the two key variables in measuring GDP advancement. During recessionary times unemployment shrinks, demand for goods and services dry up, productivity wanes and GDP is reduced. During these reversals however, excesses are flushed out the system and corporate America gets back into fighting trim. As the downturn peters out employment and productivity gain momentum, consumers unlock their wallets and both GDP and net profits click into higher gear.

Essentially, the only reason for purchasing equities is to generate a profit. That is not so on the sell side. Over a dozen reasons exist for unloading stocks. Portfolio rebalancing, tax decisions, estate purposes, margin calls and taking a profit are among them.

Fear and greed are the two emotions that can lead to costly illogical buy and sell decisions. During bear markets stocks collapse faster than they rise and selling pressures rapidly overpower buyer enthusiasm. Also, the longer and deeper a bear market goes on, the greater the chances fear will pummel logic. When panic sets in hordes of investors capitulate and sell at any price. They throw the baby out with the bath water. Both gold and garbage are sold simultaneously thus helping to establish a market bottom.

Perceptive long-term value investors recognize that security selection demands counterintuitive thinking. Wall Street is an atypical shopping mall. When the overstocked inventory goes on sale, the parking lot is almost empty. When the merchandise becomes overpriced, it is hard to get a spot.

The equity market is also a vivid example of mob psychology in action. Most investors follow not lead, put too much emphasis on the short term and too little on the longer term. In addition, many intuitively surmise that things in motion will stay in motion and will not change.

Savvy long-term investors searching for undervalued common stocks understand that security selection is akin to firefighting. When everyone is running out of a burning building, the firefighters run in to protect life and property. These brave professionals are the first to determine which assets have retained marketability and which have little or no residual value.

At a New York Society of Security Analysts meeting several years back, Warren Buffett, the famed 89-year-old value investor and CEO of Berkshire Hathaway, Inc. was asked "how long to you usually keep a stock in your portfolio?" He responded "forever" and went on to explain is logic. He proclaimed he was not smart enough to time when to enter the market, when to exit and when to go back in. Market timing in his opinion is a "loser's game." The Oracle of Omaha further offered that he was, however, smart enough to never bet against the recuperative powers and fearsome growth potential of the United States. He also offered that history was on his side and bear markets present a bevy of outstanding long-term purchase candidates.

A second analyst asked Buffett why with all the free cash flow Berkshire Hathaway generates, his board of directors never declares a cash dividend? His response was enlightening. "I love and work for all my shareholders" was his response. By maintaining a one hundred percent earnings retention ratio, Berkshire holds the firepower to consistently deliver an annual return on common stockholder's equity hovering around twenty percent. Simply by reinvesting the owner's cash back into the company, Berkshire's management team can do much better for them than they can do for themselves. On an inflation-adjusted, after tax basis Buffett asserted, "a two or three percent annual dividend yield is no match for a ROE of twenty percent." One share of Berkshire Hathaway common stock purchased for $38 in 1968 was worth $309,096 on February 28th.

Let's hope and pray March Madness next year returns to the basketball courts.

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