I received an email from Chuin Ting, CEO of MoneyOwl a few days ago.

It was an internal education sharing by their head of Corporate Business, David Yap on how we should look at MAS upcoming monetary policy posture. Before coming to MoneyOwl, David used to work in the trading of market instruments and foreign exchange in large international banks.

I always know that unlike many countries, we manage monetary policy through our currency rather than the interest rate. However, I did not pay attention to how it is actually done.

Until I saw David’s explanation. He eventually re-penned his thoughts here: Technical Note: Understanding The Upcoming MAS Monetary Policy Statement On The Singapore Dollar

If readers are not too aware of the S$NEER, I hope this short education piece would be useful to you.

Next time, when you come across a Business Times or Straits Times article on MAS’s policy changes, you can relate to it better.

So what is the S$NEER?

The S$NEER is the framework that MAS use to manage the strength of the Singapore Currency.

The main purpose is to balance between keeping the currency strong, but not too strong that it affects the competitive edge of the country in global trade.

It is also to rein in inflation.

While the majority of the economies around the world manage monetary policy through interest rates, Singapore manages this through our currency versus the value of the currencies of some of our biggest trading partners.

Singapore has always been a small and open economy where 40% of what we spend domestically goes to imports. So the rationale is that we have imported inflation and hence the effectiveness of using the value of SGD to implement monetary policy.

Mas will

1. Strengthen SGD when inflation is high
2. Weaken when the economy is weak

How MAS Manages the S$NEER in 3 Ways

At each monetary policy review in April and October, the MAS also decides whether it will make adjustments to the band’s slope, width or center.

Here’s David’s explanation:

“Imagine this band to be made up of two upward sloping parallel lines. The policy band is always upward sloping with the x-axis representing time and the y-axis representing the value of SGD (not USDSGD but just SGD).

MAS ensures USDSGD stays within this permissible trading band by intervening each time USDSGD trades close its bounds.”

1. The Slope of the Band

“MAS will steepen this slope to fight inflation and reduce the slope when our economy weakens.

This means that MAS will allow a certain percentage of SGD appreciation every year to fight imported inflation (positive slope). “

2. The Center of the Band

“This is used when there is a more significant change to the outlook for growth and inflation.

This is a de facto SGD devaluation used when confronted with difficult economic challenges. “

Kyith: MAS decide to center the band downwards in April 2009 during the GFC to make our currency more competitive in global trade. They center the curve back in April 2010 when the situation looked better.

3. The Width of the Band

“The band widens to accommodate increased volatility in the FX market.

It is basically ‘to save MAS bullets’ on intervention when markets turn extremely choppy due to events. “

Here is What David Expects MAS to Do

Given the economic challenges we have now, here is David’s analysis of how MAS may do, with respect to the 3 ways that was explained previously:

The slope of the band

“I believe it has to be reduced significantly to flat (no slope) as the economic picture is fast unraveling, faster than the Global Financial Crisis.

And if the mega fiscal packages announced by DPM Heng is anything to go by, expect an aggressive move by MAS. The market has certainly priced in this possibility. So USDSGD may not move much if this is announced.”

The center of the band

“For reasons cited above, MAS may not wait 6 months to devalue the SGD.

There could be a re-centering of the policy band lower. This is not fully priced in by the market. So if MAS implements that, USDSGD will trade higher on the news. (Spot reference: USDSGD 1.4268 on 28 March 2020 1430 hrs)”

The width of the band

“USDSGD has been trending up but still in an orderly manner. There is, therefore, no need to widen the band”

Here is What MAS Actually Did on 30th March 2020

This morning MAS announced what they actually did.

The slope of the band: MAS set the slope to neutral. They have not done this since Oct 2017

The center of the band: MAS took more drastic action by lowering the mid-point of the policy band for the first time since the global financial crisis in April 2009. The width of the band was left untouched.

The MAS also reaffirmed that official forecasters expect the Covid-19 pandemic to thrust Singapore into a recession of between -4% and -1% in 2020.

Core inflation, headline or all-items inflation forecast is slashed to between -1% and 0. Disinflation pressure should broaden. The inflation outlook was between 0.5% and 1.5%.

Summary

The NEER is something new to me and I am glad David explain this succinctly to us. Now that I know this, it makes me a little bit more interested to see whether his reading matches what MAS would do.

In this economic climate, we will not be the one setting out a devaluation posture. Everything is relative. It depends on who would dare to take up a posture to make their currency weaker so that they can be more competitive when global trade ever pick up again.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

This post is going to be less about markets and the sort, so if you are less interested in these, you can skip it.

The Little Shops Are Going to Suffer

The unique thing about this problem is that commerce came to a screeching halt.

In other crises, the problem was a lack of liquidity. Banks could not lend and small and large firms have to tighten their belt. Those who cannot will default and this ends up as non-performing loans on the balance sheet of banks. There are more unemployed. Providing liquidity to the banks lubricates commerce.

The shit thing about what we are facing now is that you can provide all the liquidity to you to facilitate spending, but if you cannot go out and carry out some services, it is very tough to lubricate.

The world comes to a standstill for a while because the manufacturing base of the world, China, couldn’t function. Your company does not have spare parts, and therefore cannot ship.

Now that they can ship, the demand drops off because other countries are on locked down. Commerce comes to a halt.

What kind of crisis does this other than the great depression?

The toughest folks are the small and medium-sized companies. They usually depend on their peers or the big companies to give them business. A hit in demand on a wide scale hurts them the most.

My friend Caveman said the working capital for these firms is usually very challenging. The government’s main support package’s job is to ensure that these companies do not fire their workers but sometimes you wonder whether they have operated a small business before.

JD Roth over at Get Rich Slowly has a good piece asking how Coronavirus has affected your life. I like that he explores a lot of the impact on his recreational and financial life.

But what captures my attention was his description of his friend’s experience:

To check my hunch, I messaged my friend Kyra Bussanich. Kyra’s the only four-time winner of Cupcake Wars and owns a local gluten-free bakeshop. “Have sales slowed at all?” I asked.

“Oh gosh yes,” Kyra answered. “And if things continue, I don’t know if there’ll be a bakeshop when this blows over.”

Things are so bad, in fact, that she’s taken a part-time job to make ends meet — and is even considering applying for a full-time job. All this while trying to run her business, a business that’s struggling because of the coronavirus.

Get Rich Slowly

Here is another account shared on his blog:

Now imagine this level of stuff happening around the world.

Most People Depend on their Next Paycheck

I am probably going to do OK because I know how to save and have saved up some money. However, the majority out there depends a lot on their paycheck.

Those who are earning a lot, they may still be paying their mortgage. Their paycheck is likely quite a fair bit. However, their liquid cash may only last them for 1 year.

The ones who have the least slack are unfortunately those who did not have enough “financial slack”. Financial slack gives you enough leeway such that if you are forcefully asked to take no-pay leave for an extended period, you can handle it.

I am not sure if there will be higher unemployment but I do think that not having enough business will make companies cut their biggest variable expense, which is manpower.

If there is a bigger wake-up call in the world to do something sensibly with your surplus from your take-home pay, it is this event. Many grandparents were haunted by the Great Depression that they became very frugal even after they have a large monetary margin of safety.

Perception of Risks Gets Re-calibrated

Many have entered the investing world in the past decade experiencing some sort of declines.

Thus, their perception of volatility is programmed by this experience of theirs. When they are assessed their risk tolerance, they will say they are comfortable with it.

A large decline is a -2% a day on the index.

That is probably our perception if, for the past 7 years, that is our experience.

And we plan our investment strategy based on our knowledge of this. Buy the dip if it comes along…

Usually, the frequency of large decline is few and far between.

Thus, it is to be taken advantage of.

What happens when you have 5 times that and they all happen in 2 weeks?

It became a rare event that has seldom happened before. I seen these crazy moves in 2008, but I cannot remember seeing this kind of frequency + magnitude.

Some usually less flappable, more assured investors got stunned by this.

This is normal.

We get word of panic by traders who trade for their shop.

Risk is not what you can control. Risk is a deviation from the norm. And there are always new things to be added to “the norm”.

Events like this re-calibrate my perception of what is risky. And that is a good thing if you get re-calibrated in the early or mid part of your life. It makes you less gungho and always think of those situations.

Yet at the same time, we have to be aware, these are really like 5 to 9 Sigma events. They do not happen often. Don’t go design a plan thinking these are so frequent (unless this becomes a norm).

What is a Higher Priority in Life?

Some years ago, my boss at Providend shared with some of us bloggers that money is an enabler together with wealth.

I reflected back upon this while we are chasing what could be a very opportune time to accumulate wealth at a good forward rate of return. Have we got complacent by thinking about money making too much and less about another aspect of our lives?

Some of us have pretty high paying career or business. But we exchange that with our time and energy. If we are not careful, we neglect our family and health.

But we need the financial wealth for our goals. With financial wealth, we can buy back some time and health.

These three things are always interchanging.

The Corvid-19 is special because we are not just talking about exchanging wealth with time, but wealth with health.

Nick Maguilli wrote a good section in his latest post reminding us why we are doing this:

Lastly, of all the things I have learned from the Coronavirus crash, it is simply to enjoy life while you can.  To illustrate this, let me paint you a picture:

Imagine someone who has been saving money for 40 years.  They have been sacrificing day in and day out so they would have enough for retirement.  They don’t eat out often.  They don’t splurge on themselves.  They make all the right financial choices.

Then they hit retirement and decide that they can finally live a little.  They take a trip to go skiing in Italy in the winter.  Nice time of year.  Then it happens. 

It starts as a cough, but it gets worse.  A fever follows.  Then they know they have it.   

Some version of this scenario has played out or will play out for seniors across the globe. 

We always talk about the case where a person prioritizes saving and when they retire, they kanna some terminal disease and it makes us wonder what is the point of savings so much and not get to enjoy any part of it.

Well, the unique thing about this ordeal is that it increases the possibility of some version of this scenario playing out.

I would like to put it in another way:

You are going to make a lot of money but you are going to lose some of your relatives. Would your life be better?

The opportunity is there for you to take advantage of and if you have, you would have been better off than if you are not financially equipped to profit from it.

But I doubt you would really benefit if you make so much money and your father or mother or grandparents are exposed and didn’t get to enjoy the money with you.

Interesting Observations from the Paid Blogging Space

There is always this Millenial narrative that you should not depend on your main job and you need to have a side hustle.

One of them is to blog for income. Basically, you became a media channel and you take in advertising dollars or you sell your own course.

This is still a very new niche industry and one that has not suffer from any downturn since it only got really popular after the Great Financial Crisis.

But I do wonder if blogging for income is an industry that does not suffer from the usual business dynamics. When commerce has come to a standstill, what happens?

Here are some observations:

1. Freezer and Crock-Pot Recipes are up recently.
2. Organic search traffic from Google, Pinterest is down for a lot of people. However, there are some who got more traffic than they usually get
3. Cost per impression and click are generally holding up
4. Travel bloggers focused on Italy saw traffic down 80%. So are theme park bloggers. Since they are used to their traffic having seasonality, they have adjusted well to this severe reduction in traffic.
5. Bloggers in the finance space saw their traffic increase greater than usual.

Whichever way you look at it, I think blogging is one media channel and as a blogger, you are not just competing or complementing your peers but also going against other mediums.

I gain this idea in investing that no matter how defensive a business, you are going to suffer if the industry is in a downturn. When the mainstream economy is not doing so well, the advertising budget on aggregate will be smaller.

The difference is that if this is your own business, you can hustle and try to save it. The way this game work is that you might be able to focus on content that will do well during this period in order to try and survive.

If you are a big shot on the right side of the spectrum, then even if you suffer a little, you will be OK. Those in the middle and the left side of the spectrum will feel the pain as in all industries.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

I gotta say, I have never been so poorly positioned before. And I have possibly made some really schoolboy mistakes.

But I am no guru who is selling a top list of stocks to buy with a Covid-19 contagion or top list that I will be looking to buy, so that is OK.

So I just hope everyone stays safe.

Some General Indices Data Points

I would just wish to capture some data points for blog history’s sake. I remember back in the days, my fellow blogger La Papillion from Bully the Bear used to capture these when we were bully by the bear instead.

Everything is down and down by a lot. Even Bitcoin is down which is befuddling but I think it will be recovering soon with the event upcoming.

Some of the older readers would know I ran this Dividend Stock Tracker where I keep track of some high yield dividend-yielding stocks in Singapore.

The fall yesterday was crazy. Some really enticing deals out there, but not sure if there is a liquidity event on the horizon.

How Rare Are These Huge Daily Gyrations?

A lot of investors who started investing in the 2010s are not used to seeing this kind of volatility, even in the indexes.

This is new to them. Even for someone like myself who went through it, this IS a bit crazy. Even in 2008, I seldom see 9% down days on the indexes!

CFA Institute has a good table showing the standard deviation distribution of the SP500 from 1950 to 2012. This is interesting in that it bypasses the 1920s to 1930s which is very volatile.

The majority of the fluctuation in prices is within +1 and -1%. You get rare events like this. 3-4% is basically… a 3-4 standard deviation event already.

A 1 standard deviation means that there is a 68% chance the price movement is capture within -1% to +1%. If we invert this, there is a 32% probability that your daily return is not captured in this range.

In a 3 standard deviation event, we have a probability of 0.13% that it will not be captured in the -3% and 3% range.

How Are are These Huge Monthly Gyrations?

Thus, today’s -9.51% move in the S&P 500, this event almost should never happen. It is like a TOTO event.

We are basically nearly -25% from the highs on the index, which means that we are in bear market territory.

Going back to 1926, the average monthly return on the S&P 500 is 0.95%. The standard deviation is 5.37%.

S&P 500 hit a new high in February 2020 but closed off sharply lower. This is a rare situation.

• FEB 2020 returns: -9.4%
• Mar MTD returns: -16.28%

Feb returns are almost a 2 standard deviation event and Mar is almost 3 standard deviation. In the grand scheme of things, these are important buying days or important days to avert because it is rare.

Out of what I experienced, this is the monthly returns. We can see that this drawdown looks pretty similar to the mid or tail end of a bear market.

2008’s price movement is a brutal 3.8 standard deviation event. It is a rare return.

If you were to ask me what felt different for this one was that… 2008 was a difficult event for shorting because anytime a certain stimulus package was announced, there will be huge counter-rally.

Some of those look rather tame but a lot of them look like they are going to turn. They get your hopes up high until the end where you just give up believing it.

It makes shorting pretty difficult.

This time around, whatever Trump tried to say, the market got even angrier.

I guess this is the main difference.

Past Greater than 10% Drawdowns and Returns Over Time if you stayed invested

Some data may not see the light of the day at Providend because it might unnecessarily scare the daylights out of some clients.

But here it is.

There are about 25 instances where the S&P 500 fell by more than 10% in 1 month.

I took a look at the returns if you have stayed invested.

You can see how brutal the 1920s and 1930s were. There are 10 instances out of the 25 instances that the monthly return is less than 16%.

If you take out eh 1920s and 1930s, after 2 to 3 years, you would not be red anymore.

I also took a look that if we prudently be in a 60% SP500 and 40% US-Treasury, whether that helped the situation:

I think you won’t recover faster, but looking at the magnitude of the fall, it is much more livable. 6 months after the fall, if we take out the 1920s and 1930s, the largest fall is -16% on your portfolio and the recovery happens after 1 year.

If you invest after such a large drawdown month

Some of your money would have been invested, and some of your money is going to be invested.

So what if you invest after a greater than 10% monthly fall?

The 1920s and 1930s are damn brutal. I really hope we do not return to those scenarios.

Even if you are 100% cash and invested 1 month after such a fall, 3 years from now your results would still be shit.

But aside from that, the data looks compelling to put more money to work.

When you tranch or dollar cost average into the market, you will capture all these good and poor sequences. If the market goes up over time, then your returns should be alright.

If you are in a balanced portfolio, your returns are not too bad. With a lower volatility, in 6 months’ time, most months you are green while the largest negative month is about 21%.

Duration to Deepest Point

This isn’t rocket science but there are some that rebounded in 3 months and some that took nearly 3 years. On average, it took 19 months to go to the bottom.

So you can use this to pace yourself.

How Long it Takes to Recover

A recovery is a period where prices go down, then comes back up to the original point.

There are about 121 falls from the peak sequences since 1926.

Where we are now, there are again 6 instances where the drawdown is greater than this. The length of time it takes to recover ranges from 2 to 4 years to as long as 15 years (pray that it is not the 15 years)

The difficulty with market timing is that 88% of the time, the fall is less than 10%. If you sit out of them, you missed out on the returns.

Yet each of those 10% to 20% falls feel like the start of a great fall we are seeing now. But they turn right back up and you could not all in.

This is why we always say… stay invested.

Summary

Ok, this took longer than expected. Lack of sleep. Not in a good mood now.

For those who are accumulating your wealth, look upon periods like this as an opportunity to get at a good price.

The math here is that if returns suck in the first 10 years, the returns next 10 years tend to be better. Your time horizon is long. Keep your job and be frugal and put away money regularly.

For those who are invested, there are silver linings based on the data that I have shown. These things are a cycle. Even doggy European countries can do OK.

Some of you might have your risk profile re-calibrated by this event. You think you could take volatility but in actual case, this might be a little harder.

There is a reason we have a portfolio made up of less correlated assets (even though in times like this, you realize they are all correlated!) such as bonds. They act as a cushion to your portfolio.

If you are near retirement, your adviser should have structured your net wealth such that great negative volatility like this should not derail your retirement.

If you are not sure if you are well structured for it, get some help.

The toughest would be the 35 to 50 who are halfway in your journey. You have invested and are still getting there. Stay strong people. (I would probably break this out to another post)

Stay away from crowds and wash your hands.

Do Like Me on Facebook. I share some tidbits that is not on the blog post there often. You can also choose to subscribe to my content via email below.

I break down my resources according to these topics:

1. Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
2. Active Investing – For the active stock investors. My deeper thoughts from my stock investing experience
3. Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
4. Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
5. Free Stock Portfolio Tracking Google Sheets that many love
6. Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
7. Providend – Where I work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works

I think for newbie investors, these 2 weeks have been a bit surreal. For as long as I could remember, we seldom have days of 2-3% daily up moves and 2-3% daily down moves since the financial crisis.

On usual markets, we should have the odd 2-3% moves but they should be over pretty fast.

A possible sign of a bear market is when you have many of these 2 to 4% daily moves clustering together.

Today’s post consists of some of the data that I see out there. It might be useful or might not be useful.

The chart above shows the 1-month yield change for Singapore’s 10-year government bond yield.

The 10-year government bond yield indicates a few things for me:

1. It is the rate where corporate bonds take reference from when pricing their debts
2. It generally indicates the GDP growth of a country
3. Inflation expectations
4. It shows the tug-of-war between stocks and bonds. A falling long term yield sometimes indicates that despite good economic times, the demand for bonds is increasing. This indicates cautiousness

The 10-year rate has fallen, even before the United States Federal Reserve decide to make an emergency rate cut of 50 basis points. This might indicate a mixture of lower GDP growth expected, lower inflation expectation and greater cautiousness.

In the past week, the yield has tumbled from 1.4% to 1.20%.

This is good news for interest rate sensitive assets such as REITs and Bonds. Their prices have shot up. This indicates that borrowing costs may be lower by as much as 1%.

The chart above shows the yield movement of the 10-year USA government bond. The 10-year in its long history has never been below 1%. Until this week.

When we were with Manulife US REIT’s results brief on the 5th of Feb, we were discussing their upcoming debt refinancing. The rate was 1.64% then. Management indicated in the market back then they should be able to refinance at slightly below 3%.

Today, at 0.77%, they might save 0.6% in interest cost. If the interest rate remains at this range, it would be conducive to the REITs.

Be Wary of the Magnitude Interest Rate Could Change

Interest rate matters to a lot of our lives since many readers own private property or leveraged endowment plans.

The loans are likely priced with some of these interest rate swap rates in mind.

Not too long ago, there was this fear that rates are rising and it is better to lock in the rates.

Now there is no fear anymore.

I always wonder whether you realize how much interest rate can change. In 1 month’s time, the USA 10-year yield dropped 53%.

The implication for you is that if you are risk managing your loans, instead of factoring in a 5% to 10% interest rate sensitivity, perhaps the better metric is 25%, 50%, and 75%.

If you use these sensitivity tests, you might realize that maybe these leverage endowment plans do not have much margin of safety and could be cash flow negative.

A Possible Liquidity Crisis?

If the interest rate goes down, then interest-rate sensitive assets such as REITs, MLPs should benefit in these bear markets.

But why aren’t this always the case?

Because in bear markets, it is usually accompanied by a recession which is not good for business. So income is affected (which brings me to the point that REITs is not always interest rate sensitive only)

A second reason is that in these bear, the sentiments towards debt lending shifts from easy to stringent. If your REIT is poorer in quality, you might not be able to refinance. There is generally less money out there to be borrowed.

Howard Marks, in his book, Mastering the Market Cycle, he talks about the credit cycle:

1. At the start, appropriately risk-averse investors apply stringent credit standards to the issuance of high yield bonds
2. The same healthy economic environment that facilitates bond issuance makes it easy for companies to service their existing debt (meaning default is scarce)
3. Thus high yielding bonds – with their generous interset coupons and little damage from defaults – provide solid realized returns
4. Those returns convince investors that high yield bond investing is safe, attracting increased capital to the market.
5. Increased capital for investment translates into increased demand for bonds. Since Wall Street never allows demand to go unmet, this results in increased bond issuance.
6. The same condition that allows larger amounts of bonds to be issued – strong investor demand – invariably also allows bonds of lesser creditworthiness to be issued

Usually, the credit cycle turns when the economy turns (not always):

1. A slower economy makes it harder for companies to service their debts.
2. With the credit market closed, refinancing can’t be accomplished, meaning defaults rise.
3. Rising defaults damage investor psychology
4. Investors who were risk-tolerant when things were going well now become risk-averse
5. Advancing capital to financially distressed companies – which seemed like a good idea just a short time earlier – now goes out of favor
6. Potential debt buyers back away, refusing to “catch a falling knife” and saying they’ll wait until the uncertainty has been resolved
7. Capital that is mobile flees from the market. Buyers become scarce, and sellers predominate
8. Selling of bonds increases; bond prices cascade downward; funds that receive withdrawals become forced sellers, and eventually, bonds are available for sale at any prices

This is how textbook knowledge is thrown out of the window. I realize that you can rename companies in the above two lists into ourselves and it will explain some of our behavior.

What I learn is that the irrationality affects lenders and spenders as well. The whole mood is just cautious. Cautious mood makes everything cautious.

A liquidity crisis is something the Fed is always trying to prevent. But what could cause one?

Daffodilistic from our Telegram chat brought my attention to the distressed in the Banking Repo Market. The repo market is a black box market where banks can put up their debts (loans to clients, businesses) in a market so that they can get short term cash.

With this market, they can alleviate short term liquidity with the debts on their balance sheet. In Aug to Sep last year, I started hearing that the Treasury had to step in to offer liquidity because… the Repo rate went up to 10%. For some reason, there is a real shortage of liquidity.

If you go down this rabbit hole, it might lead you to some doomsday subprime kind of crisis. Is it possible? I think it is possible but we are not sure about the magnitude of all the things.

I believe this is possible because we are getting some crazy historical high/low data points. When markets are so connected you get the feeling it is not out of the question there is a flaw not many see it coming in the system.

Modeling a 1 Year Lost in Earnings

The Covid-19 Virus is going to cause some very ugly numbers for a lot of companies. The market is currently adjusting to price in this scenario. The adjustment is usually mixed with the psychology of the investors as a collective.

So the price in the short term might not equal to the value.

Brooklyn Investor(BI) has a nice post in which he tries to explain how to model the impact of the Covid-19 virus.

One way of valuing a business/stock/company is to do a discounted cash flow analysis on the stream of cash flow of the company.

BI uses the case of a business that we do not expect the earnings per share (EPS) to grow over time. Suppose for this company we demand a discount rate for taking a risk of investing in this business of 4%.

Suppose we expect that this Covid-19 has a 6-month impact on the earnings of a particular company:

The image above shows the present value for an infinite stream of earnings from the company, discounted at 4%. In investing-speak, we say the intrinsic value of the company, based on discounted cash flow methodology, is 250.

If we reduce the 1st year EPS by 50% (deduct 6 months of earnings), the present value of the business is 1.92% less.

That looks quite ok because…. the value of the business is not just on the first year of earnings. The value of the business is in its future stream of earnings.

BI simulated the intrinsic value if the company did not receive income for 1 year:

And 2 years:

And 3 to 4 years:

Even a 14% fall in valuation looks OK. The future is uncertain and I don’t really wish for this to be stuck 4 years.

I do however like to caution that EPS can be negative. I think if cash flow is negative, it is difficult to do a DCF, and thus putting it as 0 makes sense.

How low valuation can get also depends on the discount rate and growth rate. BI didn’t use a growth rate (which is conservative) and he used a discount rate pricing the business as PE 25 times.

Some of your business might not be like this. The business might be riskier such that you would demand a 10% discount rate (which is a discount rate I used by default for a lot of uncertain businesses). However, I do think the discount rate does not matter.

This is because we are comparing the same company. If you are using a 10% discount rate before the ordeal and comparing it against the company after the ordeal, the difference in valuation due to having 1 year less of earnings should be similar (I have verified the math).

If we are realistic, let me modify BI’s case study to bed in a 5% a year growth for 3 years, 3% growth for 6 years and a 0.5% a year terminal growth rate after year 10:

The difference is 7.28% versus 3.8% if there is no growth (as illustrated by BI). But it is rather assuring that the intrinsic value is just a few percentage difference.

But what if the growth rate is 15% for the first 3 years instead of 5%?

The loss of 1 year of earnings matters much more to valuation.

This is because base on the time value of money concept, the cash flow in the earlier years is much more valuable than the future years. By “losing” 1 year of earnings, the impact is greater if you are expecting great growth rates.

A good example would be that if you like this high growth stock. It trades at 30 times of last year’s earnings. However, you are expecting a growth rate of 20% at least for the next 2 years.

The impact due to lower-income is going to affect the valuation of the company more.

However, these are theoretical and one reason I seldom use DCF so much in my valuation nowadays is because it is so hard to judge the stream of income going forward. Nevertheless, we can all learn from this exercise. It shows how important would it be to miss that 1 year of cash flow for the business.

My thinking: the earnings the company lost are just deferred to a later date. If the business is not a going concern, this is a good opportunity to pick up these stocks.

The businesses that will struggle to emerge with things intact are the businesses that have slim resources, have very tight working capital, those that do not have buffers.

I would normally ask you to have an emergency cash, and businesses need to have their own version of this as well.

I would see if I got some more posting tomorrow. Back to work.

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