Coronavirus and OPEC Black Swans Crash Stock Market like 1987

Stock and oil prices were declining due to the China-centric coronavirus demand shock, when on March 9^th, Saudi Arabia, OPEC’s de facto leader, eliminated oil production restrictions prompting a one day 24% oil price crash. This OPEC dispute has triggered a second global demand shock, which in combination with coronavirus has led to a 26.8% three and one half week rout in the S&P 500. Because both the coronavirus and the OPEC oil shocks are unpredictable and news flows are ubiquitous, global markets have priced in worst-case expectations culminating in nearly 30% peak to trough declines across the major averages.

Both the coronavirus and OPEC oil shocks will end. Because quantitative and computer trading dominate market action, this meltdown has been very rapid and created extraordinary bargains for those who can distinguish between the value of and the price of a security. This past week’s broad-based and record volume-selling suggests that forced liquidations have occurred and, assuming a diminution in bad news, suggests a stock market bottom–like that hit on October 19, 1987–has occurred. This creates a rare opportunity for those steely-nerved investors to buy when everyone is selling—a condition both Ben Graham and John Templeton suggest creates bargains in the market.

Sources: Chart on left,  Chart on right: Goldman Sachs

Oil Decline sizes:

• Daily: March 9, 2020. 24%. Largest since 1991.
• This year: 41 to 27.7 = 32.4% intraweek. Weekly decline 41 to 31.37 = 22.9%
• This year: peak to trough 65 to 27.7 = 57.38%. Year to date: 60.8 to 31.7 = 47.9%.

The oil price crash jeopardizes operators, like oil drillers, whose businesses are not hedged and or are oil price dependent. The oil industry is a massive economic engine and this disruption will absolutely slow the economy; however, like coronavirus, this will be a temporary disruption.

Saudi Arabia and Russia’s objective in flooding the market with oil is to realign the global production shares. In the last 15 years, the Saudi Arabian and Russian share of the global oil market has remained flat while US production has doubled from 6mm bpd to 12mm bpd to emerge as the largest oil producer in the world. The OPEC gambit is very costly so a reordering of production shares should occur within six months.

The chart below shows the 26.8% decline in the S&P 500. The decline merely returns the market to levels seen in 2018.

Since both the coronavirus and OPEC shocks were unforeseen and without clear precedent, they engender high levels of anxiety. These unforeseen macroeconomic events are called “black swans”, a term coined by Nassim Taleb. The level of panic, whether it is toilet paper hoarding or traditional market indicators suggest that the markets have fully digested, if not overreacted to, these shocks.

The chart below shows the VIX indicator “Wall Street’s fear gauge” spiked to 76 on March 12th. Friday’s VIXs reading is comparable to 9/11, LTCM, the Asian Contagion, the 2015 ETF crash,… suggesting the market is pricing in a severe economic slowdown.

Source Yahoo Finance.

The Chart of the VIX below shows the 76 reading nears the financial crisis’ in 2008.

Source Yahoo Finance.

Only during the financial crisis of 2008, when Lehman Brother’s collapsed along with Fannie Mae, Freddie Mac, and other major financial institutions, and the 1987 market crash, when the Dow Jones Industrial Average declined 22% on October 19th, has the market priced in more frightening scenarios than it does today. Even the 1987 market crash did not cause an economic recession. Given the likely two-quarter duration of these shocks, the odds of a global recession still remains low.  With the massive monetary stimulus and economic benefit of lower oil prices, the probabilities of a sharp market and economic rebound are strong.

Markets trade on valuations and alternative investment options. The Fed Model provides a method to evaluate the attractiveness of equities and compare them to bond yield—specifically the 10-year US Treasury.The Fed Model Risk Premium model below measures 5.38%. This indicator equals levels seen during the 2012 European Financial crisis and the Financial Crisis of 2008 and 2009.

The databox below shows the risk premium in 2008, 2000, 2012 and today of 7.15%, 6.61%, 6.61% and 5.38%, respectively. The risk premium is the difference between the earnings yield of the S&P 500 and the 10 year US Treasury yield. The earnings yield measures how much earnings is generated by a dollar’s worth of the S&P 500. Today the S&P 500 earnings yield is 6.33%. In 2008, 2009 and 2012, the databox below shows it was 10.32%, 9.44%, 8.18%.

The Fed Model framework is quite similar to the MLP to US Treasury valuation model. In both cases, the yield of the S&P earnings and the actual yield of MLPs is compared to the 10-year US Treasury Note. We believe that the earnings and yield stability for MLPs is better than the S&P 500. And since the spreads of MLPs to US Treasuries is at all-time records, MLPs are an especially attractive investment compared to the S&P 500.

For decades, MLPs have traded in line with bonds, due to their stable utility like cashflows. However, during market selloffs, MLPs are sold like stocks but are among the first assets to rebound due to their noncyclical cashflows. The spread between the Alerian MLP Index yield versus 10-year US Treasury note shows this market behavior.

As of Friday’s close, the MLP to Treasury spread was 16.8% exceeding the 12% peak during the 2008 Financial Crisis.

Historic market panics like this offer a rare opportunity for those investors who can distinguish between the price of an investment and the value of that investment. There is a compelling investment case to buy closed-end midstream MLP funds because their earnings and distribution risks are negligible.

We are buying Kayne Anderson MLP Investment Company (KYN) for our clients because KYN just dropped 63% resulting in a 26% yield and a 9% discount to NAV. Since MLPs process and transfer energy within the United States, the economic slowdown from COVID19 and the oil price shock should have a negligible impact on MLP’s utility like cashflows. The chart below shows the extreme price decline suffered by KYN.

Source: Interactive Brokers Trader Workstation

The cashflow stability of MLPs is graphically displayed below. Even during the financial crisis, cash flows were still positive for MLPs.

The chart below graphically shows the historically sharp declines of MLPs during market events and their rapid rebound from 2008 and 2016. These rapid rebounds are due to the vast majority of investment money searches for yield. When reason and calm begin returning to the market, large sober pools of capital like retirement plans will begin snapping up 25% MLP funds like KYN or any stable double-digit yielding MLP or fund where the underlying cashflows and distributions appear safe.

Source: Goldman Sachs and Alerian Research

Since the 2016 oil bear market, MLPs have reduced their leverage, and the Alerian Index now has a distribution coverage ratio of 1.58. Further, while some drillers will close due to this oil collapse, we anticipate that only a single digit decline in cash flows from this temporary shock. Consequently, we are buying diversified MLP funds for our clients, as the distribution coverage, cash flow stability, and risk mitigation of a diversified portfolio provides an unprecedented risk reward proposition to informed investors.

We believe the worst case scenarios are largely priced into the stock market today. This decline is rare opportunity to pick up bargains like closed end MLP funds with high yields, discounts to NAV and steady cashflows. We have been selling gold, gold stocks and using those proceeds and cash to make opportunistic and compelling investments during these panicked days in the market.