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Now THAT'S Livin'...

My Grandpa Jerry was a lawyer, an artist, a pilot, and one funny SOB.  His favorite joke (and the one he made my father promise he would tell at his funeral!) went something like this:

BillyBob, Bubba, and Sonny are three rich Texas oilmen. One night, they find themselves sitting around a campfire discussing their many conquests and great fortunes that they had spent their lives accumulating… the conversation soon shifts to the fact that their best days are likely behind them and they should probably start thinking about what they’ll be remembered for.

As the whiskey flows and the limited nature of their legacies becomes more apparent, the three of them realize how easily they’ll be forgotten and figure at least one of them should be remembered for something... so they make a pact:

Whichever one of them is the first to die will be buried in a gold-plated Cadillac, paid for by the other two.

Surely, they surmise, a man buried in a gold-plated Cadillac will be remembered forever.

Well, years go by, and their fortunes continue to grow until one day… good ol’ BillyBob kicks the bucket. Bubba and Sonny each stay true to their word and write a check… a gold-plated Cadillac arrives just in time for the funeral.

Sonny and Bubba show up to the funeral in their Sunday best. Just as BillyBob and his gold-plated Cadillac are being lowered into their final resting place, Sonny turns to Bubba and says:
 
“Now THAT'S livin’, Bubba!”
 
 
The history of the oil business is an entertaining one.  It's chock full of colorful characters, littered with stories of gushers and dry wells, and brimming with tales of quick bankruptcies and even quicker resurgences.

A new chapter came along this week though...

Oil prices went negative for the first time in history on Monday.  No, you can’t actually have someone pay you to throw it in your pool… but you could have had someone pay you to go take delivery of 1,000 barrels of black gold in Cushing, Oklahoma.  There are a lot of different reasons that you could point to for why this happening: demand is falling off a cliff due to COVID-19, the Saudis tried to start a price war and squeeze out their American competitors, Russia is willing to cut off its nose to spite its face, all sorts of technical factors in the way oil is traded, etc…
 
The one simple explanation that I don’t think gets quite enough credit, though, is liquidity.  Specifically, the lack thereof.
 
Any time you make an investment, you’re betting that liquidity will be available at some price when you want to exit your position.  So, say I buy 1,000 shares of stock, my belief is that if I need to sell those shares at some date in the future, there will be a buyer lined up to take them off my hands.  The greater the liquidity in a given market, the greater confidence I can have that there will be more accurate “price discovery” and, thus, prices won’t move too far from the asset’s intrinsic value.  Said more succinctly, liquidity helps ensure that I won’t get completely ripped off when I’m looking to sell.
 
Liquidity is a funny thing, though.  It can dry up quickly and, sometimes, for no apparent reason.  When things are good, it’s everywhere to be found.  When things are bad…well, I guess I’ll just paraphrase my favorite Warren Buffett quote:

Liquidity is like oxygen.  You don’t notice it until it isn’t there.

So there was a lack of liquidity in the oil trade on Monday, mainly due to the fact that there aren’t a lot of places left to store oil right now and buyers don’t want to run the risk of running out of space when they actually have to take delivery.  Also, oil contracts settle each month and the May contract was settling at the end of Tuesday’s session, giving buyers limited time to line up ever vanishing storage.  This created the dreaded combination of forced sellers without a lot of buyers to hold prices on the other side of the trade.  That’s what a liquidity squeeze looks like.
 
This week’s oil market trade is only the latest in what has been an ever increasing and alarming amount of illiquidity seen across a variety of markets recently.  This is not uncommon in ugly market environments; I covered this in pretty great depth here and here so I’m not going to belabor the point but it’s worth noting. 
 
One point I will belabor, however, (and I swear this isn’t a victory lap because I had absolutely no idea that oil would nor even could trade negative) is from my note on March 9th that said:

You're about to see some things happen in markets that will be somewhat goofy.  As leverage unwinds, it usually takes prices lower with it.


When forced selling hits, markets can do crazy things and Monday’s oil trade was just the latest example.  There will likely be more.
 
 
Pretty much everyone agrees at this point that COVID-19 will be disastrous for the economy.  There is a great deal of divergence, however, in how long that will last and what the resulting financial market impact will be in the immediate term.  Here’s the 30 second version of where I think we are:

The most reasonable argument for the bulls at this point in the cycle is that the government’s various stimulus packages are going to reflate the economy.  Make no mistake, the government has shot a bazooka at this thing… it’s way more than what they’ve ever done before, miles ahead of the actions at the depth of the 2008 financial crisis. We’ve obviously seen a strong move higher in equity markets over the past 3 ½ weeks on the back of this theme. On the one hand, we’ve seen higher lows and higher highs in equities over this period of time… that’s a good sign. On the other hand, we’ve seen Treasury yields continue to grind lower over this period of time… that’s a really bad sign. In order for the stimulus to work, we need some inflation and we need pretty robust business activity to resume quickly. Let’s continue to wait and see what happens, but neither looks terribly promising at the moment.

The most reasonable argument for the bears at this point in the cycle is basically that this problem is way too big and broad for even the US government to effectively contain.  This is the inverse of the age-old adage “don’t fight the Fed”. This argument goes that the natural state of affairs should be for complete economic and market carnage, a clearing of prices, and a resetting of the new market order. On the one hand, an incredible number of business closures and bankruptcies are coming and it will be devastating for financial assets… that’s not a great sign. On the other hand, lawmakers have actually found a way to coalesce around a common goal of supporting small businesses and could help keep some of their doors open… that’s a pretty good sign.

As you might imagine, I fall somewhere in between these two camps. I wouldn’t want to stand on the other side of a trade from the Fed. They have a printing press (read: an unlimited amount of money!) and I don’t. But I also don’t think it’s possible to fight the natural order of these things without some very serious and negative unintended long term consequences. I think the Fed is putting those on the back burner right now with the idea that you throw everything you have at this thing now and worry about the rest of it later.

So, if I had to pick a position, I would say I’m probably tilted slightly bearish at the moment, with the caveat that I do think this will pass… but it will take a while.
 
 
There are some really big questions that need to be answered that will help determine the shape and duration of any eventual recovery.  Those include:

When will companies be able to accurately provide future earnings guidance?  If there has been one theme to an admittedly young earnings season over the past week, it’s been withdrawn guidance for the full year as companies assess the macro environment. We’ve seen it from companies of all sizes and from across pretty much every economic sector. No one wants to step out on a limb and make a wrong prediction given the speed at which things are moving… that needs to change so we can see what full-year earnings look like and how quickly corporate America can recover lost profits. It's pretty tough to gauge whether the market is cheap or not when you don't know what kind of earnings to expect in the future.

Who are the big players that are going to go under?  You know they’re out there.  Neiman Marcus and J.C. Penney are obviously in the headlines now, but they were in trouble coming into this thing.  I still think there’s going to be a few big ones that no one saw coming.  Remember, second order effects matter.  Hopefully it isn’t anyone that would create a systemic risk but we won’t know who it is until this thing drags on a little longer.

What kind of economic relief will be provided to state and local municipalities?  Secretary Mnuchin alluded to this in his comments yesterday but, thus far, the government has kept its focus on the private sector. Make no mistake… all of this is deeply negative for state and local balance sheets and we’re starting to hear this from governors on down the line. The largest line item cost in all 50 states is healthcare spending and that is set to go a lot higher. Sales and income tax receipts will simultaneously fall, which isn't a great combo platter.

How will the government step in to ameliorate the damage in real estate markets over the long haul?  The financing behind the commercial real estate market has become much larger and more complex over the last couple of decades as CMBS and other forms of shadow financing have grown to be a much greater piece of the overall financing pie. Everyone from “mom and pop” apartment building owners on up to large REITs are struggling with the same core issues right now: their tenants can’t pay, their mortgage payments and property taxes are still due, and they have no clue when any or all of this might change.
 
 
It’s kind of hard to believe but today marks one year since I started this business.  It’s been a wild ride full of twists and turns I never saw coming, most of them positive but some of them negative as well. I started writing this weekly update as a way to keep all of you apprised of my thoughts with the hope that it would help you better understand why I position portfolios the way that I do; it’s morphed into a way for me to stay connected with so many of you, hearing how you and your families are doing in an extraordinary time of societal and economic upheaval.

As I enter year two of this endeavor, I’m reminded of my Grandpa Jerry, about whom I started this post. He’s someone I think of often when the world is in peril given all of the turmoil that he experienced in his life. He undoubtedly would have had some strong opinions about what we're seeing today and how best to move through it... and he would have told you a few jokes while he was at it.

I recall being reminded of all that this great man was when we laid him to rest some years ago:

A child of the Great Depression who took a job at a movie theater as a teenager to help his family make ends meet.

A pilot that flew gliders over enemy territory in World War II.

A civil rights attorney in the Department of Justice who fought for and won the ability for everyone to vote, regardless of the color of their skin.

A family man and a hero to me.
 

Now THAT’S livin’…