Who knew it would take a pandemic to take down the bull market? I had an inkling that the Corona Virus would take down equity prices a little but not like this. When I read Sequoia Capital’s letter to their startups warning that the Coronavirus was the “Black Swan” of 2020, I immediately thought of Nassim Nicholas Taleb’s book of the same name. So what did his nearly two decade old book have to say about the crisis at hand? Before I share his advice, there must be a universal understanding of the environment at hand.
The first and principal condition that investors must consider is the novel (new) Coronavirus and it’s potential ramifications, which we’ll discuss below. The second condition that must be considered, albeit to a lesser degree, is the oil price war. However, the oil war is only an idiosyncratic concern with regards to some very specific equities.
The ramifications of Covid-19 (the disease caused by the new Coronavirus) have both social, political, and economic consequences. The numbers coming out of South Korea and Italy, both democratically elected governments, indicate two different worlds. South Korea, with more than eight thousand cases as of March 15, has a case fatality rate of about 1%. While this mortality rate is 10x deadlier than the flu, and still very concerning, it would not decimate economies as markets are predicting. Italy’s story however is extremely concerning and warrants the reaction that has been taking place across Europe and the United States. With more than twenty-four thousand cases and eighteen hundred deaths, Italy’s mortality rate with Covid-19 is 7.5%, as of the same date. With a mortality rate 75x the flu, the markets are underreacting to the possible damage of Covid-19. So if this virus is between severely damaging or just a severe flu season what does this mean to the investor?
The investor buys when the value of a security is prejudice-ly sold below its true value. However, with regards to the broader market, this has not happened. Price-to-Earnings multiples are still at all time highs and the market is not correctly reflecting the true risk posed by Covid-19. A 7.5% mortality rate is on par with the Spanish Flu of 1918-20, which killed more than 70 million people. If the conditions Italy has been subjected to becomes pervasive, the World will experience a global recession worse than the financial crisis. This disease will stifle consumer demand and prevent production to continue. Both of these factors will invariably depress economic growth until a vaccine is found. Because this exogenous threat is not purely anthropomorphic, like the financial crisis, it will NOT be resolved quickly. The investor should prepare for a prolonged period of declining economic activity and have cash on hand to purchase securities when markets drop further.
But what did Nassim Nicholas Taleb have to say about this scenario nearly twenty years ago? He said maximize the NUMBER of bets that have the possibility of a positive black swan. What does this mean in practice? Consider the current black swan of a novel virus. Companies that produce disinfectants have more business then they can handle. Teleworking companies like Zoom have exploded in market value. These opportunities could have been realized by purchasing call options with a very high strike price. In this way, the possibility of realizing a very large positive payoff could be gleaned without risking too much capital. This same consideration could be applied to the second economic condition markets are operating in: artificially low oil prices. The positive black swan in this scenario is a large rebound in oil prices. Exposure to this considerably high probability black swan could occur through purchasing call options on an oil ETF with a high strike price. This way we are risking minimal capital with a potentially huge payoff.