The Black Swan

Every time people talk about a black swan during calmer times, they assume they have managed to factor in the most remotest of chances. Everything from the past and the craziest ideas are all thought through and that justifies unabated rallies. Complacency in the market is built one brick at a time. Feb 2020 would have to be one of those months. Having climbed all possible hurdles the market was set to rip higher. Targets were all revised up no matter the economy was growing at 1%. And then the virus came calling.

As unpredictable as this last month has been, was it really that unpredictable? Hollywood has been showing us all the worst case scenarios and a TED talk by Bill Gates about our unpreparedness for a pandemic from 5 years ago has been there on my feed for the past two years. But then again Black Swans are always obvious in hindsight.

I am grimacing at the thought of all the PUTs I had last year which would have been an amazing windfall if I held them today. But psychology is such that I could never predict what I would have done if I was holding it through this crash. Some PUTs that I still held on to this year worked really well but they hardly compensate for all the damage on my long side. The only solace is that my trading account where I play options is looking a lot better now compared to two months back.

So what now....

Bottom fishing again is a tough job. Almost as hard as options. So I will not even pretend to know if this would be the right time to buy. But what I am focused on right now are some ideas I developed from the last couple of books I had been reading. One about market cycles especially was a well timed read (unlike most of my attempts to time a trade). One of the best lessons I learnt from that book is to focus on the debt side of things to determine when the real fear has either set in or abated.

The general idea is simple. Equity is ownership of an operating asset. The instrument that super cedes equity is debt. And since equity has to cede to debt in times of distress, the real instrument to focus on during times of distress is debt and not equity. Equity volatility is more to do with psychology than real present value. In good times, people feel good about the prospect of the company and so are willing to pay a premium, while in times of distress they feel rather beaten down and hence are unwilling to buy at a discount. Sure, earnings and profitability are all factors that play into the valuation but they are only an afterthought during the extremes of a cycle.

Debt however is a more stable instrument. People buy debt instruments for income and perceived risk is reflected in the yield on the debt. The yield is determined by its differential compared to safe haven assets like treasuries. For the past decade this differential has been ever shrinking even in the junk debt space to a point where junk debt was trading as low as 2% points from treasuries. This gap has obviously widened in the past couple of months, but that was only to be expected. The real test however is after the initial correction how does the debt instruments hold under relentless selling.

The real red flag comes when debt instruments begin breaking the 70-80 cents to a dollar mark as that would indicate that the bond holders don't trust the ability of company to pay back the principal of the bond. If not an outright default, the higher yield starts pricing in a lack of confidence in the finances of the company that forces the management to prove that it is financially sound. This would require raising new capital in a challenging market that begins pressuring the equity value due to dilution. That is when the second and the biggest leg down for the equity happens and what most equity holders need to avoid. If you know me long enough you will be know me for my Citibank stories from 2008.

So this time around my investing experiment is going to hinge partly on this philosophy. I am going to use the bond market as my guide. There are a bunch of companies that I had been researching but not buying because I thought they were too high. Now a few of them have come to levels much lower than the price I had in mind. But I am going to be using the bond prices as a filter to see if the price fall is unjustified and I should take the risk of buying it even in a market whose bottom is unclear.

In that spirit the watchlist looks something like this: DGX, PSX, CVX, COP, BAC, WFC and GOOGL

I have started with long dated call options on some of these and looking to buy them in small numbers slowly. All this while holding on the railing as the rollercoaster rides on.

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