Kevin Lenaghan on Investing in the Age of COVID: Market Strategists are Not Epidemiologists
Ivy Academy Overview
Ivy Academy LLC provides investment advisory and admissions consulting services based in Los Angeles, California. Kevin Lenaghan co-founded Ivy Academy LLC in early 2020 after a 20-year career in financial services, including 12+ years as an asset allocator and investor in hedge funds and other alternative asset classes. He has worked closely with many of the world’s largest and most sophisticated institutional and HNW/family office investors.
Ivy Academy’s investment advisory division, which is led by Kevin Lenaghan, provides strategic and tactical asset allocation and alternatives advisory services for HNW/family offices and institutional investors. The firm allocates capital globally, with an emphasis on sustainable alpha profiles and dislocated and/or opportunistic investments. The investment process is predicated on an awareness of macroeconomic and geopolitical considerations, but Ivy Academy generally avoids making directional bets on highly efficient, liquid asset classes. Ivy Academy works closely with clients on developing bespoke portfolio solutions, depending on their needs, preferences, and constraints.
Ivy Academy Insights
The following thought piece, “Investing in the Age of COVID: Market Strategists are Not Epidemiologists”, is the second in a series related to investment issues and implementation challenges. These insights are meant to be relevant and thought-provoking, but certainly not dogmatic or necessarily definitive. It is important to highlight that the insights presented are based on Kevin Lenaghan’s collective experience and analysis, relying on publicly available sources.
Investing in the Age of COVID: Market Strategists are Not Epidemiologists
The COVID pandemic has caused tremendous suffering throughout the globe, while presenting investors with unprecedented challenges. While other historical recessionary periods were preceded by predictive indicators such as overlevered consumers or steeply inverted yield curves, the rapid outbreak of global infections and dramatic decline in economy activity was a much more unpredictable shock, the ultimate “black swan” or “unknown unknown”.
Throughout my investment career, I have been fortunate to develop strong relationships with many of the hedge fund industry’s most experienced and thoughtful risk managers. The best risk managers conduct extensive scenario analysis and stress testing with respect to both historical shocks and theoretical “worst case” scenario events. However, a global pandemic that evolved in the same devastating and insidious manner as COVID were certainly not on risk managers’ radar screens.
The pandemic has presented herculean challenges for market strategists and forecasters, starting with the novelty and highly contagious nature of the disease itself. The nation’s leading epidemiologists were initially stymied by multiple characteristics of the virus, including its origin, nature of transmission, effective treatments, and highly divergent medical outcomes (ranging from non-existent symptoms to quick death). While COVID was initially discovered in late 2019 in Wuhan, China, most global market participants, particularly those in the US and Europe, were completely blindsided by the explosion of cases in February and March 2020. This was even true for firms that supposedly had an information edge in the country where the virus originated, although part of the misinformation was arguably due to the initial obfuscation of the Chinese government. Of course, there are multiple market indicators for the dramatic market reaction associated with the US lockdowns in March 2020, including nearly all risk assets (which fell sharply) and the VIX Index (a measure of short-term implied equity volatility which spiked upwards). While the unprecedented lockdowns caused enormous disruption of economic activity, some asset classes such as structured credit were even more significantly impacted than would logically be expected.
The dramatic increase in joblessness, reduction in mobility, and rapidly deteriorating credit market liquidity caused the Federal Reserve to quickly react with two dramatic interest rate cuts of 50 bps and 100 bps on March 3rd and 16th, respectively. The Fed also quickly undertook a host of other actions, including clarifying its dovish forward guidance, significantly expanding its QE program, re-engaging the Primary Dealer Credit Facility, backstopping money market mutual funds, and vastly expanding repurchase agreements to funnel cash to money markets. Furthermore, there were a variety of other programs that encouraged banks and consumers to lend, or provided direct loans, or liquidity facilities to various market participants.
From a fiscal policy perspective, the $2.3 trillion Coronavirus Aid, Relief, and Economic Security Act (“CARES”) was signed into law on March 27, 2020. The CARES Act represented approximately 11% of GDP and provided eight different types of support to consumers and business, including direct transfer payments, expanded unemployment benefits, forgivable small business loans, and other transfers to state and local governments. Congress also enacted the $483 billion Paycheck Protection Program and Health Care Enhancement Act in early April 2020.
This extraordinary monetary and fiscal policy actions provided meaningful, and timely, support to equity and credit markets, and drove the sharp snap-back in economic growth in Q2 2020. While most of these programs were adapted or expanded from the response to the 2008 financial crisis, market participants were still broadly surprised by the rapid recovery from near depressionary economic conditions.
Problematic Forecasting & Overconfidence
As the COVID pandemic increasingly dominated market sentiment and government policy, strategists argued that one could not have a view on the markets without having a view on COVID. Unfortunately, market participants misinterpreted many aspects of the virus’ evolution and its impact on markets, from the severity of the initial outbreak to the speedy market recovery, followed by the second (and third) outbreaks. Ivy Academy also witnessed some comically wrong forecasts about the virus, the likely political responses and human nature, from a variety of overconfident market strategists who are neither epidemiologists nor psychologists. While many of these market strategists were just seeking Media Coverage, this is a partial list of inaccurate forecasts related to either the virus itself or the market reaction (Ivy Academy Responses in Italics):
· March 2020: Daily increases in China started falling after February 3, which implies that the US outbreak will be contained. The strategist posited the following question: Is the US 2X or 5X more incompetent than China? (Actually yes!)
· May 2020: People will become increasingly “anti-science” as a result of the COVID crisis. (Who has more credibility now: Donald Trump or Anthony Fauci?)
· May 2020: the US will outperform over the next six months because the COVID-19 situation will get resolved much more quickly than people think. (The COVID crisis is obviously still raging in the US at the worst levels since the start of the pandemic. The MSCI World index of global equities has modestly outperformed the S&P 500 Index over the past six months, with very high correlation.)
· May 2020: US states representing 85% of GDP can begin to ease by June 1st without negative repercussions. (The states that eased restrictions, ignored CDC guidelines, clearly have the worst outbreaks now.)
· May 2020: Current levels of social distancing are unsustainable, the 2nd wave narrative is “ludicrous” as it cannot be bigger than the 1st one. Humans will adjust their behavior and no one will go to Miami’s South Beach to party. (This was obviously a ridiculous forecast. Here is an article from July 15th about maskless revelers returning to South Beach: https://www.reuters.com/article/us-health-coronavirus-usa-miami-beach/as-pandemic-worsens-miami-beach-visitors-party-residents-mostly-comply-idUSKCN24G16L)
· May 2020: A vaccine could be negative for the economy, if there is certainty about a vaccine coming into production. (Equity markets have reacted with euphoria to the recent announcements of highly effective vaccine test results from Pfizer, Moderna, and AstraZeneca.)
· Early November 2020: COVID’s impact on mobility is overstated, people are de-sensitized and no one cares anymore. The COVID reduction efforts in CA in July were much weaker than in February/March, except for the schools. (The school closures are a pretty big exception, and Los Angeles County announced a renewed closure of ALL dining, both indoors and outdoors, as of November 22, 2020.)
This thought piece argues that market strategists have been mostly lost in the “COVID fog” since the pandemic began. Like most financial professionals, Kevin Lenaghan does not have any edge in predicting the severity of the current wave of the pandemic, the timing of vaccine approval, the efficacy of vaccine distribution, or the speed that economic activity returns to “normal”.
Ivy Academy has no reason to disagree with the consensus view that the vaccine developments are clear positives, and that the politicization of basic public health measures was highly counterproductive. Furthermore, we agree that there should be a meaningful amount of pent-up demand for categories such as leisure travel and large-scale events whenever there is broad vaccine adoption, and public health restrictions are eased. However, it is pretty clear that the US in particular is facing a long winter for several important reasons, including the following: (a) increasingly cold weather will force people indoors, (b) Americans still seem willing to travel for the upcoming holidays despite CDC guidance, © the Trump administration continues to exhibit both incompetence and indifference, (d) the high “R”, or reproduction rate, of the disease has effectively nullified traditional containment methods like contract tracing and targeted lockdowns, and (e) market expectations for a quick approval and delivery of an effective vaccine are exceedingly high.
Therefore, Ivy Academy has recently worked with clients to reduce risk in equities and other high beta asset classes, while selectively implementing hedge overlays at relatively attractive volatility levels. Kevin Lenaghan believes that the time horizon of these hedges should be one to six months, which roughly aligns with the expectation that (a) economic activity will weaken in the short-term, and (b) a meaningful fiscal support package will fail to materialize. Ivy Academy is constantly monitoring market conditions and will adjust or nullify hedges as facts change and market pricing adjusts. The firm continually searches for uncorrelated alpha and opportunistic/dislocated asset classes to help clients generate strong returns irrespective of the macro environment.
 For example, one large quantitative hedge fund firm has been particularly creative with modeling “theoretical worst case” scenarios with low likelihood but significant impact, such as “The Great Depression X2” and “China Coup”.
 A small handful of investors, including famed hedge fund manager David Tepper, were more prescient in anticipating the severity of the outbreak. During a February 3, 2020 interview with CNBC host Jim Cramer, Mr. Tepper referenced a now-famous Lancet article which caused concerns about the seriousness of the disease and its potential market impact.
 See https://www.brookings.edu/research/fed-response-to-covid19/ for more details.