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In the midst of chaos and confusion, it is human nature to look for order and for a unifying theory that explains the world. As I have navigated my way through this crisis, I have used data from markets to try to come up with explanations for why markets have rebounded as quickly and as much as they have, and in the process, why they have added value to some companies, while reducing the value of others. It is in this pursuit that I noted that the crisis has enriched growth companies at the expense of value companies, flexible companies have gained at the expense of rigid ones, and young companies have gained on older, more mature businesses. But why have these shifts occurred? In this post, I look at a factor that lies behind all of them, and that is the resilience of private risk capital, taking the form of venture capital for start ups and private business, initial public offerings in public markets and debt (in the form bonds and bank loans) to the riskiest companies, as the crisis has unfolded.
Market Outlook
Let me start, as I have in my prior posts on this crisis, start with a market overview. In the three weeks since my last update, equity indices have continued their recovery, albeit at a more modest pace, from the worst days of the crisis:
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Note that I have broken returns down into two periods for every index, the first period (2/14-3/20) marking the worst days of this crisis, and the weeks since (3/20-7/17) representing the comeback. By July 17, the NASDAQ had not just recouped its losses but was up 9.61% since February 14, my starting date for the crisis. Within each region, there remain divergences, with the DAX outperforming the FTSE and CAC in Europe, and the Nikkei and Shanghai doing much better than the Sensex in Asia. As stocks have gone through a roller coaster ride, US treasuries seem to have gone into a coma, after an initial period of frenetic activity:
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The rates on US treasuries dropped significantly in the first four weeks of the crisis, but since the middle of March, have shown almost no movement, with short term treasuries staying close to zero, and 10-year treasuries at or around 0.7%. Tracking oil and copper, two economically sensitive commodities, here is what I see:
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Both commodities saw prices drop between February 14 and the end of March, but oil dropped significantly more than copper in that period. In the weeks since, both commodities have recovered, with copper now trading 12.5% higher than it was on February 14, but oil his still down more than 20%. As the crisis has played out in the equity and bond markets, I also tracked gold and bitcoin price movements over the period:
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Since February 14, gold prices are up more than 14%, reaffirming its role as a crisis asset, but bitcoin has been on a wild ride, dropping more than 50% between February 14 and March 20, as stock prices dropped, and rising almost 75% in the weeks since, as stocks have recovered. In short, it has behaved like very risky equity, not a crisis asset.
Equity Breakdown
While looking at indices, treasuries and commodities gives big picture perspective on this crisis, the real lessons are in the company-level data and to learn them, I examined market capitalization changes across all publicly traded companies, classified by region:
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Emerging markets, at least collectively, have lost more value than developed markets, with Latin America, Eastern Europe and Africa showing the biggest losses. Asian stocks have done better, with China being the best performing region of the world and India being the laggard in that region. Updating the values globally, stocks have lost $3.6 trillion in market capitalization since the start of the crisis, but that is quite a turn around from the $26 trillion that had been lost through March 20. Breaking down the changes in value, by sector:
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While every sector has seen improvement since the bottom on March 20, energy, financials and real estate still show substantial losses in market cap over the entire period, but six of the eleven sectors now show positive returns, with health care leading the way, up 9.5% since February 14. Breaking the sectors down further into industries, here is the list of the ten best and worst performing industries:
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There are two striking features in this table. The first is that the worst performing industries are a mix of capital intensive businesses and financial services and the best performing industries are dominated by capital-light businesses and health care. The second is the divergence between the best and worst performing industries is striking, with the best performing industries (online retail and internet software) up more than 30% since February 14, while the worst performing industries (oil and airlines) are down more than 40% over the same period.
Risk Capital
There is little that I have said in this post, so far, that is new, since it is a continuation of trends that I have seen since March. That said, and now that we have information on winners and losers over the last five months, it is worth taking a closer look at the broader forces that are driving the market to reward some companies, and punish others, and what it is that is making market behavior so disconcerting to long-time market observers. Specifically, I will argue that the behavior of risk capital during this crisis has been very different from prior ones, and it is that difference that explains anomalous market behavior.
Definition and Crisis Effects
Risk capital is capital that is invested in the riskiest assets and markets, and it encompasses a wide range of investment activity. For young companies, private and in need of capital to be able to deliver on their potential, it takes the form of venture capital. In public markets, it manifests itself in the money that flows into initial public offerings and to the riskiest companies, often smaller and more money losing. It can also take the form of debt, lending to firms that are in or on the verge of distress, and investing in high yield bonds. In most market crises, risk capital becomes less accessible and available, as fear dominates greed, and investors look for safety. Thus, you will see venture capital, always a boom and bust business, become scarcer, and the young companies that are dependent on it have to either shut down or sell themselves to deep-pocketed and more established companies, often at bargain basement prices. In public markets, initial public offerings become rare or non-existent, and money flows out of the riskiest companies to safer companies (generally with stable earnings and large dividends). In corporate bond market, new issuance of corporate bonds drops off, across the board, but much more so for the riskiest companies (those below investment grade). As I will argue in the rest of this section, that has not been the case in this crisis. While the flight to safety was clearly a dominant theme in the first three or four weeks of this crisis, risk capital has not only stayed in the market through this crisis, but has become more accessible rather than less, at least in some segments.
Venture Capital
Investing in young companies, especially start-ups and angel ventures, has always been a high-risk endeavors for two reasons. First, these businesses have to be priced or valued with much less information on business models or history than more mature companies, and many investors are uncomfortable making that leap. Second, the failure rate among these companies is high, since more than two-thirds of start ups do not make the transition to being viable businesses. Venture capital's role is to nurture these young companies through these early dangers, and in return, the hope is that the investment will earn outsize returns, when they exit. This accentuated risk return trade off makes venture capital the canary in the coal mine, during a crisis, and you can see that play out in the following graph, tracking venture capital raised by year, both in the US and globally:
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| Source: NVCA Yearbook |
In the last quarter of 2008 and in 2009, as the public markets plunged into crisis, note the drop of in venture capital invested, down more than 50% globally, and 60% in the United States. In fact, it took until 2014 for venture capital to return to levels seen before the crisis (in 2007), but once it did, it found new buoyancy leading into 2020. When the COVID crisis hit in February, the question was whether venture capital would retreat as it did in 2008, and the numbers so far don't seem to indicate that it will:
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Venture capital infusions did drop off in the first quarter of 2020, but not precipitously, and staged a recovery int he second quarter. It is true that less money is being invested in angel seed companies, presumably the riskiest class, and more in later stage businesses, but it does not look like venture capital has shrunk back into its shell, at least so far.
Public Equity Risk Capital
In public markets, risk capital plays out in more subtle ways than in private markets, flowing in and out of the riskiest segments of the market, as fears rise during a crisis. In most crises, as I noted earlier, the money flow favors the safer companies, pushing up their pricing and valuation, and works against the riskiest companies.
1. Risk Groupings
One measure of how risk capital has behaved in public markets is to look at market capitalization shifts from groupings of companies that are considered risky to groupings that can be considered safe. Since there can be disagreements about how best to create these groupings, I have considered multiple measures for the risk/safe continuum in the table below, and highlighted how market capitalizations have changed, in the aggregate, on each measure:
To make sense of this table, pick a grouping, say PE ratios. The Risk On/Off columns highlight the conventional wisdom that low PE stocks are safe and high PE stocks are risky. The returns columns report on what companies in the top and bottom deciles of PE ratios have earned during this crisis period, in both percentage and dollar terms. Thus, the stocks with the highest PE ratios (top decile) have seen their market capitalization increase by 10.81% ($674 billion) while stocks in the lowest PE ratio decline have seen their market values drop by 8.31% ($246 billion). On almost every measure that I use for risk in this table, this market has pushed up the valuations of the companies that would be considered riskiest and pushed down the values of the companies that would be considered safest. The only risk categorization where punishment has been meted out to the riskiest companies is financial leverage, with the companies that have the most debt (in net debt to EBITDA terms) seeing market capitalization decrease by 15.49% ($1,082 billion), while companies that have the least debt have seen market value increase by 12.32% ($300 billion). It is still only five months into the crisis, and markets can surprise and shift quickly, but at least from today's vantage point, this crisis has played out in a most unusual way, with the riskiest companies increasing in value, at the expense of the safest, with debt-driven risk being the exception.
2. IPOs
One of the most observable measures of market confidence in access to risk capital is initial public offerings, since companies going public are often younger, more risky companies. The best way to illustrate this is to look at initial public offerings over time, measuring both the number and dollar value raised in these offerings:
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| Source: Jay Ritter IPO data |
In terms of number of initial public offerings, the 1990s clearly set a standard that we are unlikely to see in the near future, and while the dot com bust brought the IPO process back to earth, you can see the damage wrought by the 2008 crisis. In the last quarter of 2008, as the crisis unfolded, there was only one initial public offering made in the US and the drought continued through 2009. While the number of IPOs has remained well below dot com era levels, the value raised from IPOs bounced back in the last decade, reflecting the fact that companies were delaying going public until they were bigger in market cap terms, with 2019 representing a year with several high-profile IPOs that disappointed investors in the after-market. When the COVID crisis hit in February, the expectation was that just as in prior crisis, the IPO process would come to a grinding halt, as private companies waited for the return on risk capital. In the graph below, I look at initial public offerings (both in numbers and dollar proceeds), by quarter:
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As with venture capital, there was a pause in the IPO process, in the first few weeks, and you can see that in the first quarter numbers. However, initial public offerings returned to the market in the second quarter, in both numbers and dollars, and the pipeline of IPOs is filling up again. In fact, I have not counted IPOs of SPACs (or blank check companies) in my statistics in my analysis, and there were quite a few of those in the second quarter of 2020, another indicator of investors willing to take risk.
3. The Price of Risk (Equities)
When risk capital is on the move, the number that best reflects its movement is the equity risk premium, rising as risk capital becomes scarcer and falling with access. During 2008, for instance, my estimates of the equity risk premium reflected this fear factor, rising from 4.4% on September 12 yo a high of 7.83% on November 20, before dropping back to 6.43% on December 31 (still well above pre-crisis levels):
I have reported that process during this crisis, but my estimates of the equity risk premium for the S&P 500 are in the graph below:
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The story embedded in this graph is the same one that you see in the VC and IPO pictures. In the first few weeks of the COVID crisis, the price of risk in the equity markets surged, just as it had in 2008, hitting a high of 7.75% on March 23. In the weeks since, equity risk premiums have almost dropped back to pre-crisis levels, as risk capital has come back into the market. Incidentally, this return of risk capital is not just a US-phenomenon, as can be seen in the picture below, where I report my estimates of the equity risk premiums, by country, through the crisis:
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With each country, I report three numbers, an equity risk premium from the start of 2020 (reflecting pre-crisis values), from April 1, 2020, at the height of the market meltdown, and from July 1, 2020, as capital has returned. Just to illustrate, Brazil saw its equity risk premium rise from 8.16% on January 1, 2020, to 11.51% on April 1, 2020, before dropping back to 9.64% on July 1, 2020. Put simply, risk capital has returned to the riskier emerging markets, though the return has not been as complete as it has been in the US.
Risky Debt
Much of the discussion about risk capital so far has been focused on equity markets, but there is risk capital in other markets as well. In the private lending market, risk capital is what supplies debt to the companies most in need of it, often distressed, and in the corporate bond market, it manifests itself as demand for the riskiest corporate bonds, usually below investment grade.
The COVID Effect - Early Days
In the first few weeks of the crisis, the key concern that investors had about the economic shut down was whether companies that carried significant debt loads would be able to survive the crisis. This fear manifested itself not only in concerns about bankruptcies, but also in government bailouts to save companies that were most exposed, such as airlines. There was also talk of how this crisis could spread to other sectors burdened with debt, and put the banking system at risk. It is these fears that led the Fed to announce on March 23, 2020, that it would be provide a backstop in the corporate lending market, proving loans to companies in distress and buying corporate bonds. There is debate about whether the Fed should be playing this role, but it cannot be denied that this action, more than any other by any entity (government or central bank) during this crisis, changed its trajectory. It is not a coincidence that Boeing which had been having trouble raising debt, in early March, was able to borrow $25 billion in the corporate bond market a few weeks after the Fed's announcement. In fact, as you will see in the section below, the Fed's announced opened the flood gates for corporate bond issuances and caused a turnaround in corporate bond yields.
The COVID Effect - Corporate Bond Issuances
In the corporate bond market, risk capital is the lubricant that provides liquidity in the high yield bond market, and allows companies that are below investment grade to continue raising capital. Not surprisingly, during crises, it is this portion of the corporate bond market that is affected the most, with yields climbing and new bond issues becoming rarer. You can see this phenomenon play out in the graph below, where I look at corporate bond issuances by year:
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During the 2008 crisis, bond issuances declined across the board in the last quarter of 2008 and the first quarter of 2009, but the drop was much more precipitous for high yield portion. During the COVID crisis, the numbers look very different:
After a brief pause in issuances in the first few weeks (between February 14 and March 20), bond issuances returned stronger than ever, with high yield bond issuances hitting an all-time high (in dollar value) in June 2020. For the moment, at least, the Fed's backstop bet has paid off in the bond market.
The Price of Risk (Bonds)
As with the equity market, there is a market measure of access in risk capital in the bond market, and it takes the form of default spreads. During a crisis, as risk capital leaves, you see spreads increase, as was the case in the last quarter of 2008:
Default spreads increased across the board for bonds in every ratings class, but much more so for the lowest rated bonds during the 2008 crisis. To provide a contrast, I looked at default spreads for bonds in seven ratings classes on February 14, March 20 and July 17:
As in 2008, default spreads surged between February 14 and March 20, as the crisis first took hold, but unlike 2008, the spreads have rapidly scaled down and are now lower for the higher investment grade classes than they were pre-crisis and only marginally higher for the lowest rated bonds.
Explaining the Resilience
If you accept the evidence that risk capital has stayed in the market during this crisis, in contrast to its behavior in prior crises, the follow-up question is why. For some of you, I know the answer is obvious, and that is that this market recovery has been engineered and sustained by central banks. While there is some truth to the "Fed did it" argument, I think it is too facile and misses other ingredients that have contributed.
- Central Banks: Earlier in this post, I noted that the turnaround in this market can be traced to the Fed's announcement on March 23, that it would provide a backstop to the corporate bond/lending market. That said, the actual amount spent by the Fed on these programs has been modest, as can be seen in this graph:
While there is a healthy debate to be had about whether central banks have become too activist, I believe that the Fed's corporate backstop announcement is the type of action you want central banks to take, since in its absence, bankruptcies and bailouts would have been the order of the day. In fact, the very fact that the Fed has actually not needed to use it is evidence that it worked, since private lenders stepped in to fill the gap. I concede that some risk taking investors will take the wrong cues from this action, expecting that the Fed will protect them from the downside, while they take advantage of the upside.
Source: Financial Times - Investor Composition: The Fed's actions worked as well as they did because investors in both equity and bond markets responded quickly and substantively, and that response may reflect the changed composition of investors today. First, markets have become much more globalized, and investors are much more willing to invest across markets, with money moving from equity to debt markets, and across geographies, much more easily than it used to. Second, the investment world has flattened, as retail investors (the so called stupid money) catch up to institutional investors (smart money?) in terms of access to information, data and tools and are more willing to deviate from conventional wisdom.
- Unique Crisis: As I have noted in prior posts, this has been an unusual crisis, in terms of sequencing. Unlike prior crises, where market meltdowns came first and the economic damage followed, in this one, the economic shutdown, precipitated by the virus, came when markets were at all-time highs and risk capital was widely accessible. It is possible that risk capital, for better or worse, believes that this is crisis comes with a timer, and that economies will revert back quickly once the virus passes, and shut downs end.
- Change in Corporate Structure: After two decades of disruption, it is quite clear that center of gravity has shifted for both economies and markets, with the bulk of the value in markets coming from companies that are very different from the companies that dominated the twentieth century. While much is made of the fact that the biggest companies of today's markets (in market capitalization terms) derive their value from intangible assets, I think the bigger difference is that these companies are also less capital intensive and more flexible. That flexibility, allowing them to take advantage of opportunities quickly, and scale down rapidly in the face of threats, limits downside and increases upside. At the risk of using a buzz word, there is more optionality in the biggest companies of today, making risk more an ally than an enemy for investors, and with options, risk can sometimes be more ally than enemy.
Five months into this crisis, I am still learning, and there is much that we still do not know about both the virus and markets.
Data
- Market data (July 17, 2020)
- Regional breakdown - Market Changes and Pricing (July 17, 2020)
- Sector breakdown - Market Changes and Pricing (July 17, 2020)
- Industry breakdown - Market Changes and Pricing (July 17, 2020)
- Market Changes and Pricing by classes: PE, PBV, Size, Growth, Age, Debt, Div Yld
- Risk Capital (VC, IPO and Bond Issuances) during crisis
- Equity Risk Premiums for S&P 500, by day: Feb 14, 2020- July 17, 2020
- Equity Risk Premiums for countries: July 1, 2020