Cam Hui, CFA | cam@pennockideahub.com Page 1

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Quantitative & Strategy

A LEHMAN CRISIS OF A DIFFERENT SORT

March 2, 2020

EXECUTIVE SUMMARY

Remember the Lehman Crisis? The failure of Lehman Brothers marked the start of the

Great Financial Crisis that destabilized and almost brought down the global financial

system.

What we are seeing is a Lehman Crisis of a different sort. The Lehman Crisis of 2008 was

characterized by financial institutions unwilling to lend to each other and banking system

liquidity seized up.

Today’s version of the Lehman Crisis is characterized by countries and regions in

lockdowns and the propensity of individuals or groups to increase their social distance,

either owing to quarantine or fear. This is leading to both supply and demand shocks. It is

a supply shock because production and transportation are seizing up, which is leading to a

collapse in global trade. It is also a demand shock because when social distance rises it leads

to a collapse in the demand for goods and services.

We believe the global economy is undergoing a period of stress that will take some time to

resolve. Asset prices are likely to be highly volatile for the next few months until the full

extent of the uncertainty is resolved. In the short run, the stock market is extremely oversold

and washed out. A relief rally and climactic price reversal can happen at any time. However,

we expect any rally would be followed by re-tests of the old lows, which may not necessarily

be successful.

Investment-oriented accounts should be minimizing risk and aim for asset allocations with

below-average equity risk. We reiterate our call to overweight emerging market equities and

commodities because the market has already embedded low expectations for their outlook,

and underweight U.S. equities because of their valuation risk.

Cam Hui, CFA cam@pennockideahub.com

Table of Contents

Lehman Crisis 2.0 .................................... 2

Outbreak Not Contained .......................... 3

Modeling the Economic Impact ................ 5

The Policy Response ............................... 8

Investment Implications .......................... 10

A Long Bottom Process ......................... 17

Cam Hui, CFA | cam@pennockideahub.com Page 2

March 2, 2020

Quantitative & Strategy

Lehman Crisis 2.0

Remember the Lehman Crisis? The failure of Lehman Brothers marked the start of the Great

Financial Crisis that destabilized and almost brought down the global financial system.

What we are seeing is a Lehman Crisis of a different sort. The Lehman Crisis of 2008 was

characterized by financial institutions unwilling to lend to each other and banking system

liquidity seized up.

Today’s version of the Lehman Crisis is characterized by countries and regions in lockdowns

and the propensity of individuals or groups to increase their social distance, either owing to

quarantine or fear. This is leading to both supply and demand shocks. It is a supply shock

because production and transportation are seizing up, which is leading to a collapse in global

trade. Even before the onset of the COVID-19 outbreak, global trade had been weak. It is

about to become even weaker.

Exhibit 1: Global Trade Was Falling Even Before the COVID-19 Infections

Source: Bloomberg

It is also a demand shock because when social distance rises it leads to a collapse in the demand

for goods and services. As an example, France’s Finance Minister Bruno Le Maire told CNBC

at the G-20 meeting that tourism had fallen 30-40%.

Cam Hui, CFA | cam@pennockideahub.com Page 3

March 2, 2020

Quantitative & Strategy

Outbreak Not Contained

The latest update from Johns Hopkins shows that the spread of the COVID-19 virus is growing

steadily outside China. Infectious clusters in South Korea, Japan, Italy and Iran show that the

strategy of containment has not been very effective. Much of northern Italy is in lockdown.

Exhibit 2: Daily Coronavirus Infection Rate xChina Still Growing

Source: Johns Hopkins CSSE

The New York Times reported that CDC officials are warning Americans to prepare for an

outbreak:

Federal health officials starkly warned on Tuesday that the new coronavirus will almost certainly

spread in the United States, and that hospitals, businesses and schools should begin making

preparations.

“It’s not so much of a question of if this will happen anymore but rather more of a question of exactly

when this will happen,” Dr. Nancy Messonnier, director of the National Center for Immunization

and Respiratory Diseases, said in a news briefing.

She said that cities and towns should plan for “social distancing measures,” like dividing school classes

into smaller groups of students or closing schools altogether. Meetings and conferences may have to be

canceled, she said. Businesses should arrange for employees to work from home.

“We are asking the American public to work with us to prepare, in the expectation that this could be

bad,” Dr. Messonnier said.

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March 2, 2020

Quantitative & Strategy

The American healthcare system does not appear to be very prepared for an outbreak. To start,

virus testing capability is limited. Initially, tests to identify infected patients had to be sent to

the CDC lab in Atlanta. The CDC has now sent out test kits to state and local authorities in all

50 states, but at the time of this writing only three states, California, Illinois and Nebraska, can

actually conduct the tests. The New York Times reported that a California coronavirus patient

had to wait days to be tested because of the CDC’s strict screening criteria for conducting tests.

If you can’t look for an infection, or are unwilling to look, how will you ever find it?

While the CDC has conducted hundreds of tests for the coronavirus, South Korea has tested

tens of thousands to identify possible victims.

In addition, Axios reported that much of the supply chain of pharmaceutical drug production

is locked up in China. While not all of the pharmaceutical plants are in China, much of the

precursor materials are principally sourced from China, and a prolonged Chinese production

slowdown could cause worldwide drug shortages.

About 150 prescription drugs — including antibiotics, generics and some branded drugs without

alternatives — are at risk of shortage if the coronavirus outbreak in China worsens, according to two

sources familiar with a list of at-risk drugs compiled by the Food and Drug Administration.

A 2019 article by the Council on Foreign Relations made a similar point about supply chain

vulnerability:

As Rosemary Gibson noted in her testimony, centralization of the global supply chain of medicines in

a single country makes it vulnerable to interruption, “whether by mistake or design.” If we are

dependent on China for thousands of ingredients and raw materials to make our medicine, China

could use this dependence as a weapon against us. While the Department of Defense only purchases a

small quantity of finished pharmaceuticals from China, about 80 percent of the active pharmaceutical

ingredients (APIs) used to make drugs in the United States are said to come from China and other

countries like India. For example, the chemical starting material used to make doxycycline, the

recommended treatment for anthrax exposure, comes from China. When an influential Chinese

economist earlier this year suggested that Beijing curb its exports of raw materials for vitamins and

antibiotics as a countermeasure in the trade war with the United States, the worries surrounding our

API dependence to China seemed to be vindicated. Concern about a disruption in the supply chain

could explain why the tariffs on Chinese products proposed by the United States Trade Representative

in May 2019, worth approximately $300 billion, excludes “pharmaceuticals, certain pharmaceutical

inputs, and select medical goods.”

Indeed, the FDA issued its first notice of a drug shortage due to COVID-19 supply chain

disruptions:

A manufacturer has alerted us to a shortage of a human drug that was recently added to the drug

shortages list. The manufacturer just notified us that this shortage is related to a site affected by

coronavirus. The shortage is due to an issue with manufacturing of an active pharmaceutical ingredient

used in the drug. It is important to note that there are other alternatives that can be used by patients.

We are working with the manufacturer as well as other manufacturers to mitigate the shortage. We will

do everything possible to mitigate the shortage.

Cam Hui, CFA | cam@pennockideahub.com Page 5

March 2, 2020

Quantitative & Strategy

Modeling the Economic Impact

How bad can things get for the U.S. and global economy?

The Congressional Budget Office conducted a study in 2005–2006 that modeled the effects of

a 1918-like Spanish Flu outbreak on the economy. The CBO assumed that 90-million people

in the U.S. would become sick and 2 million would die. Those assumptions are not out of line

with current conditions. The population of the U.S. is about 330 million, so an infection rate

of 27% (90-million infected) and a fatality rate of 2% (1.8-million dead) are reasonable

assumptions.

The CBO study concluded that a pandemic of this magnitude “could produce a short-run

impact on the worldwide economy similar in depth and duration to that of an average postwar

recession in the United States.” A severe pandemic could reduce GDP by about 4.5%, followed

by a V-shaped rebound. Demand shocks would also be evident, with an 80% decline in the arts

and entertainment industries and a 67% decline in transportation. Retail and manufacturing

would drop 10%.

A recent paper by Luo and Tsang at Virginia Tech entitled How Much Output Has The

Coronovirus Reduced?” studied the effects of the outbreak on China and the world. It

concluded that Chinese GDP would fall by a minimum of 4%, and there would be considerable

spillover effects outside China.

Using a network approach, we estimate the output loss due to the lockdown of the Hubei province

triggered by the coronavirus disease (COVID-19). Based on our most conservative estimate, China

suffers about 4% loss of output from labor loss, and global output drops by 1% due to the economic

contraction in China. About 40% of the impact is indirect, coming from spillovers through the supply

chain inside and outside China.

The researchers concluded that the direct and indirect effects of Chinese dislocation alone

could amount to 1–2% of global GDP growth.

Cam Hui, CFA | cam@pennockideahub.com Page 6

March 2, 2020

Quantitative & Strategy

Exhibit 3: Estimated Impact of Coronavirus on GDP Growth

Source: Luo and Tsang

A Federal Reserve discussion paper published in October 2019 entitled “Global Spillovers of a

China Hard Landing” also yielded some clues on the economic impact of Lehman 2.0. Here is

the abstract:

This paper analyzes the potential spillovers of acute financial stress in China, accompanied by a sharp

slowdown in Chinese growth, to the rest of the world. We use three methodologies: a structural VAR,

an event study, and a DSGE model. We find that severe financial stress in China would have

consequential spillovers to the United States and the global economy through both real trade links and

financial channels. Other EMEs, particularly commodity exporters, would be hit the hardest. The

U.S. economy would be affected to a lesser degree than both EMEs and other advanced economies,

and the primary channel of transmission to the U.S. could well be adverse financial spillovers through

increased global risk aversion and negative equity market spillovers.

Cam Hui, CFA | cam@pennockideahub.com Page 7

March 2, 2020

Quantitative & Strategy

The authors' estimates based on a Chinese 4% hit from normalized growth (blue) and 8.5% hit

(red) indicate considerable damage to U.S. GDP growth.

Exhibit 4: Modeled Effects of China Hard Landing

Source: Ahmed, Correa, Dias, Gornemann, Hoek, Jain, Liu, and Wong

Cam Hui, CFA | cam@pennockideahub.com Page 8

March 2, 2020

Quantitative & Strategy

The Policy Response

During the Lehman Crisis, central bankers swung into action and flooded the global financial

system with liquidity. In the current crisis, it is unclear whether either fiscal or monetary policy

are effective to combat both a supply and demand shock. The authorities can stimulate all they

want, but if people are unwilling to, or unable, either to go to work or brave reducing social

distance to spend on goods and services, fiscal and monetary stimulus cannot boost economic

growth. These policies are likely to have limited effect until the supply shock begins to wear off

and people return to work.

To be sure, the monetary authorities can act to reduce risk premiums and inflate asset prices.

Credit spreads have begun to edge up, and central bankers can act to put a lid on spread

expansion.

Exhibit 5: Credit Spreads Edge Up

Source: FRED, Federal Reserve Bank of St. Louis

However, measures of financial stress remain relatively low, and policy makers will loath to

engage to excess stimulus and create another bubble.

Cam Hui, CFA | cam@pennockideahub.com Page 9

March 2, 2020

Quantitative & Strategy

Exhibit 6: Financial Conditions Are Tame

Source: FRED, Federal Reserve Bank of St. Louis

Nevertheless, China is certainly trying the stimulus route. Xinhua reported that the Chinese

leadership has turned on the fiscal taps and decreed a series of infrastructure projects to jump

start the economy.

The Chinese capital has announced to push forward 300 urban projects in 2020, involving 252.3-

billion yuan (around US$35.9 billion) in investment.

The projects will include 100 infrastructure projects, 100 livelihood improvement projects and 100 high-

tech industrial projects, according to Beijing’s development and reform commission.

Cam Hui, CFA | cam@pennockideahub.com Page 10

March 2, 2020

Quantitative & Strategy

Investment Implications

What should investors do under these circumstances? A recent Bloomberg article surveyed 10

market strategists. Their views were highly disparate. They ranged from “gold rally” and “risk

aversion” to “a short sharp V” and “hello TINA”, or There Is No Alternative (to risky assets).

In other words, no one knows anything.

We have experienced a series of market crises during our tenure as a quantitative bottom-up

equity manager. While our quantitative factor sets were well diversified across growth, value,

momentum and other dimensions, we learned to turn off all of the quantitative factors when

faced with a sudden crisis, such as the Russia default or 9/11. As details of the shock became

known, the following classes of factors began to add value, in the following order:

Technical Analysis Factors: The market’s price signals were the fastest to respond.

Estimate Revision and Earnings Surprise: When the crisis hits, company analysts

will not revise their estimates because they cannot quantify the impact. First, top-down

strategists begin to revise their estimates, then the bottom-up company analysts. We

saw one such example when the U.S. stock market rallied on Trump’s tax cuts.

Fundamental Factors: As the environment normalizes, fundamental factors such as

growth and value begin to add value once again.

Today, the market is only in the first phase, where technical factors are in ascendance. Here is

what the market technical outlook is telling us.

The intermediate-term outlook is uncertain. The monthly S&P 500 chart printed a doji candle

in January, indicating indecision and a possible turning point. The turn was confirmed by a

bearish red candle in February. Such patterns have been followed be at least 1–2 months of

either sideways or bearish price action.

Exhibit 7: Signs of a Bearish Reversal

Source: StockCharts

Cam Hui, CFA | cam@pennockideahub.com Page 11

March 2, 2020

Quantitative & Strategy

In addition, our “Ultimate Intermediate Bottom Spotting Model” has not turned bullish yet.

This model flashes a buy signal based on two conditions: when the NYSE McClellan

Summation Index (NYSI) turns negative, indicating intermediate bearish momentum, and the

Zweig Breadth Thrust Indicator becomes oversold, which is a short-term oversold indicator.

We are not there yet.

Exhibit 8: Ultimate Intermediate Bottom Spotting Model

Source: StockCharts

In the short run, the market may be setting up for a short-term bounce and all indicators are in

maximum oversold territory. The oversold signal flashed by the Zweig Breadth Thrust

Indicator has usually been resolved with a relief rally.

As measured by the 5- and 14-day RSI, the market is as oversold as it was at the Christmas Eve

bottom of 2018, as more oversold than the VIXmageddon bottom of early 2018. A similar

oversold condition occurred in October 2018, which was followed by an interim relief rally.

Cam Hui, CFA | cam@pennockideahub.com Page 12

March 2, 2020

Quantitative & Strategy

Exhibit 9: An Oversold Extreme

Source: StockCharts

Non-U.S. markets are also acting in a constructive manner. We had suggested in the past that

investors might be better served to buy commodities and EM equities while avoiding U.S.

stocks (see The Guerrilla War Against the PBOC). It was a contrarian call because of the high

sensitivity of commodities and EM to a possible Chinese downturn. Both commodity and EM

markets have begun to stabilize and exhibit positive relative strength, indicating a possible turn

in market psychology. The worst may be over.

Cam Hui, CFA | cam@pennockideahub.com Page 13

March 2, 2020

Quantitative & Strategy

Exhibit 10: EM Equities and Commodities Take Leadership Mantles

Source: StockCharts

To be sure, a deeper examination of EM market strength shows that most of it comes from

China and India. EMEA and Latin American markets are still lagging. However, EM leadership

cannot be dismissed as purely a China and India effect, as frontier markets are also turning up

in relative strength.

Cam Hui, CFA | cam@pennockideahub.com Page 14

March 2, 2020

Quantitative & Strategy

Exhibit 11: EM and BRIC Relative Performance vs. ACWI

Source: StockCharts

There are other signs that the world is edging back to normalcy. The Baltic Dry Index, which

measures shipping costs, is showing signs of bottoming after a catastrophic decline. The worst

of the global supply shock may be over.

Cam Hui, CFA | cam@pennockideahub.com Page 15

March 2, 2020

Quantitative & Strategy

Exhibit 12: Baltic Dry Index

Source: StockCharts

Finally, copper prices are stabilizing and have not breached their early February lows. Copper

is a cyclically sensitive metal that it has been dubbed “Dr. Copper” by traders because it is said

to have a Ph.D. in economics.

Exhibit 13: Listen to Dr. Copper?

Source: StockCharts

Cam Hui, CFA | cam@pennockideahub.com Page 16

March 2, 2020

Quantitative & Strategy

A Long Bottoming Process

This bottoming process is just beginning and is likely a long process. Nick Maggiulli at Of

Dollars and Data compiled the past market reactions after drops of over 6% over two days. On

average, the stock market was but volatile for the next 100 trading days before rising again.

Exhibit 14: S&P 500 After 6% Drops

Source: Of Dollars and Data

The option market is also signaling a prolonged resolution to this COVID-19 induced Lehman

Crisis. The term structure of the VIX Index has inverted, which is not a surprise during these

periods of fear. A recent article by Luke Kawa at Bloomberg pointed out what is unusual is the

inversion is extending out past the front month:

And what makes this inversion scarier than normal is what’s happening just a bit further out on the

curve. Typically, when the front of the VIX curve inverts, the rest stays relatively flat. It’s an

acknowledgment that the market tumult is expected to be a relatively short-lived affair.

Not so this time. The April VIX future has closed as much as 1.3 points above May’s during this

pullback, the biggest such backwardation between the second and third-month contracts since the

idiosyncratic volatility blow-up in February 2018. This is an indication that traders expect an

environment of heightened volatility to persist for longer than your run-of-the-mill stock market

correction.

This dynamic speaks to the evolution of traders’ perception of the coronavirus: what was first a

contained supply shock is now morphing into a potent threat of unknown magnitude to a fragile global

economy.

Cam Hui, CFA | cam@pennockideahub.com Page 17

March 2, 2020

Quantitative & Strategy

Even if the market were to stage a relief rally from current levels, the bearish episode is likely

not over. A more typical bottoming pattern would see the markets rally, falter to retrace and

retest the previous lows. There are no guarantees whether the retest would necessarily be

successful.

The next shoe has yet to drop. While we have seen selected profit warnings from corporate

management, such as MasterCard and United Airlines, estimate revisions so far are still positive.

As well, the negative Q1 guidance rate is roughly in line with the historical average.

Exhibit 15: Forward EPS Estimates Are Still Rising

Source: FactSet Information Systems

Historically, analysts have been overly optimistic in forming EPS estimates, and they tend to

revise them downwards as the date of the earnings report approaches. The current experience

indicates that Street estimate revisions are not especially negative compared to history,

indicating that Wall Street has not fully factored in the effects of the coronavirus yet.

Cam Hui, CFA | cam@pennockideahub.com Page 18

March 2, 2020

Quantitative & Strategy

Exhibit 16: Where Are the Coronavirus Related Estimate Cuts?

Source: FactSet Information Systems

We need to see EPS estimates start to fall, followed by a period of stabilization, before the

fundamentally driven institutional investors feel more comfortable in taking more risk. Current

survey data indicates that institutions are in a crowded long in equities and they are just

beginning to de-risk.

In conclusion, the global economy is undergoing a period of stress that will take some time to

resolve. Asset prices are likely to be highly volatile for the next few months until the full extent

of the uncertainty is resolved. In the short run, the stock market is extremely oversold and

washed out. A relief rally and climactic price reversal can happen at any time. However, we

expect any rally would be followed by re-tests of the old lows, which may not necessarily be

successful.

Investment-oriented accounts should be minimizing risk and aim for asset allocations with

below-average equity risk. We reiterate our call to overweight emerging market equities and

commodities because the market has already embedded low expectations for their outlook, and

underweight U.S. equities because of their valuation risk.

Cam Hui, CFA | cam@pennockideahub.com Page 19

March 2, 2020

Quantitative & Strategy

Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am

confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit

every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but

final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing

this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for

the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may

contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and

assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of

the information contained in this note.

This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,

express or implied, is made by the author or any other person as to its fairness, accuracy, completeness or correctness.

This article does not constitute an offer or solicitation in any jurisdiction.

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