April 13, 2020


1st Qtr Return
S&P 500 -19.60%
Barclay’s Bond Index 3.15%

Investment Commentary

2020 started off with a bang as both stocks and bonds extending their substantial gains from 2019 over the first six weeks of the year. The second half of February saw this economic cycle and bull market, which will go down as the longest on record, come to an end with one of the swiftest downturns in stock market history. Leading economic indicators quickly reflected the coming economic carnage due to the global pandemic. The first quarter of 2020 was the ninth worst price performance for the S&P 500 since 1928. Only one of the eight worse quarters was part of the Global Financial Crisis (Q4 2008). A summary of these periods is shown below.

Quarter Ending S&P 500 PR
6/30/1932 -39%
9/30/1931 -35%
12/31/1929 -29%
9/30/1974 -26%
12/31/1937 -23%
12/31/1987 -23%
12/31/2008 -23%
6/30/1962 -21%
3/31/2020 -20%

This means our most “experienced” clients have maybe experienced a quarter like this four other times in their investing lifetimes. As you might suspect, none of the bear markets above were caused by a global restriction of both supply and demand as a result of a pandemic. If we use the Dow Jones Industrial Average (an older index), we’re able to see data during the 1918 Pandemic (commonly known as the “Spanish Flu”). Returns for the index during 1918 and 1919 were +11% and +30%, respectively. Perhaps the markets were anticipating, and later celebrating, the end of World War I, and that optimism overtook the negativity of the estimated 50 million killed by the flu. More likely, a large portion of the population was generally unaware of the pandemic until it was far too late, as wartime media coverage generally did not cover the impact of the virus. Thus, they continued their daily lives unaware or unconcerned with the risks. We are clearly living in different times.

International stocks fared poorly as well, declining 24%. Bonds provided some safety as the Bloomberg Barclays Aggregate increased 3.15%, but that was muted by the credit portion of the index (i.e. excluding Treasuries) which finished the quarter down 3%. Certain parts of the investment grade bond universe were hit harder than that. West Texas Intermediate crude oil dropped 66% to $20.51 per barrel.

Economic Outlook

Since the labor market has been a key focus of ours for a while, let’s start with jobs. Shortly after the February Employment Situation Summary was published by the Bureau of Labor Statistics (BLS), we looked at what we considered to be the “highly virus sensitive” segments of the labor market (leisure and hospitality, department stores, air transportation, etc.) and looked at what the unemployment rate would be if 50% of workers employed in these areas lost their jobs and were still unemployed one year from now. This showed us an unemployment rate of about 10%, significantly higher than the 3.5% reported with the February report. The last weekly report of March and the first report of April registered 3.2 million and 6.6 million initial jobless claims, respectively. These were far and away the highest on record, with March’s number 4.7 times higher than the next highest observation. Two weeks of unprecedented jobless claims should be sufficient to get us from the lowest levels of unemployment since the 1960s to a 10% unemployment rate – roughly in line with the worst levels observed during the global financial crisis in 2009. The sharpest year over year change in unemployment going back to 1949 was 4.2% in October of 1949. This was nearly matched with the 12 months ending April and May 2009, each up 4% from the previous year. It’s entirely possible we will see a move of that magnitude or greater in two months. While it will not be officially announced for some time, it is clear at this point that, barring a miracle, the above data points suggest that the U.S. economy has entered an economic recession.

Next, we’ll take a look at earnings. FactSet reported on March 27 that the estimated earnings decline for calendar year 2020 is 1.2%. This is led by Energy (-62.3%), Industrials (-10.2%), and Consumer Discretionary (-8.0%). As of that report, six of eleven sectors were not expected to experience earnings declines for the full year. We think this is optimistic, and have been using larger decreases in earnings to estimate market valuations. Companies quickly began withdrawing earnings guidance, and sell-side analysts have been slow to adjust earnings expectations as the scope and magnitude of the pandemic was made clearer throughout March.

During the depths of the 2008 Global Financial Crisis, the U.S. Federal Reserve (“The Fed”) rolled out a number of increasingly unprecedented programs to stimulate the economy over a period of nearly a year. The monetary policy response during the current crisis has been even more impressive in terms of both scope as well as speed. There were several emergency interest rate cuts, and the Fed funds rate is now back down to zero. The Fed announced a number of facilities in March to calm a credit/liquidity squeeze as investors rapidly began selling their most ‘liquid’ investments in what has been called the “dash to cash”. These facilities include, but are not limited to, a money market liquidity facility, a commercial paper facility, and a term asset-backed loan facility. Finally, the Fed announced that they would be restarting Quantitative Easing (“QE”), which was a big feature of the first half of the post-global financial crisis years. This includes expanding the Fed’s balance sheet through purchasing trillions of dollars of U.S. treasury bonds, mortgage backed securities, and, for the first time ever, investment grade corporate bonds. The QE program is open-ended as the Fed has essentially promised to do whatever it takes to provide liquidity to keep financial markets stable and functioning smoothly.

In addition to the significant monetary policy response, clients will no doubt be aware of the unprecedented fiscal policy response. The Federal government passed the $2.2T stimulus package in late March known as the “Coronavirus Aid, Relief, and. Economic Security Act” or the “CARES Act”. Time will tell if the size of the stimulus package will be sufficient to offset the contraction in economic activity resulting from the pandemic, but at roughly 10% of GDP, the government certainly responded in a significant way. Furthermore, there has been discussion of additional stimulus packages, including the possibility of a long-rumored infrastructure bill, the extension of enhanced unemployment benefits, and expansion of assistance programs aimed at businesses.

Investment Strategy

As a result of the historic spike in unemployment, long time readers might assume we are decreasing our allocation to stocks. The fact that fairly small changes in employment could suggest meaningful shifts to portfolios is one of the things that made it an attractive indicator. Small changes could be shrugged off by markets or masked by more upbeat news, leaving an opportunity to decrease our allocation to stocks at reasonable valuations. Unfortunately, we saw a situation in which years worth of change happened in weeks, and was preceded, instead of followed, by a dramatic drop in equity markets. Such is the case when a health crisis quickly and simultaneously becomes an economic and financial crisis. As we look to next steps, we plan to use price targets to rebalance if markets deteriorate further, and time intervals to rebalance if markets are range bound.

Investors will only be able to see the bottom of this bear market with the benefit of hindsight, but we are having discussions now about the areas we believe will benefit from a recovery. It is important to contextualize and remember that often we see financial markets price in a recovery long before the economy realizes that recovery – just as global equity markets priced in the pending recession long before the economic data confirmed it. While we do not claim to have any particular expertise in timing markets, we do pay a lot of attention to risk premiums. In times of significant uncertainty, investors who are willing to take risks are often provided with above average risk premiums which tend to lend to above average long term forward returns. By the time the uncertainty is no longer present, those risk premiums will no doubt have already collapsed. Those above average risk premiums are materializing across risk markets, not only in equities but also in higher quality credit.

After discussions between Saudi Arabia and Russia broke down regarding reducing oil output to support the price of crude, we followed the playbook from when OPEC had similar discord in 2014 and sold midstream energy positions. We redeployed into the S&P 500. Since that time, the S&P declined substantially less than the midstream energy segment.

While interest rates will likely remain low for an extended period of time, we sold positions in long term treasuries that are particularly sensitive to changes in interest rates as yields fell to all-time lows. Unless rates rise and market valuations increase dramatically, it’s likely we will be underweight intermediate and long term Treasuries for the foreseeable future. Opportunities in investment grade corporate bonds have allowed us to redeploy fixed income assets into an asset class we have been cautious of for quite some time.

We encourage clients to maintain their risk profile and not succumb to the panic and fear that our collective personal experiences reasonably engender. Ultimately, stocks will be driven by their long-term earnings. We will no doubt see those earnings meaningfully impacted in the short-term, but staying focused on the long-term while taking advantage of short-term dislocations has always been a recipe for successful investing. The monetary and fiscal response to this crisis has been monumentally large and swift. This is to say nothing of the human response as we’ve seen many people make sacrifices to slow the spread of the virus and treat those who have been impacted. Commerce has changed, and in some arenas these changes may be permanent. We will grow and adapt as a world and as an economy.

Finally, on a personal level, we sincerely appreciate the faith and trust that you place in us. With many of our team members working remotely, we have been hosting virtual meetings with clients throughout this period and the feedback we’ve received has been quite positive. Please do not hesitate to reach out if you would like to discuss the state of the world, your portfolio, your financial plan, or any other concerns you may have. Stay safe, stay socially distant and stay healthy.

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