What Did We See?

• We are now at the precipice of a recession, the length and severity of which is unknown.
• I believe equity markets will see brighter days but a bottoming process must unfold beforehand.
• The opportunity to invest at low levels only comes a few times in an investing career and must be taken advantage of.
• Portfolios remain in an extremely protective posture with high cash levels to buffer further moves lower and offer ammunition to buy equities later.
• I continue to monitor portfolios for tax loss harvesting opportunities as they present themselves.

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The first quarter of 2020 has proven to be one for the record books. Both “good” and “bad” records were broken as the world struggled with the effects of the Coronavirus pandemic. From February 19 to March 23 the U.S. equity markets saw their fastest drawdown ever, losing about 34%. The next day the market turned and gained 17.5% in three days, it’s best performance over three days since the 1930’s. However, this still left the S&P 500 about 26% off it’s most recent high water mark of 3,386. Two trading days later, the index ended the quarter very close to this level. There is a long way to go and much to be done before normalcy can return to the markets. While the global central banks responses have been swift and numerous, fiscal policies have been rife with fits and starts. Furthermore, the coordination of global governments have left a bit to be desired, choosing to point fingers more often than they should be. We are now in a position of unprecedented uncertainty with a lack of guidance from prior periods to help us map out a safe exit. Markets hate uncertainty, but uncertainty in investing can oftentimes mean opportunity as well.

Uncertainty

First let us tackle the uncertainty and its effect now and over the next few months for investors. This virus is a massive negative in the short term for the economy. We have already seen unemployment claims exponentially increase beyond any level in modern history. The level of unemployment that will result from pulling the emergency brake on our economy will be massive. Right now no one can thoughtfully predict the magnitude of the effect of the required actions we have taken. It will likely come down to time to determine the real effect upon companies and industries. The longer companies remain idle, the more damage they will absorb. Many of the companies in our universe came into this environment with high levels of debt (leverage) and an eye towards stock buybacks instead of saving for a rainy day. As this recession wears on one can expect to see increased levels of forced mergers, bankruptcies and insolvent organizations. It is just the nature of these environments. In our fast paced lives people often forget these market bottoms are a process. A base needs to be created for the next bull market to work off of. We have not created that base yet.

Fundamentals

In times such as these the fundamental performance of companies does not help investors much. In fact, many companies have stopped trying to forecast their own results to investors because they just don’t know. Because of this, valuation analysis will not matter in the short term. How does one value a company when you have no idea when its workers will return and what the levels of revenue will be in 6, 9 or 12 months? Certainly there will be winners in the short term. Companies associated with finding a cure (biotechnology), companies associated with stemming the flow of the virus (disinfectants, mask manufacturers, etc..) and companies associated with the new reality of “work and teach from home” (video conferencing) have all done well. However, most if not all of these companies have seen their stock prices move higher at an unsustainable rate under normal conditions. The problem with investing in these areas today comes down to timing. If this all passes faster than we expect, their stock prices will reflect that and your “great trade” will fail you as the rest of the stock market plays catch up. Better to be safe than trying to catch a shooting star. The only clue valuation analysis can give us right now is related to the tendency of the overall market. The S&P 500 is currently trading at about 15x Price to Earnings (P/E). This is well below the long term average of about 16.5x but still above the final P/E ratio reached during the last recession (10x). That doesn’t mean it has to get to 10x. It just means we are still high if in fact we are going to experience a prolonged recession.

Technicals

So where does one turn in these environments to gain a sense of the future? While not a perfect science, technical analysis can sometimes offer us clues. One tool of technical analysis is known as “Elliott Wave Theory”. The belief in this system of investing is that markets tend to move in waves, often associated with a formula in math known as the Fibonacci Sequence. Not to get too “technical” here but the theory believes that markets move in “impulse” waves and “corrective” waves. Certainly we have seen a corrective wave over the past quarter and then we saw an impulse wave over the last few days of the quarter. The next “expected” move is another corrective wave as the markets begin to digest the potential length of the shutdown and its effect on the broader economy. Some analysts expect this move to bring the S&P 500 down to around 2100 – 2200 or even lower. If we take the midpoint (2150), that means another 16% or so lower. Personally, I don’t know if it gets there but I am of the belief that a retest of the recent lows (2300) is at least likely. The trick here is to be invested for when the positives start to effect the markets in a sustainable manner.

Positives

No one is talking about the positives right now, for good reason. People are “stuck” in their homes and the human element of this virus is too much to talk about. It is really sad. We do, however see some progress out there. The earliest countries hit with the virus have seen the reported data on new cases “flattening”. Some forecasters are assuming the virus is brought under control (not cured) within three months. This scenario sees improved levels of testing that will allow those infected to be quarantined, herd immunity developing, warmer weather arriving and treatments and eventually a vaccine produced. All within a few months. Under this scenario the damage to the economy is short lived and markets recover quickly (over months, not quarters). The actions over the past few weeks (and those to come) by the Treasury and Fed will be successful in enabling a large swath of our economy to weather this storm. Remember, the actions taken in the last recession took months of deliberations. This time they acted in weeks. Furthermore, our banking system is much more stable than it was in the last crisis. Lastly, never underestimate the will and power of a people that just want to get back to work.

Your portfolio and our plan

As I said in a missive to clients during the quarter, “I have been deliberately underweight all equites, including large companies, in your portfolio. It may be a little early yet to jump back in as the environment is so fluid right now. However, I would expect some serious action from the Fed and Congress in the coming days and weeks, so that will act as support or at least slow the slide.” Those actions did in fact come to fruition and the markets reacted positively. I took that as an opportunity to further de-risk portfolios across all clients. In conjunction with this, many clients were able to “capture” tax losses in their accounts to use against future gains and reduce tax burdens in the future.

As one whom is entrusted in the dual mandate of wealth preservation and wealth creation sometimes it is better to protect than to risk assets. This does not mean a wholesale change to client portfolios has occurred. Clients have asset allocation strategies that are important to the long term well being of their portfolios. Nothing has changed in this regard. Furthermore, as we saw in the last week of the quarter, it is extremely difficult to “time the markets” in environments such as these. There will be massive “up” days to go along with the “down” days and you don’t want to miss the positive days. As a rule of thumb a mild recession usually equates to a 20 – 30% drop, a big recession = 40-60% and a depression = 60-80%. I am somewhere between the mild recession and worse than mild recession camp right now. The only trick is that you never know when you come out of it and more importantly, how. It could be a relatively quick snap back or a longer grind higher. So you want to be positioned BEFORE it happens. There’s no glory in this part of the game. There’s nothing wrong with buying stocks, have them go down another 5% and then see the market much higher a year or two later. Here’s where people make the big mistakes, trying to perfectly time the bottom and then miss those first few moves higher. They miss 10 or 15% trying to save themselves from another 2 or 3% loss. Everyone should have buying power to set up their portfolios for the eventual rebound without sacrificing their long term goals or their allocations to fixed income investments.

If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.