Apr 15, 2020 2020 1st Quarter Commentary

 

Market Summary

The longest bull market in US history came to an end.  Global equities fell into bear market territory due to a worldwide pandemic. The year started well, but as fears about COVID-19 spread and it became clear that there was a severe global pandemic on hand, markets responded quickly and severely. The S&P 500 Index declined 34% from its all-time high on February 19th to the quarter’s low on March 23rd – the fastest decline from an all-time high ever. It then rallied 16% to close the quarter (and has continued to surge through April).

The S&P 500 ended down almost 20% for the quarter, the sixth-largest quarterly decline since 1927, and the worst since 2008. Stocks seesawed wildly throughout the month. There was only one day in the month where the S&P 500 didn’t move more than 1%. There was a large dispersion in returns between different segments of equity markets. Small-cap, non-US, and value-oriented stocks declined the most, while US large-cap, growth, and more defensive names held up better.

As the volatility of stocks reached historical highs, the bond market also experienced extreme volatility as investors indiscriminately sold anything with a hint of risk. Few investors were willing to buy anything but cash or US Treasurys during the peak of the panic. For example, municipal bond funds experienced record outflows for March. The large outflows, combined with few buyers, meant that many investors sold at prices that didn’t reflect the fundamental value. The forced selling exacerbated the price decline. A similar scenario played out in the corporate bond market. As a result, highly rated municipal and corporate bonds sold off sharply. The Federal Reserve moved quickly to provide the needed liquidity and funding support to stabilize markets. Once that occurred, prices quickly recovered, and fixed income markets began to act in a healthier fashion. Below is a summary of returns for the quarter[1].


Road to Recovery Playbook

We continue to follow our Road to Recovery Playbook for guidance in assessing the market’s bottoming process.

  1. Confidence in the timing of a peak in new COVID-19 cases in the United States. We believe we reached a peak in new COVID-19 cases in the US
  2. Visibility into the probability and severity of a US recession. A recession is all but assured, and we have a sense of the severity of the downturn
  3. Markets have priced in a US recession. A recession was priced into the market in late March when the S&P 500 was down 34% from its peak. However, with the S&P 500 now down only 16% from its highs (as of 4/14/2020), a slowdown may not be adequately factored into pricing. At this level, the entry point into stocks is not as attractive given the economic and earnings uncertainty
  4. Sentiment and technical analysis indicate a limited number of sellers remaining. Analysis of the market’s technical and investors sentiment pointed to a “washout” with indiscriminate selling and possible seller exhaustions
  5. Will policymakers’ response be enough to restore confidence?  We had the “shock and awe” policy response from governments and central banks around the world to help cushion the economic decline

 

Confidence in the timing of a peak in new COVID-19 cases in the United States.

It appears that the growth rate has peaked, although the total number of cases continues to grow. The below chart shows the details.

 

Visibility into the probability and severity of a US recession.

It appears inevitable that the US economy will enter recession in the second quarter putting an end to the longest expansion in US history. Every economy is suffering from the consequences of social distancing. This makes it especially challenging to see what the current economic state looks like, let alone how and when economies will recover.

It’s important to note that the business cycle didn’t end due to excesses in the economy. The downturn is due to the health crisis. Governments around the world shut down large parts of the economy, instructing workers and consumers to stay home.

Before the pandemic, there did not appear to be any significant imbalances or toxic assets that required correcting. The financial system entered this situation in a good spot, particularly compared to the 2008-2009 financial crisis.

  • Unemployment was falling.
  • Personal income and spending were growing.
  • Manufacturing activity had started to pick up after China and the US signed a trade deal.
  • Inflation was moderate.
  • Real estate activity was healthy, with home prices continuing to the trend higher.

We currently have minimal data but expect some clarity on the severity of the recession as more data is released. Given the vast unknowns we are facing, the range of possible outcomes is broad. This recession could be severe in terms of its initial decline in GDP and potentially large unemployment numbers. The first post-pandemic report of initial unemployment claims was a staggering 3,307,000, and the second release totaled 6,6648,000.  An increase so large that it looks like a chart error.

The industries most affected so far tend to be employers of lower‐wage labor like food services, leisure, and retail sectors. These industries account for more than a fifth of US employment but are less significant when measured in GDP terms or as contributors to stock market earnings[3]. Consequently, this recession may be most noticeable in its impact on unemployment and could be somewhat less impactful on corporate earnings.

 

Also, the recent CARES Act provides some incentives for firms not to lay off workers and also provides for very generous unemployment benefits over the next four months.  In many cases, workers would fare better by being laid off and collecting unemployment benefits than continuing to work.  This is another reason we expect the unemployment numbers to be extremely high.

 

Markets have priced in a US recession

From a market perspective, investors just experienced one of the fastest and deepest bear markets in history. There have been only five other 30%+ declines since the 1950s. Assuming the US economy goes into recession, the average bear market has lasted 18 months with average declines of 37%[4]. The peak to trough decline this time is 34%.

Predicting the duration and severity of any decline is impossible. This decline is unique due to the magnitude and speed of this shock. The market is trying to anticipate the policy responses and possible reverberations and amplification.

A point to keep in mind is that equities typically bottom 3-6 months before a recession ends. We will likely see worse economic news, but that may not equate to worse market performance. Market prices move based on changes in expectations, not necessarily changes in data. Below is a history of how market bottoms are different from the economic bottoms[5].

Current market prices, as measured by the S&P 500, are not pricing in a recession. We know that the stock market is a leading indicator of the economy so some could infer that the market thinks the economic recovery could be quicker and more robust than past recoveries. However, given all the unknowns, we want to be careful when increasing equity positions at these levels. Valuations are toward the high end of their historical range, and we may have more severe economic and earnings fallout than is currently expected.

 

Sentiment and technical analysis indicated a limited number of sellers remained

A bear market bottom has historically been marked by several economic and market markers including depressed investor sentiment, widening credit spreads, and policy response to the systemic shock. We see several signs that point toward a bottom including:

  • Investor Sentiment reached an extreme bearish point in March. Market volatility, as measured by the VIX, reached extreme highs, higher than 2008-2009[6].
  • Corporate credit spreads widened meaningfully have started to come back down.
  • Record outlfows from long-term funds and into money market funds. (The chart shows nearly $700 billion went into money market funds during the quarter.)

 

Will policymakers’ response be enough to restore confidence?

Because this downturn was unprecedented in speed and scale and driven by a forced government shutdown, the government is likely to play a crucial part in making sure the economy comes out on the other side of COVID-19 intact. The fiscal and monetary policy response by the federal government has been both swift and vast.

For example the Federal Reserve initiated 14 different mechanism to provide lending and support to small business, corporations, municipalities and households. The measures push the Fed far beyond anything it attempted in the 2008 financial crisis and may be strong enough and fast enough to ensure that liquidity isn’t a threat to the solvency of the financial system like it was during the 2008 downturn.

These actions lower the chances of corporate and municipal defaults and should help small businesses and consumers weather the economic consequences of the pandemic. For markets, these action have significantly reduced the extreme left tail events such as a depression. The adage of “Don’t fight the Fed” comes to mind. They have an unlimited balance sheet and it has already increased by 50% from $4 trillion in February to $6 trillion[7].

Meanwhile, Congress provided significant fiscal stimulus by passing a $2.2 trillion rescue package (the CARES Act) – nearly three times as large as the 2008 crisis. There is talk of additional stimulus packages in the coming months. It’s also important to note that virtually all lawmakers and central banks around the world have taken similar actions.

Portfolio Positioning

We made portfolio changes during the quarter. We moved up in market cap from small-cap stocks to mid-cap stocks. Historically small-cap stocks have been the most vulnerable to market shocks, and this time was no different. We think mid-cap stocks can better weather the uncertainty over the next 12-24 months. For similar reasons, we moved from international small-cap stocks to a global large-cap fund.

We also moved a portion of the alternative funds into cash. The alternative funds protected capital during the downturn, and we took the opportunity to position them to cash for future opportunities. Despite about two weeks of severe bond market volatility, our bond funds came back strong and held up relatively well for the full quarter. In our most conservative accounts, we have been raising cash with the rallies in fixed income as well.

In accounts that were not spending, or more aggressive,  we rebalanced portfolios and bought stocks when they were on sale. The rally off the lows has been robust. Given the potential for worsening economic news and lower than expected corporate earnings, we cannot be sure that stocks won’t test their lows again. For now, we are patiently waiting for further opportunities to add to equities.

Many of the valuation anomalies that existed in markets before the onset of the crisis persist today. In particular, the COVID-19 crisis has extended themes of growth over value, large-cap over small-cap, and US stocks over non-US stocks. Historically, the opposite has occurred: Value has outperformed growth, small-cap has outperformed large-cap. The US vs. Non-US has fluctuated and depends on the lookback period. Contrarian investing has not benefited.

Despite the underperformance, we continue to think that value, small-cap, and non-US equities all have a place in your portfolio. Both small-cap and value stocks finished the quarter, by many measures, as cheap relative to large-cap and growth stocks as they have ever been. Growth funds that have done well are also in your portfolio, but we think it is important to avoid concentration on growth names. We’ve seen market trends change quickly in the past, and while we don’t know when these current trends will reverse, we do believe they will.

Steep and rapid market drops are scary, but trying to time the market is nearly impossible and selling after big declines only exacerbates the issue. You must be present to win the long-term game. Market returns do not come like clockwork but rather in spurts when you least expect it. As an example, here’s a simple chart that shows how much returns you would lose by missing only a few days during the period January 1, 1970, to July 31, 2019 – that’s 50 years or 18,108 days.

Some say that volatility is the price investors pay for long-term gains. Unfortunately, that doesn’t make it any easier to stomach bear market drawdowns and daily fluctuations. We do take comfort in knowing that history is on our side. It feels scary and terrible, but markets have seen and endured crises before. The market and our economy carry on, often more resilient than before. Volatility spikes, aggressive drawdowns, and rapidly changing sentiment are features of the market, not bugs. This is particularly true in highly uncertain times.

 

If you’d like to discuss how this applies to your situation, please call your advisor.

 

 

[1] Morningstar Direct as of 3/31/2020.

[2] Alternatives benchmark includes 60% SG Trend Index and 40% Swiss Re Global Cat Bond TR Index.

[3] JPMorgan, Guide to the Markets

[4] LPL Reseearch, 3/17/2020

[5] Legg Mason. Anatomy of a Recession Presentation

[6] Koyfin data

[7] Koyfin data

 

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any particular strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore.

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the US and globally, changes in the liquidity available in the market, change and volatility in the value of the US dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors. For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.

 

INDEX DEFINITIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the US investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index of approximately 900 stocks and is designed to measure equity market performance in 21 developed market countries outside of North America.

The SG Trend Index is a subset of the SG CTA Index, and follows traders of trend following methodologies. The SG CTA Index is equal weighted, calculates the daily rate of return for a pool of CTAs selected from the larger managers that are open to new investment.

Swiss Re Global Cat Bond Index tracks the aggregate performance of all catastrophe bonds issued offered under Rule 144A. The index captures bonds denominated in any currency, all rated and unrated cat bonds, outstanding perils, and triggers. The index is not exposed to currency risk from non-USD denominated cat bonds.

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Important Disclosures

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein and take no responsibility therefore.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.

For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.