2020 1st Quarter Market Commentary
In just under two months, stock prices worldwide have plummeted from historic highs to bear market lows and have rocketed part way back up again. The coronavirus has infected nearly 2 million people, killing over 100,000, and shut down vast swaths of the world economy. In less than one month, our way of life has been dramatically altered. We don’t know how long this will last, and we don’t know what tomorrow will look like. We are living through an unprecedented crisis on many levels.
In This Time Is Different, Harvard economist Kenneth Rogoff, a world-renowned expert on financial crises, and co-author Carmen Reinhart examined 800 years of such crises. The following extensive quote from Rogoff’s April 7 Project Syndicate article is the best summary I’ve seen of our current economic troubles.
With each passing day, the 2008 global financial crisis increasingly looks like a mere dry run for today’s economic catastrophe. The short-term collapse in global output now underway already seems likely to rival or exceed that of any recession in the last 150 years. Even with all-out efforts by central banks and fiscal authorities to soften the blow, asset markets in advanced economies have cratered, and capital has been pouring out of emerging markets at a breathtaking pace. A deep economic slump and financial crisis are unavoidable. The key questions now are how bad the recession will be and how long it will last. Until we know how quickly and thoroughly the public-health challenge will be met, it is virtually impossible for economists to predict the endgame of this crisis.
Readers of our commentaries know that we have profiled the equity investor’s dilemma over the past several years as a bet between underlying investment fundamental values, which have argued for far lower prices, and central bankers determined to prevent any appreciable damage to investment prices. The current tragic drama is shining a spotlight on that struggle with both sides now on steroids.
The major equity averages collapsed by 20% or more in the first quarter, marking their worst ever start to a calendar year. Volatility exploded after stock prices climbed to all-time highs in mid-February. As the pandemic circled the globe, prices fell to bear market levels faster than ever before. In fact, a one-month plunge of 35% was twice as fast as the first 35% drop in the Crash of 1929, which ultimately saw stocks decimated by 89% by mid-1932. This quarter’s decline brought the Dow and the S & P 500 back to 2016 levels, while the New York Stock Exchange index, which includes all companies on that exchange, retreated to a level first reached in 2006, before the Financial Crisis. That frenetic activity demonstrated the old Wall Street adage that stocks rise on an escalator and fall on an elevator.
The destruction has been so sudden that politicians and investment strategists have excused a lack of preparation with the claim that no one could have seen this coming. While pandemics, it’s true, are not common, Harvey Fineberg, M.D., of the Standing Committee on Emerging Infectious Diseases, indicates that there have been 10 in the last 250 years, roughly one per generation. In addition, there have been 14 U.S. stock market declines of 35% or more in the past 130 years, some taking away many years of prior gains. Even a cursory study of history demonstrates clearly that severe market disruptions unfold with regularity for a great variety of reasons, including : wars, assassinations, pandemics, recessions/depressions, tariff wars, drought, real estate collapses, bank failures, corporate bankruptcies, Wall Street scandals, presidential scandals, oil embargoes, stock exchange closures and terrorism. Throughout history, many have come unannounced.
Markets are especially susceptible to serious damage from such events when stocks are extremely overvalued. And at the market highs in mid-February, a composite of the major, traditional valuation measures showed stock valuations close to the dot.com era’s most overvalued level ever. A great many investors assume that valuations have improved markedly with prices having been cut so aggressively. Of course, if underlying fundamentals remained the same, that assumption would be true. Unfortunately, the coronavirus has shut down a massive portion of world business. As underlying fundamentals collapse further in the months ahead, valuation measures will not decline appreciably and might even become more egregiously high.
With significant segments of the world’s population out of work or working at home, vast portions of normal supply and demand is missing. On April 9, the International Monetary Fund forecast that the pandemic will push the global economy into the deepest recession since the Great Depression of the 1930s. JP Morgan expects no less than a global depression in this second quarter. In early April, Goldman Sachs warned that the US would suffer a sharper loss of real GDP than in the 2008 recession. And the St. Louis Fed anticipates that the unemployment rate may exceed the rate at the peak of the Great Depression.
What will that do to corporate earnings? FactSet Research Systems, which provides composite forecasts of Wall Street analysts, expects soon to be announced earnings to decline by 10% for the first quarter. This would mark the largest year-over-year decline in earnings since the negative 15.7% in the third quarter of 2009. At this point, analysts are predicting declines in earnings in the second quarter (-20.0%), third quarter (-8.5%), and fourth quarter (-0.9%) of 2020. However, with uncertainty so great right now, since February, more than 10% of the companies in the S&P 500 have withdrawn prior earnings guidance. Additionally, a recent IMF report indicated that some 20% of US companies are vulnerable to default or bankruptcy in the next recession. In an April 1 commentary in The Wall Street Journal, the always insightful Jim Grant opined: “Perhaps never before has corporate America carried more low-grade debt in relation to its earning power than it does today.” In addition, Goldman Sachs’ Peter Oppenheimer reports that corporate earnings are expected to collapse in 2020 and not return to beginning of the year levels until 2023. At that point, Goldman’s anticipated corporate earnings level would be the same as that of 2007, effectively resulting in identical earnings more than a decade and a half apart. Should that earnings forecast be realized, it would be interesting to see whether stock prices would also revert to the level which marked the beginning of the Financial Crisis.
We have been pleased to inform our clients that their portfolios have weathered the current storm extremely well so far. Except for portfolios with significant capital gains tax concerns or protected legacy securities, we had earlier reduced all portfolios to their minimum mandated equity allocation levels. Where we have complete asset allocation responsibility, we have had minimal equity exposure, and all such portfolios are showing profits for the year-to-date.
Did we foresee a pandemic and subsequent destructive fallout? Of course not, but we clearly recognized and warned about historic levels of overvaluation. As students of market history, we also remained fully conscious of the myriad of events that, generation after generation, have brought stock prices back to or below their long-term fundamental means. At seminars and in our writings over the past few years, we have expressed our willingness to assume whatever level of risk a client prefers. We never lose sight of the fact that it’s the client’s money, not ours. As a deep discount value manager, however, when left to our own preferences, we are willing to wait until we can find real value before committing an appreciable portion of a portfolio to common stocks.
In the long run, we have the patience to accept the bet that the equity markets will ultimately revert to their historic means. On the other side of the bet, however, is an 800-pound gorilla that has been on a decade-long winning streak—our Federal Reserve—in concert with fellow central bankers around the world. In less than six weeks, the Fed has dropped interest rates back to the zero bound, eased banking regulations and, together with Congress, promised money to individuals, small businesses, large businesses, cities, counties and states. The amounts almost don’t matter, because the Fed has made it clear that there’s more where that came from.
More than a decade ago, in response to the Financial Crisis, Congress and the Fed implemented a variety of rescue measures with price tags in the hundreds of billions of dollars, ultimately totaling in the trillions. At the time, knowledgeable commentators almost universally said something like: “This will end badly, but it’s necessary because of the severity of the immediate problem.” This time around, we’re starting the rescue efforts with trillions, and we don’t even hear cautionary admonitions like “This will end badly, but….” Those of a certain age can remember Everett Dirksen’s famous line about the spending proclivities of his congressional colleagues: “A billion here, a billion there, pretty soon, you’re talking real money.” It seems quaint today, doesn’t it?
This willingness to spend without apparent restriction demonstrates that the 800-pound gorilla is clearly alive and well. The question now is whether these efforts can remain successful in supporting stock prices when underlying fundamentals are collapsing. At this point, nobody knows the answer, and it puts a particularly heavy burden on investors faced with deciding on reasonable levels of investment risk to assume.
Compounding the problem of rescuing the economy in the current crisis is the preexisting debt burden that lurks on balance sheets worldwide. It’s sobering to realize that the average ratio of government debt-to-GDP for G-7 economies reached 117% in 2019, before coronavirus rescue efforts began, up from 81% in 2007 before the Financial Crisis. While we’re not hearing alarms go off today with interest rates near historic lows, danger will arise quickly if interest rates increase appreciably for any reason in the quarters or years ahead.
Venturing into forecasts for upcoming market behavior takes fortitude—or perhaps foolhardiness—given the vast number of medical, economic, corporate and government uncertainties. Ned Davis Research, however, did a recent report on stock market behavior following waterfall declines, such as we have just experienced. Evaluating the six previous precipitous declines in the past half century, NDR found that rallies following the declines have invariably been strong and are almost always followed by a retest of the original low, which can unfold weeks or months later. Nearly 70% of the time, the retest sees prices fall below the waterfall low. Robert Prechter of Elliott Wave International pointed out in an April 7 report that rallies following a bear market’s first leg down typically retrace between 30% and 80% of the prior decline with a median of 55%. Through the April 9 close, major US equity indexes had recovered between 45% and 59% of their initial losses with a median of 48%, so far right in line with past experience.
The strongest, most lasting rallies after bear markets have almost always launched from environments in which there was precious little public interest in stock ownership. The picture at the March 23 bottom was almost the exact opposite of that condition. A Bankrate survey of 2500 US consumers found that 2/3 intentionally left their investments as is in the first quarter. Of those that made changes, a few more added equities than subtracted. According to RBC Capital Markets, US stock investors were more bullish in the firm’s end of March survey than in any other since the survey began in 2018. And Bank of America said that its clients were net buyers of over $6 billion of US equities in the last week of March, the second-largest weekly inflow in its data history since 2008. The general public was hardly panicking out of equities. It’s an open question whether or not Fed monetary support can again negate longstanding market precedent. Can the Fed precipitate another lasting bull market despite collapsing fundamentals? If monetary policy should fail, would the Fed resort to buying stocks, as has been suggested by more than a few commentators? One would hope that the singular lack of long-term success by Japan forging into widespread equity ownership would dissuade this country from a similar action, after having already forfeited much of its former widely envied reputation as a bastion of free markets. In any case, the mere speculation of such potential intervention makes betting against the market a riskier proposition.
We all have reason to hope that medical breakthroughs will render COVID-19 a more typical infection that can be prevented and/or controlled in future years. Of course, we don’t yet know how long it will remain tragically destructive, nor can we know how long it will take for the world economy to get back on a normal track. St. Louis Federal Reserve Bank President James Bullard recently cautioned: “We just have to stop thinking that next year things are going to be normal.” On April 1 in the New York Times, Nobel laureate Robert Shiller added: “I worry that the present anxious situation may stay in the collective memory for decades, much as the stock market crash of 1929 did. That could make people more risk-averse, possibly portending lower valuation on the stock market. Consider that the 1929 crash and the Great Depression have remained vivid in the collective memory for over 90 years.”
Damage to the infrastructure of the world economy is so severe that there is little chance we will experience business as usual for some years to come. As we have counselled for years, however, the resolution of the bet between stock prices reverting to their fundamental means and central bankers holding stock prices well above such levels will punish or reward risk assumption, potentially for years to come.
We invite clients to review with us what level of risk assumption or asset protection is most appropriate given your individual or corporate needs. Please let us know if we can provide additional information about your portfolio or our investment thinking.