Market and Strategy Update
WHAT’S GOING ON NOW AND WHAT TO EXPECT
The coronavirus is the most severe health challenge the world has faced in recent history. Global markets continue to be roiled as the quickly developing pandemic disrupts lives and economic activity. We wrote on February 28th to expect more volatility, and that has proven to be painfully true. As the global health situation continues to evolve and financial markets respond, we want to update you on what we are doing amid the uncertainty.
Global stocks are now officially in bear market territory, down over 30% from February 19th highs. Oil prices dropped below $30, and the 10-Year US Treasury yield briefly dipped below 0.50% before rebounding to 1.1%.
The market moves in the last few weeks remind many of us of the market turmoil during the financial crisis of 2008-2009. Then, the fear was centered on structural instability in the financial system. Now, the biggest concern is the impact on the economy from this crisis and how long it will last. At this juncture, consumers and investors are left to assume the worst.
In their midst, all crises feel unprecedented. The 2008-2009 financial crisis felt as though the financial system would collapse. Today, we worry about the healthcare system and how our economy will deal with mass quarantines. Similar to the financial crisis, there is the sentiment that governments and central banks are not doing enough. At times, it takes a leap of faith to think that we will get through all this. As investors, we must continue to plan and invest for a future that will endure.
Governments and central banks are stepping up, slashing interest rates and taking extraordinary actions to support the functioning of the markets. The US Government has approved $50 billion in funds for pandemic help and is proposing a fiscal stimulus package of over $1 trillion, including direct payments to taxpayers and specific industry support.
In the coming weeks, we will begin to see how new quarantine measures and large-scale social distancing are impacting the spread of the virus. In China, the first lockdown in Wuhan took place on January 23rd. Now, a little under two months later, reports of new coronavirus cases are rapidly falling, and life is starting to return to normal.
Near term in the US, there is limited potential for good news, and the financial markets reflect that uncertainty. In most bear markets, investors are worried about the outlook for the next 6-12 months. The concern now is over the next 4 to 6 weeks. Until there is a clearer path forward, we should prepare for more volatility in stock prices. It could still get worse before it gets better.
WHAT WE ARE DOING
Long-term strategies based on careful planning will continue to be our lodestar through the market turmoil. We are also working to ensure our clients can get through whatever may happen in the short run. While we are not making significant changes to asset allocations (stocks vs. bonds), we continue to review all investment holdings to uncover any potential problems that could arise.
In the fixed income portion of portfolios, we reduced exposure to corporate bonds. The sudden shift in the yield curve and the market’s concerns about a credit squeeze favors US government securities. We sold all international bonds some months back; the reduction in corporate bonds is an additional move to batten down the hatches and ensure the fixed income allocation performs its role as a portfolio shock absorber and primary source of liquidity. It is also important to note that we do not hold high-yield, or “junk” bonds, which can act more like stocks in a downturn.
In our enhanced cash strategy, we have completely eliminated corporate or credit-backed securities. We now hold a combination of short-term government bills and notes to reduce the risk of short-term liquidity strains that could impact money market instruments.
In equity portfolios, we continue to review individual positions and look for rebalancing opportunities. Most accounts are now underweight long-term targets for stocks. In the coming days and weeks, we will proceed cautiously and incrementally with new purchases. This is not an attempt to call a bottom – no one can do that skillfully. Prudent portfolio management, especially in times of stress, requires patience and small steps toward long-term goals.
We have changed our targets for rebalancing to effectively reduce exposure to large international stocks. Europe has particularly struggled to break out of sluggish economic growth, and European banks are not as financially stable as US-based firms. Europe is also more heavily weighted toward economically sensitive industrial companies, while the US has a more robust technology sector that is performing well relative to the overall market.
We will continue to harvest losses in taxable accounts as opportunities are presented. The taxes saved from this strategy can help offset market declines while keeping investment positions intact for an eventual recovery.
STOCKS, FUNDAMENTAL VALUE, AND THE LONG-RUN
NYU finance professor Aswath Damodoran makes an important point in a recent blog post. Using a basic valuation model of the S&P 500, he shows the impact on the “fair value” of the S&P 500 based on sensitivity testing of two assumptions. The first assumption is how quickly corporate earnings drop, and the second is how slowly they rebound. His analysis shows the fair value of the S&P 500 depends less on how much earnings fall and more on how quickly earnings recover. Ultimately, long-term fundamentals matter much more than what is happening right now.
This is not a forecast, but it offers a key point. Stock prices and values often diverge, especially during a crisis. If investors are fearful enough, prices can stay low longer than fundamentals warrant. However, the real value of stocks is determined by the earnings and cash flows beyond this year or even the next.
WHAT IT ALL MEANS
While the coronavirus has sent us into bear market territory, stocks can rebound very quickly, particularly when underlying fundamentals are in place. As painful as they can be, bear markets are a feature and not a bug of investing in stocks. Globally diversified stocks have returned about 8% per year over the long term. This is the reward for sticking with a strategy through gut-wrenching ups and downs.
Bear markets – while inevitable – don’t last forever. Downturns will come and go, even those as scary as this one. The results of a well-designed and consistently followed plan, however, can serve you the rest of your life.
As events continue to unfold, we will be sharing our latest thoughts on the crisis — both on the immediate situation and how it is shaping our long-term outlook — in email updates and on our website at www.proffittgoodson.com. In the meantime, please don’t hesitate to contact us with specific questions or concerns. We are here to help.
Contact us at 865-584-1850 or info@proffittgoodson.com
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