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The Brave Report: Market Commentary for March 2020

Click here for the .pdf version of this report: The Brave Report-March 2020

Panic or patience? A historic selloff to end the month of February has put us in a very uncertain spot.  After hitting all-time highs, it only took six trading days for all major indices to lose more than 10% and enter correction territory. This is the fastest drop from all-time highs to correction in history.  It wasn’t just the speed at which markets dropped but the intraday volatility that we saw that was shocking.  The DOW Industrials experience multiple intraday swings of more than 1000 points while logging some of the largest single-day point decreases in history (it is important to point out that the drops were not near the largest from a percentage standpoint).

With new developments on the Coronavirus happening all the time and the continued spread of the virus around the world we are still struggling to quantify the full economic impact of the virus and the reaction to the virus. It seems that most investors just decided to sell and ask questions later. This panic selling was exaggerated by electronic and high-frequency strategies that pushed stocks to the extremes.  So, will this selling be justified by actual economic impact or has this rapid drop just provided long term investors with a great buying opportunity?

Market Overview

After rising for the first few weeks of the month, the markets saw the swiftest move to correction territory in history.  Over the course of the month, the Dow Industrials lost just shy of 10% while the NASDAQ and the S&P 500 sold off 6.3% and 8.9% respectively.  While these are some drastic monthly drops, they do not clearly represent the severity of the declines.  On February 19th the S&P logged an all-time, intraday high of 3393. Just 7 trading days later it logged an intraday low of 2855.  This marks an almost 16% decline from peak to trough.  This kind of drop has rarely been seen before. This also dropped all major indices into negative territory for the year, bringing us back to levels we last saw in October.

While the drop in the equity markets was very dramatic, the rush to safety that accompanied was equally as eye-opening. As investors exited equities, they rapidly bought up treasuries, driving rates to what at the time were all-time lows. During the same time frame that we saw equities sell-off into correction territory, we saw the yield on the 10-year treasury drop from 1.57% all the way down to 1.12%.  This again only happening over 7 trading days.  This kind of panic move to safety again has little precedent.  Even with this rapid drop, we still could be far from the bottom in rates.  I expect the Fed to continue to take aggressive actions to help counteract the economic impacts of the Coronavirus fallout and this includes a few rate cuts over the course of the year.  Now, it can be debated whether this is the right move but at this time the market is pricing in a number of cuts, and anything less would be viewed poorly by the markets.

 

The full health and economic impact of the Coronavirus outbreak is yet to be determined.  We have seen things improving in China while in other parts of the globe the virus is spreading rapidly forcing widespread cancelations of travel and large gatherings.  Domestically we are just starting to see the beginning of the health impact as new cases have begun to pop up each day. If we look at how this virus has spread in other areas, I think it is safe to assume things will get worse here before they get better.  Shortages of testing kits and the virus sometimes presenting without symptoms will only exacerbate the problem.  I do have confidence that we will be able to contain or limit the longer-term dangers posed by the virus but only time will tell how much damage has already been done.  As is often the case in situations like this, it is not the virus itself that has the real economic impact but the public fear and reaction to the outbreak that causes the economic disruption.

From an economic standpoint we are and will continue to see a slowdown in activity in the coming weeks.  Even if the health side of the virus can be contained in short order, the panic and fear around the outbreak will cause real short-term changes in people’s behavior which will translate into a reduction in spending and business activity.  The determining factors in the longer-term economic impact will be how long these changes in behavior last and what amount of the reduction in spending and business activity is lost forever and how much is simply delayed to the future.  Service-based, experiential and consumption-based spending will be lost forever.  For example, if you decide to forgo going to Starbucks today to get a coffee for fear of being around other people that doesn’t mean you will go out and buy two coffees when things are back to normal. However, if you need a new car and decide to not go out and buy one right now due to the virus you will still have to go buy one when things go back to normal. While this delayed spending will hurt the economy in the short run, it has little impact on the long term as any loss in this quarter will be made up for in future quarters.

With the full economic impact still to be determined, from a fundamental standpoint, is this drop in stock prices justified? The short answer is no. I think the markets have overshot to the downside and are currently pricing in more than the worst-case scenario in terms of economic impact. Market conditions going into the selloff and the current mechanics of the market created the perfect storm for a swift pullback.  The markets were sitting at all-time highs and by many measures, valuations were a bit stretched. After the runup, we saw last year and to start this year, a lot of traders were looking for an excuse to take some profits.  Once the selling started, the algorithmic and electronic traders took over, pushing the market moves to extremes.  Even as I sit here and write this, the same dynamic exists.  We have seen more than 1000 point intraday swings in the Dow Industrials 4 of the last 6 days. These are not rational or fundamentally based market moves and can make it very unsettling for the retail investor. We will need to see some of this intraday volatility diminish before we can really assess the damage that has been done and determine where things are going next.

So, based on fundamentals, how much should the market have sold off? The value of a stock can be calculated by discounting future cash flow or profit back to today.   This would mean that more than 90% of a stock’s value is based on profits that are more than a year in the future. For argument sake, let’s assume that the virus wipes out all corporate profits for the next year, not just profit growth but all profit and then the economy returns to normal. If this is the case, then around a 10% drop in the value of stocks is about what we should see. This is a pretty extreme assumption and not one that anyone is predicting.  The expectation is for a short-term disruption in business activity and in some sectors, just a delay in business activity that pushes profits out a quarter or two.

I am not saying that the drop we have seen is not warranted for certain names or certain sectors. The damage to future profits and growth could be severe in some areas. However, the indiscriminate, market-wide drops we have seen have gone well beyond long term fundamentals. With this being the case, this sharp pullback represents a great long-term buying opportunity for the disciplined investor.

Similar to last month, I am not saying that everyone should run out and start buying right now. When the market stops trading on fundamentals and is being primarily driven by fear and algorithmic trading then the short-term price movements can be swift and unpredictable. I expect volatility to remain very high for the foreseeable future with 1000 point daily swings becoming the norm until we start to get some real data about the actually economic impact of the virus. When this is the case, it can become very difficult to call the bottom on stocks or predict whether the market still has another leg lower to go. Now is the time to put together a shopping list of names and sectors that have been unfairly brought down with the rest of the market that you like for the long-term and slowly start adding to these positions over the course of a few days or weeks. The goal is not necessarily to buy at the exact bottom but to buy at an average price that presents a good long-term value.

Strategy Commentary

Overall, I maintained most of my equity exposure throughout the month.  I did trim a little on the edges as some stop losses triggered but these trims were only minimal.  Obviously, in hindsight, I wish I had trimmed more but during times of extreme volatility, it can be very dangerous to make any large-scale adjustments to portfolios.  My client portfolios are base

d on long term fundamentals so when the market stops trading on these fundamentals in the short-run I tend to shy away from making any rash decisions.  If it does look like the fundamentals have changed, I will reassess my allocations at that point. As I have discussed already, I do think short term fundamentals have changed but the long-term economic picture is still intact.

I continue to maintain my overweight to technology. While some of the highflyers in this sector got sold off pretty drastically, I think some of this was in part due to profit-taking.  I also think this will be one of the first sectors to recover.  I am still maintaining my utilities exposure from last month and this has held up well in the face of the selloff.  I did trim my exposure to financials as some stop losses triggered and the sharp drop in rates clouds the profitability of the sector moving forward.  From a valuation standpoint, I do think the sector is cheap but with uncertainty around how this severe drop in rates will impact profitability, I am comfortable staying on the sidelines.

Internationally, I have been underweight Europe for a while now and with the coronavirus spreading there rapidly my stance has only strengthened. The interconnected nature of the European block makes it much more difficult to implement widescale containment efforts.  In Asia, I am still taking a wait and see approach.  I think the worst could be over in China and it seems they are working back toward business as usual. But some substantial economic damage has already been done.  I do think they will be able to bounce back quickly as their political system allows for more draconian containment measures and more flexibility around economic stimulus. With that said I would like to see some more convincing bottoming in their markets before I think about any opportunistic buying.

On the fixed-income side, I have totally missed the boat.  I said last month that “without any other black swan shocks I think rates will probably stabilize back to the range they were in over the past 4 months.” Well, I was partially right, but we did get that black swan event.  While I have maintained my neutral stance across fixed income it seems I should have had more exposure to help offset some of the equity losses. We are now in a difficult position with rates so low.  Rates have dropped so low that adding could be dangerous if we see a snapback at all.  But with so much uncertainty around the virus and the expectation of continued rate cuts we still could be far from the bottom in rates. For now, I am maintaining my neutral stance.