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The Brave Report: Market Commentary for April 2020

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

We are currently living in unprecedented times. The measures taken by governments around the world can only be compared to wartime efforts and even then, the comparison does not hold water. The loss of life from the virus is tragic and the lingering impacts on poverty and global health will remain for years to come. However, it is important to understand that we will get through this.  The disruption to everyone’s lives is temporary and with the lessons we have and will learn, we will come out of this stronger than we came into it.

This marks the first time in history that the entire world has been united against one common enemy. The type of cooperation we are seeing on the health front, both domestically and around the world should be a source of hope and provide some solace that we can all come together to work towards a common goal. While my job is to focus on the economic side of the equation, if we can solve this problem on the health side the economic side of things will work itself out over time.

Market Overview

It’s tough to sugarcoat the past month in the markets as we saw some of the steepest market declines in history.  During the month of March, the S&P 500 lost 12.51%. The NASDAQ lost 14.09% and the DOW Industrials was the big loser on the month, losing 17.58%.  The loss in the DOW was more outsized as it is a price-based index so the severe drop in Boeing weighed more on the index. These losses also don’t paint the whole picture of the destruction that we saw, as the markets rallied in the last week of the month to finish almost 18% above the mid-month lows. The severity and the pace the markets dropped for the first 3 weeks of March have no historical precedent making it the fastest the markets have ever dropped into bear market territory. From the all-time market highs, we saw on February 19th the market lost more than 35% in just over a month.

On the fixed-income side, we saw quite a rollercoaster over the last month.  First, we saw rates drop sharply to start the month as investors sold stocks and rushed to the safety of treasuries. The 10-year treasury reached an all-time low of 0.39%.  This drop quickly reversed. There became a point in the month that credit markets weren’t operating properly so investors also sold treasuries and moved to cash. This caused rates to spike, with the 10-year hitting 1.26%. It was a rare moment where we saw both stocks and treasuries selling off. Traders decided that nowhere was safe and cash was king. The Fed responded by adding some liquidity to the credit markets and purchased a wide swath of fixed income instruments.  This, in turn, pushed investors back into treasuries, albeit in a more organized fashion, again putting downward pressure on rates.  As we work our way through this crisis, I expect rates to remain very low but volatility to continue. The speed that we make our way out of this forced recession will be the determining factor in how fast rates move back up.

Coronavirus: The economic impact of the virus has far surpassed anything that I expected. I will be the first to admit that I did not think we would get to a point of a global lockdown.  With the numbers coming out of China (that we now know to be vastly underreported) and other Asian countries as well as my naïve perception of our own preparedness I expected a short-term disruption in supply chains and some basic impacts on consumer behavior domestically. Instead, what we have seen is the first-ever forced recession. The government-mandated lockdowns have forced the economy to a standstill. The service and leisure industries have basically stopped, and we are left in a situation of trying to predict how long this halt will last.

The markets have already priced in a pretty dramatic drop in economic activity and a massive rise in unemployment.  Most forecasts are calling for a severe drop in economic production for around 2 quarters with a snapback of activity after that.  We continue to see revisions in GDP growth forecasts with some predicting as much as a 30% decline in the 2nd quarter.  From a long-term fundamental standpoint, the specific level of the drop in Q2 GDP doesn’t really matter.  We all know it will be bad.  The big factors moving forward will be how long does the economic contraction last and how quickly do we return to normal. Currently, both factors are unknowns, and the markets hate uncertainty.

While I expect the entire economy to slow over the next few quarters and then snap back over the period of a few quarters I do think there will be definite winners and losers during and after this contraction. Some companies will take a much bigger hit during the downturn and some will not recover as fast, if at all. While other companies could actually benefit from current changes in behavior and come out of this in a stronger position than they went into it. The longer this crisis drags on, the more defined these winners and losers will be.

The other big factor in terms of the economic impact of the virus will be in how governments have and do respond, both from a health and an economic standpoint. This includes steps they take in mitigate the initial damage as well as how they navigate coming out of the crisis.

Government Intervention: There is a lot of debate and finger-pointing going about the government’s slow response to the health side of the crisis. However, we have seen swift action on the economic and financial side of the equation. The response has been fought on two major fronts.

First, the federal reserve stepped in to ensure financial markets and the banking system continue to run smoothly.  They moved quickly to drop interest rates to zero. They also injected liquidity into the credit markets at levels that far exceeded what they did during the financial crisis.  As it stands now, they have said they will continue to purchase unlimited amounts of treasuries, mortgage-backed securities, municipal and corporate bonds in order to keep these markets operating smoothly.  These types of monetary moves are meant to make capital cheaper and easier to get while also greasing the wheels of the banking system to avoid any panic or runs on the bank.

On the fiscal side the government can’t move quite as fast since things need to be negotiated between Congress and the President.  While many have been frustrated with some partisan bickering, Congress has been able to pass three relief bills in record time.  These first few bills serve to help prop up those hurt by the forced lockdowns and encourage business to maintain their workforce or rehire when things open back up.

I am not going to do a deep dive into the specifics of the bills but so far they have focused on providing direct payments  to anyone making less than $75,000 (phasing out above that), a vast expansion of unemployment benefits and debt relief, forgivable loans and injections of capital for small and medium-sized business.  There has also been money allocated to help larger corporations avoid layoffs and continue to operate through the crisis. This is mostly in the form of loan facilities.   The goal for these first three bills has been to lessen the impact of the economic disruption caused by the forced lockdowns.  We will probably see one or two additional bills.  Their contents will be determined by the duration of the crisis but I expect their focus to be more on simulating the economy as we come out of the crisis and ensure any recession we see is short-lived.

Where is the bottom? This is the question that everyone in the investment world is asking. Historically speaking, this is the wrong question and one that is almost impossible to answer. For the long-term investor, the goal is not to call the exact bottom correctly but to take advantage of lower prices now that they have presented themselves.  We aren’t trying to put all of our cash to work on one specific day because we think it is the bottom but to buy systematically over time to try to get the best average price.

We are going to continue to see increased volatility as the markets search for certainty.  There may be another 20% to the downside or we may have already seen the bottom. Because of this uncertainty we want to use this opportunity to reassess our allocations and slowly start buying into high-quality companies and companies or sectors that could benefit from a changing global landscape. Over the last two weeks, I have started to redeploy capital for a number of clients.  This has been in the form of putting cash to work as well as through some strategic rebalancing to take advantage of specific sectors or names that I expect to outperform coming out of this downturn. Buying during these times may cause anxiety and may feel like trying to catch a falling knife. However, due to the drop we have already seen, the downside risk in the markets is much lower than it was a few weeks ago. The long-term risk-reward profile is much stronger now than it was back in February.

With that said, there will also be some signs that tell us the downside risk is abating.  The first and biggest will be on the health front. With the never-ending barrage of bad news and death tolls that continue to climb, any positive news on this front should help put a floor on markets.  This could come in the form of the curve flattening or a treatment showing efficacy but once we have any certainty on the health front, we can start to model an end to the economic disruption. I expect to see the markets jump quickly if we see some progress in this area.  I am not saying we see a v-shaped bounce back to February levels, but we would see a quick jump followed by some consolidation as the markets parse out how much economic damage should finally be priced in.

Even without any substantive progress on the health side, there also becomes a point where markets get desensitized to bad news.  In all downturns there becomes a point where bad news stops having a noticeable impact on stock movement. This is based on two factors. First, stock prices are forward-looking and represent expectations for company performance in the future.  If the bad news is not as bad as what is expected or priced in, then there is no downward impact on stocks. So far, the markets have priced in a lot of economic destruction.  If the economic impact isn’t as dire as expected, then stocks will be supported. Second, there becomes a point where investors have seen so much bad news that they just become desensitized to any new news causing its impact to be muted.

When we start seeing either of these factors at play it can indicate that at least a short-term bottom is in.  In these situations, we also start to see investors craving good news. This creates outsized positive moves to any good or less bad news. It is important to note that this is not always a sign of a sustained bottom but can indicate a reprieve from selling and a chance for long-term investors to reassess their allocations.

A last sign I am looking for is going to be on the earnings front.  Over the last month, we have been in a bit of an information vacuum. There were very few new earnings reports coming out and any economic data we were getting was backward-looking so did not account for the impact of the virus.  That is about to change.  We are entering the start of earnings season and will start to get quarterly reports and projections.  While I, along with everyone else, expect earnings and guidance to be very weak, we will start to get a more concrete glimpse of what the actual economic impact will be on various companies and sectors. In this case, bad news is better than no news at all. Additionally, amongst the carnage, we will start to see some green shoots.  There will be some companies where the economic impact isn’t as bad as people thought. There will also be other companies that have performed well during this troubling time.  Through all of this, the sign I am looking for is a reduction in correlation.

For much of this pullback, everything was getting sold. The selling did not discriminate.  With the first look at real economic impacts on companies, we will hopefully start to see more selective buying and selling.  When this happens, overall market volatility drops, and we can start to see an established floor in individual sectors or companies.  There will still be some losers and some significant downward pressure in certain areas, but the damage will no longer be market-wide.

The one other variable over the past month that I have not had a chance to touch upon is the sharp drop in oil prices that also contributed to the downward pressure on equities and some issues in the corporate credit markets.  The initial drop was due to supply issues and a battle between OPEC and Russia in terms of overall production.  After this initial drop, the energy space was hit by a huge demand disruption caused by the forced virus lockdowns. In a normal month, I would dive much deeper into this issue but for the sake of time, we will have to leave it at that.

Strategy Commentary

The correlated drop in equity prices over the past month left very few places to hide. As I have discussed in the past, it can be very dangerous to try to make widespread changes in portfolios when volatility rises so much. The founder of Vanguard, John Bogle, said it best, “These times of crisis, these times that try investors’ souls, are terrible times to make decisions. If you really have to make a decision, just to keep your own sanity, make it a small and incremental one.”  With that in mind, I have been a net buyer over the past month.  This has included putting some extra cash to work as well as through some strategic rebalancing.  I have done some tax-loss harvesting in some of my wide market exposure. I then replaced these positions with more selective individual sectors or specific companies.  I normally do not do a lot of individual stock selection for my clients but as I have discussed, there will be some definite winners and losers coming out of this and we want to try to take advantage of that

I continue to maintain my overweight to technology but am more selectively adding exposure to larger, more established names.  No matter what the sector, those companies with strong balance sheets will fair the best. I also think large technology companies will see a reduced economic disruption as their businesses can still operate under the current restrictions. I am still maintaining my exposure to utilities and am also staying far away from the energy sector. Even if there is a bounce-back in oil prices, the amount of leverage in the sector makes the risk in the sector unpalatable.

Internationally I have cut my European exposure even more.  The virus impacts in the region are still ramping up and the interconnected nature of the block make coordinated fiscal and monetary response much more difficult to negotiate and implement.  I am also starting to selectively add to my Asian exposure. Even though the virus numbers we saw in China seem to be vastly underreported they are still further along in the fight against it. They also have an unrivaled ability to stimulate the economy.

I continued to miss out on the fixed income side of things this past month. I actual reduced my exposure even more when rates dropped to the lows and I wanted to raise some cash.  This is only a short term move and will look to build out that portion of my allocation once we see some stabilization in rates.