The Margin of Safety Quarterly Spring 2020
First Quarter 2020
- We just witnessed the fastest 30% decline from a recent high on record for the S&P 500 (in only 30 days)
- Larger cap U.S. stocks fell 20% this quarter
- Smaller cap U.S. stocks have done even worse, falling 31%
- Developed international stocks and emerging market stocks both dropped around 24%
- In the fixed income markets, core bonds gained just over 3%, once again playing their key role as portfolio ballast against sharp, shorter-term stock market declines
- Floating rate loans and high yield both dropped around 13%, emerging market bonds were down 20% and investment grade corporate bonds fell 4%
- Our diversified alternatives position declined just over 9%
We are all now living through a period in history none of us will ever forget. The impact on our families, communities, and country has been profound. And it continues. There remains great uncertainty, worry, and fear about the coronavirus and its impact: how widely it will spread, how fatal it may be, how long it will last. When will we see signs of stabilization in its spread and a decline in daily new cases? When will we “flatten the curve”?
We’ve frequently said that recessions and bear markets are inevitable phases within recurring economic and financial market cycles. We talk about “downturns” and “recoveries”, and have graphs and slides as well for our client meetings. We talk with clients that as investors, we need to be prepared for these events to happen, but the precise timing is consistently unpredictable. We’ve also said there is always the risk of an unexpected “external shock” to the markets and economy (e.g., a geopolitical conflict or natural disaster).
It’s one thing to say it and another to actually live it. And still another when the precipitating event or catalyst for the recessionary bear market is something none of us have experienced before: a global pandemic, which has instigated an extreme societal response—including the indefinite closure of schools and non-essential businesses, shelter at home orders, quarantines, lockdowns, and social distancing—and has potentially overwhelmed medical facilities, personnel, and supplies.
We will get through this crisis period. Things will improve and recover. This too shall pass.
In the meantime, events are moving very rapidly, policy responses are in flux, and markets are extremely volatile. Below is our investment commentary based on events and the global situation as of the middle of April.
The first quarter of 2020 has been an unprecedented period in U.S. financial market history. We just witnessed the fastest 30% decline from a recent high on record for the S&P 500 (in only 30 days). We have experienced historic volatility as well, as measured by the VIX, which reached its all-time high on March 16. Oil’s 25% drop on March 9 was its biggest one-day drop since the 1991 Gulf War. Finally, 10-year and 30 year Treasury bond yields fell to all time lows of 0.54% and 0.99%, respectively! However, the volatility has also been strong in the other direction as well. The week ending April 10th was the best week since 1974 for stocks, emphasizing the danger of trying to time when to be in or out of the market.
The major global asset classes declined in the quarter, except for U.S. bonds given the drop in Treasury yields and TIPs which were up slightly. Global stocks were down 14-31%, with small cap stocks faring the worst. Much of the differential between U.S. and foreign stock market returns has been due to the appreciation of the U.S. dollar, which has risen roughly 2.5% year to date.
U.S. fixed income yields have been extremely volatile as well—shooting up on some days when stocks were also sharply selling off. The 10-year yield ended the quarter at 0.70%, down from 1.92% at year end. Turning to the credit markets, floating rate loans and high yield bonds took it on the chin. Both dropped around 13%. But investment-grade corporate bonds were far from immune, losing over 4%. Our foreign bond exposure was down 20%, some of that due to the appreciation of the U.S. dollar noted earlier.
Our allocations to lower risk fixed income and diversified alternative strategies have offset some of the equity losses. But even this level of diversification has not been able to completely counter a steep and quick equity downturn.
The near term economic damage from the United States’ and other countries’ response to the coronavirus outbreak now looks almost certain to be severe. GDP is expected to sharply contract, potentially by historic proportions, and unemployment is rising to levels never seen before.
The depth and duration of the recession (and the speed of the recovery) depend on the effectiveness of our medical and policy responses. A medical resolution is a “known unknown.” But the Federal Reserve and other major central banks seem to be all in to support markets. At the same time, governments around the globe understand something massive needs to be done quickly on the fiscal policy side. As everyone knows by now, the U.S. stimulus is over $2 trillion dollars and there is potentially more to come.
Yet when stock prices—or any asset’s prices—drop, forward looking returns rise. Our outlook for U.S. stock returns improved with their cheaper valuations. So, in mid-March we began taking advantage of this bear market by adding a small allocation (4%) back to U.S. stocks at better prices. This has essentially brought all of our balanced portfolios up to our neutral targets for global equities. We funded the increased stock weighting by reducing our allocation to alternatives. We are monitoring global equity markets, as we assess the next point that we might overweight equities and/or change our allocation mix between U.S. and non U.S. stocks.
While the news may sound dark and hopeless at times, remember that this too shall pass. The world has faced many challenges and economic downturns and has always come out the other side. We are all facing unique risks and unknowns today, but we will bet on our resilience.
Update on the Macro Outlook
We entered the year with an outlook for a moderate rebound in the global economy (especially outside the United States) on the back of reduced U.S.-China trade tensions and extensive global central bank monetary accommodation. A number of investors that we respect now say that their base case economically is that the U.S. economy is headed into recession in the second quarter. It is likely to be a severe one, with a sharp contraction in GDP and an unprecedented rise in unemployment.
The near term economic damage from the United States’ and other countries’ response to the virus now looks almost certain to be severe (barring some unexpected major medical breakthrough in the near future). While we do not forecast economic data, the current Wall Street first quarter and second quarter GDP forecasts are for annualized declines in the range of 9% to 34%. The wide range of expectations tells us that at best these are guesstimates.
The depth and duration of the recession—and the strength and timing of the ensuing recovery—depend on two key variables:
1) The effectiveness of our medical response and social policy efforts in flattening the curve
2) And the speed and effectiveness of our fiscal, monetary, and regulatory policy response
One lesson learned from the 2008 global financial crisis is that a policy response needs to be significant and executed quickly. Governments need to make a credible commitment to “do whatever it takes” to support the economy and prevent a negative spiral from taking hold. The Federal Reserve and other major central banks seem to have gone all in to support the fluid functioning of credit, lending, and financial markets, and their critical role as the “plumbing” of the real economy. At the same time, governments around the globe understand something massive needs to be done quickly on the fiscal policy side. On March 27, Congress passed, and the president signed into law, a $2 trillion stimulus package. Similar support measures are being debated or implemented around the world. Discussions continue about additional steps to take in support of markets and the economy.
When you diversify across asset classes and consider a variety of potential scenarios, there will always be leaders and laggards in your portfolio. Some positions, like U.S. stocks, work well in strong up environments like we experienced last decade, while we have incorporated others that benefit portfolios during tougher times like the start to the 2020s. Put together, they build resiliency and protect a portfolio from betting on a single outcome, which can be a disastrous financial result if the opposite happens.
Our portfolio allocations to core fixed income and alternative strategies performed well (relative to stocks) as global stock markets sold off, delivering better returns and significantly outperforming U.S. stocks. These allocations helped to offset some of the decline in stocks and should continue to do so if the selloff continues.
For taxable accounts, we have been harvesting tax losses, to improve after tax returns in the future, while also maintaining a clients exposure to equity asset classes using appropriate replacement positions. We have also been rebalancing client accounts, to maintain the proper balance and mix of various investment positions.
Positions in foreign stocks were a headwind in this first quarter. European and emerging market stocks have underperformed U.S. stocks during this swift and severe downdraft. As markets have fallen, there has been a strong “risk off” demand for U.S. dollars and a resulting appreciation in the U.S. dollar. This has hurt dollar based investors in foreign stocks and our foreign bond position. In fact, European markets have performed in line with U.S. markets in their respective local currencies. And emerging market stocks have outperformed U.S. stocks in local currency terms—dropping only 19%. We—and many other respected investors we follow—expect the dollar to weaken as the crisis abates and a global recovery resumes. If so, that will be an additional boost to our foreign stock and bond returns going forward.
Within the U.S. stock market, growth stocks are again beating out value stocks this year—outperforming on the downside. This continues their winning streak, which has been a headwind for many of our active U.S. stock managers. Since we are valuation focused investors, the tilt of our portfolios to value strategies has been a drag on performance. However, as we have written in the past, growth and value strategies do go in cycles and we believe that we are closer to the end of this current cycle. Developed international stock pickers have performed similar to the index.
We continue have confidence in our active stock managers. We believe our patience in sticking with them through this period of underperformance will be well rewarded as we come out of this uncertain and tumultuous time. We maintain exposure to a range of manager investment styles and approaches. We definitely do not believe value investing is dead.
We are maintaining our positions in European and emerging market stocks because their expected returns have also gotten much more attractive on a forward looking basis after their recent price declines. And, unlike U.S. stocks, they were already at relatively attractive valuations and offered attractive expected returns prior to the virus related selloff. As we have from the beginning, we remain cognizant of their potentially larger downside risk compared to U.S. stocks in our overall portfolio construction, risk management, and expected returns analysis.
During these historic times, it is paramount to stay disciplined and recognize when emotion rears its head in investment decision making. For over two decades, we have employed a disciplined process and philosophy for client portfolios. Although different environments, we have taken clients through the 2000-2003 tech wreck and the 2007-2009 financial crisis. If we invest based on emotion, we are very likely to exit the market after it has already dropped meaningfully, locking in losses. By the time the discomfort and worry are gone, the market will already be much higher. Buying high and selling low is not a recipe for long term investment success.
For our clients, it is so important to maintain focus on their long-term financial goals and objectives. For some clients, as we updated their financial plans during the market drop in the first quarter, the projected success of their financial plan did not decline in a material way. Investing is a “long” game, not a “short” game and even for individuals in their late 60’s and early 70’s, the investment time horizon can span decades. The financial plans that we develop attempt to factor in bad market environments such as today, when determining over all success of the plan.
As hard as it may be, from an investment perspective we need to try to look through the current environment of fear and concern—emotions which, given the circumstances, are totally justified and felt by all of us—to the almost certain outcome of the virus crisis receding and economic recovery occurring.
We see on the news people reacting to the pandemic in their personal lives, including stockpiling food and paper products. This reaction is one of fear, to make themselves feel more in control. In financial markets investors do the same thing, selling stocks because they feel stocks will keep falling in price, moving into assets that make them feel safe. This results in opportunity for those with discipline and an investment plan, which helps the investor do the hard thing and buy when others are selling, knowing that buying at cheaper prices will be good in the long run.
Global markets have endured severe challenges and economic downturns in the past and have always weathered the storm. Attempting to time the market’s tops and bottoms is a fool’s errand; however, incrementally adjusting portfolio allocations in response to changes in asset class valuations, expected returns, and risks can be highly rewarding to long-term investors.
The time to be adding to stocks and other long-term growth assets is when prices are low and markets—and most of us personally—are gripped by fear and uncertainty rather than complacency, optimism, or greed. It may seem like the market could just keep dropping with no bottom in sight. But that is exactly where research, analysis, patience, experience, and having a disciplined investment process come most into play. Investors make most of their money in bear markets, it just does not feel like it at the time.
One in two Americans now live under lockdown (and maybe more by the time you read this). Our medical infrastructure could be overwhelmed. We are probably already in a global recession. Facing this dual medical and economic crisis, the situation is probably likely to get worse before it gets better. We would love to be wrong. But it will get better.
We can look at historical events to know this. People read or hear that this is the worst crisis the markets have ever faced. However, 26.4 million people died around the world in one year of the Spanish Flu in 1919. This was when the population of the world was much lower than it is now. Also just to put things into perspective the chart above illustrates the most common causes of death in the world. Currently for COVID-19 there have been 116,000 deaths around the world. This would put it between poisonings and fire in terms of number of deaths. However this is much below cancer, dementia, and other diseases. This isn’t to say it isn’t important but it is to say that it isn’t unprecedented.
The future is uncertain but our investment playbook remains the same: diversify; balance long-term returns with short-term risks; buy low into fear, sell high into greed. Stay the course.
River Capital Advisors News
Normally when we write this newsletter (spring), tax filing season has just ended. This year, as most everyone knows, the IRS has moved any tax return or payment due April 15 to July 15. At our affiliated CPA firm, Smoak, Davis & Nixon, we continue to process and finalize returns. The CPA firm has also been assisting business clients in evaluating options under various government programs, such as the Payroll Protection Program (PPP) and various SBA loan programs. Please contact us or the partner in charge of your account for more information on these programs.
We continue to work with clients via conference calls and video conferencing as well. We look forward to the day when we have face to face meetings! Please contact anyone on the RCA with anything we can do to help with financial matters.
We have also updated our annual ADV and are including with our client quarterly performance package a Summary of Material Changes. If you would like a complete copy of our ADV, please contact Bradley Miller, CFP®, for a copy.