By Jason Lesh, Managing Principal
What a crazy time to be alive and what a volatile beginning of the year we have witnessed. It would be very easy for all of us to become overwhelmed by the daily headlines, despondent at the varying outlooks, scared for what lay ahead or angry at the turn of events. And I’m sure we’ve all felt each emotion in varying degrees over the last few months. We are living through historic times and few of us have every witnessed something remotely close to this in our lifetimes.
But while it may seem like a watershed moment from which there is no going back, all is not lost. Humans are inherently stubborn and resilient. We have overcome and weathered storms before, whether that be wars, recessions, depressions or pandemics. Allowing ourselves room to process and maintaining a margin of safety in all aspects of our lives is paramount to not just surviving but thriving. Times like these cause us to take stock of those we surround ourselves with, test our capabilities, affirm what we are doing right, and can serve as a catalyst to do better. And that we are doing.
As Nick will expound on, the first quarter of 2020 saw US markets off 30+% at one point. 30 million Americans have been laid off and roughly 19% of the pre-crisis labor force has applied for benefits(1). As we ended last year, we had become increasingly concerned about US valuations, so much so that we had actually added a hedge to portfolios should a large correction happen. With the first downward leg pausing in late March, we temporarily reduced this hedge, only to add it back over the last two weeks.
Our clients' portfolios have rebounded nicely in April, but we are still cautious: the US market valuation is the same as it was in the summer of 2019. We continue to search for value around the edges and add the rare opportunities we find (American Express for example). But we are still maintaining an abnormally high amount of cash for the time being. As we always have, short and mid-term needs are held in cash and short-term US Treasuries. As a result, any volatility that portfolios are experiencing are with the long-term part of portfolios. When seen through this lens, we view all of this as an incredible opportunity to generate above average returns in the years ahead.
Lastly, a quick personal reflection. I find myself uncomfortably full of gratitude these past couple of months. For good health. For the good fortune of the clients we have. For the days full of smiling Zoom calls while surrounded by the buzz of a healthy family working and studying from home. For the fact that we are in this together and sowing the seeds for phenomenal returns in the years ahead.
Know of our continued well wishes to you and your family. Thank you for your continued trust in us. And please don’t hesitate to reach out: to update us on any changes, to inquire about our thoughts, or to share a good story and a laugh.
Warmest regards,
In our last communication we discussed our optimism for future returns. Opportunities are appearing today for us to earn a more significant return than we expected a few months ago and thus we will be investing more of our “safe assets” in such investments. These opportunities will shape our collective retirement future for the better.
As of this writing, we have seen a significant rally on the back of the Federal Reserve liquidity and “stimulus” programs from the Treasury. In March, fixed income markets were in disarray due to an imbalance with too many sellers and not enough buyers. The Federal Reserve has been a massive buyer of treasury securities, mortgage securities, and now for the first time, corporate fixed income securities. All this in the name of facilitating the orderly operation of financial markets. I’ll spare you the debate on whether the US Government should be owning $6.5T of marketable securities, that’s a story for another time.
Additionally, the Treasury through its “stimulus” programs will be contributing at least another $2T designed to stabilize (ie. brace the fall) the economy. Interestingly, the stock market has rallied back to mid 2019 highs when the economy was still in good shape (and as a reminder we thought it was expensive for a healthy economy, let alone a floundering economy).
In the meantime, US jobless claims have blown through all kinds of records and unemployment, although much of it temporary, is thought to be nearing 15%!
One economist has projected that real GDP will be down 30% in the 2nd quarter. These are truly unprecedented times.
Where Do We Go from Here?
As always, no one really knows as. A recent Bloomberg chart shows a stock market rally in the midst of a declining market is a normal course and meaningful losses are still possible from here.
I am not sure short-term market prognostication is fruitful, but I will tell you how we are thinking. As you know I tend to think in probabilities rather than in absolutes. David Rosenberg has recently presented a pretty good framework broken into a most likely “base case” and then both a “best case” and “worst case” scenarios.
Rosenberg’s base case assumes the economy reopens in May in a staggered approach across geographies and industries. There would be periodic setbacks with additional outbreaks across the country which will require additional quarantine through 2021. These setbacks are sufficient enough to make people less confident in spending than prior to the crisis, important considering consumers have been the major driver of our economy recently. This base case assumes that we have developed better treatment protocols around the worst respiratory symptoms, but do not have a vaccine ready for the next 6-12 months.
Base case economic realities are not good. Rosenberg suggests greater than 14% unemployment by the end of 2020, and while employment improves it still averages over 10% through 2021. The stock market will likely average lower than it is today through 2021, but will show signs of recovery in the second half of 2021. The 10 year treasury will be lower by the end of 2020 and average less than 0.25% in 2021.
Rosenberg’s best case assumes that we do get a vaccine in the next 6-12 months and confidence returns gradually. Unemployment will improve but still average nearly 9% through 2021. The stock market should stabilize under this scenario in the 2nd quarter, but the economy will take time to return to real growth. Under this scenario, we should begin preparing for inflation.
Worst Case scenario assumes no vaccine and a more severe second wave of infections in the fall, similar to the Spanish Flu in 1918. Unemployment would be 20% by the end of 2020 and average 17.5% thru 2021. This would be a near-depression scenario with the stock market averaging 25% losses in 2021.
All this being said, the future is absolutely unknowable and the only thing we can do is:
Prepare ourselves and our loved ones to be physically and mentally safe.
Stress test our portfolios to ensure our financial well-being under the worst case scenarios.
Prepare ourselves with an action plan to opportunistically and without emotion put capital to work.
We Are Prepared
In our long-term portfolios, we sold ½ our position in the Cambria TAIL ETF for a more than 20% gain. It allowed us to benefit when the market declined off-setting some of our losses in stocks (we call this a “hedge”). With the recent market rally, we have reacquired that security at lower prices.
We should be equally prepared for a 50% market decline as we were for this recent rally. Speaking of the rally, value stocks, the cheapest stocks as we discussed in our last communication, have not benefited as much as they usually do coming out of a significant market decline. This leads me to believe that this rally is not sustainable.
I have often quoted Howard Marks as someone who has done an extraordinary job of managing capital over many bear markets. He released a memo recently and to quote him in summary:
“In the Global Financial Crisis, I worried about a downward cascade of financial news, and about the implications for the economy of serial bankruptcies among financial institutions. But everyday life was unchanged from what it had been, and there was no obvious threat to life and limb.
Today the range of negative outcomes seems much wider, as described above. Social isolation, disease and death, economic contraction, enormous reliance on government action, and uncertainty about the long-term effects are all with us, and the main questions surround how far they will go.
Nevertheless, the market prices of assets have responded to the events and outlook (in a very micro sense, I feel [the recent] bounce reflected too much optimism, but that’s me). I would say assets were priced fairly on Friday for the optimistic case but didn’t give enough scope for the possibility of worsening news. Thus my reaction to all the above is to expect asset prices to decline. You may or may not feel there’s still time to increase defensiveness ahead of potentially negative developments. But the most important thing is to be ready to respond to and take advantage of declines.”
Sure enough, we will be ready on our clients' behalf. We love what we do, we appreciate their trust in us, and we are here to take your questions and comments. Please feel free to reach out to us at any time. We will continue to communicate our thoughts as the year progresses.
