Reconciling market assumptions with our current reality
In our last communication, Keeping Perspective, we addressed the need to 1) confront the “brutal facts” of our new reality, 2) adjust our strategies and tactics towards helping you attain your long-term goals given this new environment , and 3) keep our well-founded faith that we will persevere through this unprecedented crisis.
We will continue this conversation, specifically discussing the markets. In our opinion, market assumptions are not fully aligned with reality. Despite the dramatic volatility we’ve experienced the last few months, the markets have already rallied significantly – as of yesterday (5/27/20), the S&P 500 has posted a year-to-date return of approximately -5.25%. While we certainly won’t “kick a gift horse in the mouth”, the unfortunate truth is these numbers don’t seem to add up… We believe there is a disconnect between Wall Street’s market expectations and Main Street’s near-term reality.
Despite the dramatic volatility we’ve experienced the last few months, the markets have already rallied significantly. We believe there is a disconnect between Wall Street’s market expectations and Main Street’s near-term reality.
As we begin to slowly restart the economy, we will see how much lasting damage remains from the shutdown measures put in place to curb the spread of COVID-19. It is naïve to think we will flip a switch and return to January’s economic levels. We have said many times over, some industries and companies have been hit harder by this crisis than others, and some will never recover. At best, we believe our economic output over the next 12-18 months will be about 90% of pre-crisis activity.
The markets, in contrast, seem to believe we will not only experience a sharp snap back to previous levels, but that we will also be able to reopen global business fairly seamlessly (despite the necessary coordination between states, countries, central banks, corporations, and scientists) and continue on our previous growth trajectory. We are very much “glass half full” people, but these rosy assumptions seem too good to be true.
Now we’re not saying these assumptions aren’t possible, nor are we calling another market pullback, although that could certainly happen. It is our fiduciary duty to examine the facts and do what we can to help the families we serve attain their long-term financial goals. Together, we must take the necessary steps to prepare for not only the more likely outcomes, but also for any curve balls that might get thrown our way. To continue the baseball analogy, we are in the business of trying to consistently hit singles and doubles…not trying to hit the ball out of the park (and not striking out).
As we restart the economy, the markets seem to believe we will snap back quickly and continue on our pre-crisis growth trajectory. We think these rosy assumptions may be "too good to be true".
So, when numbers don’t add up, it is our duty to ask why. Why has the market rallied despite the fact that we have yet to attain any real, documented positive progress towards returning to our normal lives? We believe Steve Mnuchin, Secretary of the US Treasury, deserves a lot of the credit. Secretary Mnuchin has done what no one else has been able to do in our country’s history – get a bunch of politicians who almost never agree on anything to come together for the American people and pump out incredible, unprecedented levels of financial aid and stimulus to citizens and businesses alike in record-breaking time. We can debate the politics and repercussions of this monetary policy, but at the end of the day, the Federal Reserve’s decision to act quickly and with exponential magnitude compared to previous recessions has very likely been the primary ballast against a market free-fall.
However, we believe it is unlikely the Federal Government will continue to distribute more and more aid, particularly to struggling businesses. Eventually, we’ll all be “cut off”, and those who can’t recover will either close their doors for good or merge with another company that was better positioned pre-crisis. The trick will be reducing our exposure to the next Bear Stearns or Lehman Brothers.
During the Great Recession and the subprime mortgage crisis, the casualties came from massive investment banks and brokerage firms that were highly leveraged and couldn’t meet their obligations when the real estate market bottomed out. This time around, the casualties will come from the industries hit hardest by this outbreak and the companies that were in a weak financial position before the pandemic. Airlines, Luxury Goods & Services, Brick & Mortar Retailers, Hotels, Restaurants, Commercial Real Estate etc. – these may all end up on the proverbial chopping block. Such “infected” industries have an incredibly steep hill to climb to recovery, and without additional federal aid some big companies may not survive in their current state as public entities – we have started calling them “zombies”. Similar to 2008, we would expect that if/when some of these “zombie” companies declare bankruptcy, the business itself will likely be largely rescued in some form, but the shareholders will not be.
So, what do we know? If we look at year-to-date broad-based performance metrics, an obvious pattern emerges… Companies with higher exposure to “zombie” industries or oil are doing much worse than those with little to no exposure.
Ultimately, we don’t know exactly how this situation will play itself out, and anyone who claims to have any degree of certainty is, quite frankly, either lying or delusional. Our goal is to take the data we have, and make the best decision based on the facts as they are. So, what do we know? If we look at year-to-date broad-based performance metrics, an obvious pattern emerges… Companies with higher exposure to “zombie” industries or oil are doing much worse than those with little to no exposure. While we must always say “past performance is no guarantee of future results”, we believe it is reasonable to assume this pattern will continue, at least in the near-term. Thus, in order to benefit from the potential upside within equities, we must smartly allocate our resources to areas that have a better chance of surviving or flourishing in this extended period of altered reality. We have taken steps within portfolios, aiming to accomplish this very goal.
Now, we are shifting our focus back to Fixed Income again. We made some adjustments to our bond positions in early January and February, and will review again given recent changes. We will be evaluating possible opportunities and pitfalls within municipals, given some states will likely further struggle to balance budgets as a result of the pandemic. We will also be considering whether it is appropriate to help mitigate additional risk by reducing exposure to “return seeking” investments within this space, such as High Yield, and instead direct assets towards more traditional fixed income vehicles that tend to be simply uncorrelated to equities.
Our unwavering attention and diligence continue as we move forward. We came into this crisis together, and that’s exactly how we’ll come out of it – together.