It probably comes as a surprise to no one, but the first quarter of 2020 was the worst first quarter in modern market history. The stock market lost -19.6%[i] during the quarter, but even that fact masks the truly awful stretch between February 20th and March 23rd in which the S&P gave up more than a third of its value. That kind of drop from an all-time high (February 19th) is also unprecedented. It was as if the stock market suddenly hit a brick wall. The decline in international stocks was worse at -22.8% and downright terrifying in the small cap arena which was down -30.6%[ii]. We all know why stocks went down but the speed of this decline was what was truly unique. It was augmented by computer trading programs. These trading systems had spent years over-investing in stocks because stock volatility continued to trend lower. As volatility suddenly soared in March, stocks became an increasingly risky asset to hold, meaning more and more stocks needed to be sold in order to hit target volatility. This vicious feedback loop led to -6%, -7%, -9%, and -12% days in the S&P 500. It was very hard to make a “good sale” on a very bad day, and this extreme market action spilled over into the bond market as well.
Bonds theoretically do not need the issuing company to thrive, as stocks do. They just need the issuing company to remain solvent. The price of bonds should be impacted by only two factors: is the company able to service the debt (default risk) and does the interest I’m getting compensate me fairly for the risk to my purchasing power when I get my principal back (inflation risk)? Last month, however, we saw bonds that had no risk of default plummet in value in an environment where inflation was of no immediate concern whatsoever. The reason was liquidity. In other words, owners of Treasuries, mortgages, corporate bonds, and municipal bonds were dumping them because they needed the cash to meet other obligations. For example, many foreign governments sold U.S. Treasuries because they needed to push down the value of the soaring dollar versus their own currency to avoid a debt funding crisis. Insurance companies and other financial firms sold all types of bonds in order to raise cash because they expected a surge in claims. That need to suddenly raise cash created a liquidity crisis in which, from March 9th to March 22nd, there just were not enough buyers for all the motivated sellers! As a result, bond prices became temporarily uncoupled from the underlying fundamentals of the issuing entity. This made portfolios a lot more volatile, for a few weeks, than they ever should have been.
In time, there will be enough buyers for the bonds and then some. One just has to remember that bonds don’t trade like stocks in the way that you always know at what price the market is trading and can expect to be able to buy or sell at that price. They don’t flash bond CUSIPs across the screen on CNBC for a reason. That said, massive government intervention into the bond markets did start to stabilize prices on March 23rd. Treasuries and agency backed mortgages were largely able to recover by the end of March. It would take another huge government intervention on the 8th of April to help bring the corporate and municipal sectors of the bond market more into line with actual default risk.
We are still not yet out of the woods with regard to the risk of the sell-off in stocks and bonds resuming, but for now investors believe in the Federal Reserve and the Treasury Department’s willingness to do whatever it takes to prevent a free fall in U.S. asset prices. This has had a tremendous calming effect.
While we can’t say we saw the Coronavirus coming, we can take pride in having started the risk reduction process back in February. We started by slashing broad stock market exposure through index ETFs, then in March continued to raise cash through the trimming of foreign and small cap stocks. We also went through all portfolios in order to replace funds that were performing poorly relative to their peers, or where we were not confident in their rebound potential.
As the government took steps to underpin the bond market later in March and into April, we began buying bonds with some of the cash that we had raised. We still have higher than normal cash levels in many portfolios, but now having bought the higher quality bonds we wanted that cash will go to stocks -when prices better reflect diminished earnings expectations.
We do not believe anyone has a playbook for where we are now. We believe that the economic damage done by the virus will be measured in months and years instead of days and weeks, so while we are happy that there has been a nice rebound in stock prices, we are playing the long game. We believe that it will be extremely difficult for the government to get needed funds to all the sectors and sub-sectors of the economy quickly enough to avoid a very deep recession[iii]. Just like the 2000-02 and 2007-09 bear markets, we expect several rallies during the course of this bear market, all but the last of which will fail.
That said, the stock market has its own internal logic. It will often not go up or down when you think it should. One of its favorite tricks is to stampede investors in one direction and then quickly reverse itself in order to put pressure on those who got in or out late and are suddenly looking at losses (or missed profits). Despite today’s double-digit unemployment rate, if market participants believe that there are profits to be made in buying remote communications or anti-viral biotech stocks and/or squeezing those that are short or underweight stocks, the market can move higher for a while. That just isn’t a bet we want to make because at heart we are not traders. We like to put the odds in our favor. Right now, we believe that means overweighting bonds and cash because we know that the government is actively purchasing them. This has the effect of putting a floor underneath prices. You can’t make money in bonds nearly as fast as you can in stocks but your odds of a significant loss are much lower.
When we wrote our Commentary three months ago, there were a few points we really wanted to make. We obviously didn’t expect the market to sell-off immediately, but we knew both valuation and investor sentiment were extremely high, and we knew that particular combination was traditionally associated with market peaks, not bottoms. We presented two charts, the first of which showed the stock market being 130% above its long-term regression line, which was the highest reading in history. Chart 1 below is an updated version of that chart through April 1st.
Source: A Perspective on Secular Bull and Bear Markets by Jill Mislinski.
The second chart highlighted investor sentiment with CNN’s Fear and Greed Index flashing extreme greed[iv]. Chart 2 is updated through April 20th below.
The problem with these indicators as a timing tool is that the same factors were present in January 2018. In that instance we got a 10% correction and then new highs by September. As any Minnesotan knows, hearing the ice creak does not necessarily mean you are about to break through it. But you don’t ignore it either. This time, with the added weight of a global viral pandemic, we broke through hard.
Both valuation and investor sentiment have retreated considerably at this point, but stocks are still higher than their long-term averages. This is not the what the bottom of a bear market looks like. At generational market bottoms, like we saw in the 1930s and 1970s, investors are not thinking about how much they can make in the darlings of the moment (today Amazon, Zoom Video, Netflix, etc.); they aren’t thinking about the stock market at all. They have been so badly burned by false rallies that they have given up.
The positive point to consider now is that with lower stock prices, we can think in terms of stocks being able to provide mid-to-high single digit annual returns going forward. This is an improvement from the mid-to-low single digit annual return expectations that we started the year with. We have begun to nibble at stocks in some portfolios, but we also believe more downside volatility is likely. Before this bear market is over, we may get the opportunity to buy stocks with double digit return expectations. Again, we are currently more attracted to bonds because of the higher probability of (modest) success. It is our continuing aim to provide attractive risk-adjusted returns to our clients. When it is not possible to accurately measure risk, as is the case today, you can expect us to err on the side of caution.
Thanks for your continued trust in our management,
Mark A. Carlton, CFA
Past performance is no assurance of future results. Trademark Financial Management, LLC (“Trademark”) is a registered investment adviser with its principal place of business in the State of Minnesota. Trademark and its representatives are in compliance with registration requirements imposed upon investment advisers by those states in which Trademark operates. Trademark may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration. This newsletter is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Trademark with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. A complete list of all recommendations will be provided if requested for the preceding period of not less than one year. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. Opinions expressed are those of Trademark Financial Management and are subject to change, not guaranteed and should not be considered recommendations to buy or sell any security. For information pertaining to the registration status of Trademark please contact Trademark at (952) 358-3395 or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Trademark, including fees and services, send for our disclosure statement as set forth on Form ADV from us using the contact information herein or by calling 952-358-3395. Please read the disclosure statement carefully before you invest or send money. Any reference to a chart, graph, formula, or software as a source of analysis used by Trademark Financial Management staff is one of many factors used to make investment decisions for your portfolio. No one graph, chart, formula, or software can in and of itself be used to determine which securities to buy or sell, when to buy or sell them, or assist any person in making decisions as to which securities to buy or sell or when to buy or sell them. Any chart, graph, formula, or software used is limited by the data entered and the created parameters. The data was obtained from third parties deemed by the adviser to be reliable. Nonetheless, the adviser has not verified the results and cannot be assured of their accuracy.
As a registered investment adviser, we provide certain important information to you on an annual basis, which is included in this Annual Notice. Our most recent disclosure statement as set forth on Form ADV Part 2 and 2b is now available. There have been no material changes since the February 11, 2019 Form ADV Part 2 brochure. If you need a copy at any time throughout our relationship, please call us at (866) 944-0039 or send an email to email@example.com. A copy is also available on the Internet at our website, www.trademarkfinancial.us. Additional information regarding our firm is also available at www.adviserinfo.sec.gov. Please contact us or your financial adviser immediately if there are any changes in your financial situation, investment objectives, email address, or if you wish to add or modify any reasonable restrictions to the management of your account. As always, should you have any questions or require any additional information regarding this Annual Notice, please do not hesitate to contact us.
[i] The Standard and Poors 500 Stock Index, per Morningstar Workstation
[ii] International stocks as measures by MSCI EAFE and small cap stocks by the Russell 2000 Index, both per Morningstar Workstation
[iii] Note: If it were possible for any government to get all the money and resources necessary to all of the sectors that need them efficiently, then capitalism is probably not the best economic system.
[iv] We also asked, at the end of the last commentary, “in an environment where most investors are fully committed, who does the buying if there is a mad rush to get out?” Unfortunately, we got our answer. The adage that markets take the stairs up and the elevator down was proven once again.