Now Likely Priced for Perfection, And So We Invest Cautiously
On February 19, the S&P 500 index of large US companies closed at an all-time high. This was the continuation of the 2nd longest bull market in history that began in the depths of the Financial Crisis of 2008/09. Global economic growth was strong, inflation subdued, the US Federal Reserve was keeping interest rates low and employment had continued strength. There was a crisis in China to do with the coronavirus, but popular opinion was that it could be contained and so stocks worldwide rallied further.
The following weekend however news came of an outbreak in Italy, and the markets quickly reassessed the risk to populations and economies. The most rapid decline in history to the S&P 500 was to take place – stocks fell 35% in just 5 weeks! The uncertainty of a devastating pandemic as well as the potential for a deep recession were quickly being priced into stocks. Smaller US stocks as well as International shares were not spared and fell the same amount.
Since late March however, stocks have rallied back erasing roughly half of their losses. Buoyed by incredible responses from healthcare systems, unprecedented levels of monetary and fiscal stimulus, previously unheard-of behavioral changes by the citizenry as well as the promise of medical advances, stocks in aggregate are now 19% below their February highs and down 16% year-to-date.
In addition, large US companies have performed better in the recovery, and the S&P 500 is now down just 11% year-to-date. With our balanced portfolios at Castle Wealth Planning over-weighted to these large US stocks, aggressive selling of stocks early in the collapse, continued investment in tech and the embrace of companies set to thrive comparatively in these times of social lockdown, we have minimized these losses further in your portfolios.
So where do we go from here? With so many uncertainties that you’re likely all aware of with the pandemic and the public response, what can we expect from the future of our economy, our way of life, and potential outcomes for stock and bond markets?
The pattern of stock prices in response to a panic event has been repeated historically as follows: 1) initial big collapse in prices, 2) a “relief” rally off of the lows due to remedies taken to fix the problem, 3) a decline back to “re-test” the initial low prices as the poor results feared in the first place emerge in the economic data, and then 4) prices stabilize and move back up in varying speeds based upon the economic recovery.
We obviously can’t predict what the future path will be for the markets. We’ve seen a nice relief rally, but will stocks turn back down now with the poor economic data we’re beginning to see? [40% drop in GDP, 14% unemployment, 24 million unemployment claims, $3.7 trillion deficit, federal debt more than 100% of GDP, recently plummeting consumer confidence as well]
Historically, it’s a good sign that the recent rally has erased half of the losses – this could be evidence that a bottom has been established for stocks in this crisis. But in this case where we’re battling a virus – as opposed to typical recession triggers such as the normal course of the business cycle, financial excess, or even acts of war – there is no natural or predictable timeline, and we can’t rely as much on history as a guide.
What is causing the stock market to rally as much as it has, faster than most of us would have expected? The horrific loss of life and overwhelming burden on our healthcare systems have started to improve. But the economic impact has still been devastating. It doesn’t “feel” like stocks should rally as much as they have, and maybe they shouldn’t. Maybe the rally is based on a very optimistic view of how the future will transpire.
My expectation of where the country goes from here is also what I think the stock market is responding to. I feel there’s great risk in the ultimate outcome however, and that the stock market is trading on the assumption that conditions improve perfectly, without any setbacks.
It seems inevitable that the country, for better or for worse, is going to start to open up relatively soon. The timing and speed will depend on the locality, but it seems clear that pressures are building to favor the economy now sooner rather than later. Lockdown orders will start to be resisted if left in place too long without any guidance of lifting in the future. All of this is beginning to happen now – even though polls are still overwhelming in favor of not opening up too soon, I can imagine by the end of May, the pressures will be enormous.
In trying to be realistic about the near future, I have to recognize that medical personnel and seniors will be asked to sacrifice an incredible amount in this scenario. Hospitals will likely be in a permanent crisis mode and seniors would need to continue lockdown and also be distanced from their loved ones. This may likely be the understanding struck in the desire to reopen the economy, and it might ultimately take a vaccine to get everything back to normal.
This is possibly the path we take with our society, and it is fraught with risks. Testing may not be reliable enough and/or ramped up fast enough. Immunity in those recovering from coronavirus may be questionable. Social distancing measures may not be as impactful as assumed. A second wave of the virus may naturally hit in the fall and overwhelm healthcare systems. Treatment advances might not ultimately succeed fast enough. Multi-generational families living together may be unavoidable sources of spread. And of course just the act of re-opening economies may be too much fuel to the contagion – we’ve made a lot of progress with the necessary lockdowns, but how will everything go when we try to proceed without lockdowns?
The stock market seems to be assuming all goes off without a hitch. Just thinking of this as a garden variety recession (not including a pandemic), it’s pretty typical for a stock market to fall by close to 50% when heading into a recession. Stocks have fallen 35% this time, and now are just 15 – 19% from recent highs depending on the category of stock. Especially with devastating economic numbers coming out, it stands to reason we are at least in an average recession now and haven’t seen the ultimate lows for stocks.
But we can’t tell the future obviously, and it’s certainly possible that the above scenario plays out successfully. Medical innovation – testing, therapeutics, vaccines – is the big x-factor. The race going on now to innovate and aid in the fight against the coronavirus could bring unexpected benefits. Once subdued, the unprecedented monetary and fiscal stimulus from the government could kick in with more power than we saw in the wake of the 2008/09 Financial Crisis. And this is likely why the stock market has rallied to the extent it has – looking forward as stock markets always do to hopefully better times 6 to 9 months ahead.
Our outlook is for a very choppy stock market for the remainder of this year, with the potential to fall yet again on setbacks in the fight against the pandemic and slow economic progress, but also to gain further on healthcare improvements and any kind of return to normalcy. The unprecedented monetary and fiscal spending very well might put a floor on stock prices that wouldn’t be there in average recessions. So there is risk, but we need to remain invested close to each of our long-run asset allocation investment plans.
We intend to invest as follows (and we have been doing much of the below for the past 2-3 months as well):
Modest under-allocation to stocks in recognition of the risks ahead. For instance if an asset allocation plan calls for 60% stocks, we would target 55% for investment in stocks. This reduces our risk while still maintaining significant investment, and provides cash to be invested on any pullback in stocks.
We will continue to favor large US stocks in the recovery, and in particular, the technology sector and those companies set to benefit from continued social distancing (as well as when we are on the other side of the pandemic):
Online videoconferencing and virtual work communication software
Home delivery services (Amazon, PetMeds, etc.)
Pharmaceutical and Biotech sectors
Covid Testing, Therapies, Vaccine Development
Recession Categories (affordable food, discount stores, etc.)
Name Brands selling at historical discounts / companies that we know will survive this environment
We will continue to monitor the bond markets and will invest in high-quality bonds. The recession will bring corporate bankruptcies, and there are intense negotiations going on in Washington currently putting the finances of States at risk (New York in particular). We will be monitoring the various corporate and municipal bond issues held in our portfolios, and will sell them if appropriate in the current environment.
In addition, we have benefited in the past from mutual funds holding diversified portfolios of lower-quality bonds. These have provided nice yields and liquidity in times of stability. We have since sold all positions in these funds to remove any risks that even very short-term bond holdings represent.
Lastly, we will continue to monitor the money market funds that Schwab makes available to us, and consider a variety of short-term CD’s if appropriate. FDIC-insured money market funds offer very low interest rates. So-called “prime” money market funds are historically, exceedingly safe, but are not FDIC-insured – we will continue to address the safety of your cash investments on an ongoing basis and employ a combination strategy to your short-term investments: FDIC-insured money market, prime money market and CD’s.
Thank you for reading to this point. This was a difficult commentary to write, but I think very important in explaining the issues currently and perhaps inspiring some thoughts on your part. Please feel free to contact me with your thoughts if you’d like.
Nate Cultice, CFP, FSA
Castle Wealth Planning
Santa Barbara, CA