2020 Mid-Year: Clorox, Zoom, FOMO and More

We all know that 9/11 changed everything, and so does COVID-19.  Stay-At-Home orders, social distancing and masks are now familiar parts of our routine.  Just as we evolved from 9/11, we will evolve from the novel coronavirus.  Nevertheless, “Unprecedented” seems to be the word that best characterizes the first half of 2020.  Listed below are relevant factors:

Noteworthy Movers: 

Although the broad stock market was down 3.1% for the first six months of 2020, Clorox was one of the top stock performers with a gain of 45%.  Few people knew of Zoom at the beginning of the year, but it is up 6X from it’s April 2019 IPO.  More obvious first-half winners include Amazon up 49%, NetFlix up 41% and Apple up 25%.  On the speculative side, Tesla was up 158%.  Airlines were the obvious losers with Delta down 52%

Index Benchmark Performance As Of 6/30/2020:

Major Benchmark Performance: Last 3 Last 12
1 Mo  Months YTD Months
Since: 5/31/20 3/31/20 12/31/19 6/30/19
As Of: 6/30/20 6/30/20 6/30/20 6/30/20
US Large Cap-S&P 500 1.99% 20.54% -3.08% 7.52%
US Small Cap-Russell 2000 3.53% 25.42% -12.98% -6.63%
Foreign Developed-MSCI EAFE 3.40% 14.87% -11.36% -5.15%
Foreign Emerging Mkts-MSCI EEM 7.35% 18.09% -9.77% -3.38%
US Bonds-Barclays Aggregate 0.63% 2.90% 6.14% 8.74%
Long Treasury-20 Yr+ US Treasury Bonds 0.13% 0.12% 21.62% 25.97%
High Yield-Bloomberg 0.98% 10.18% -3.80% 0.03%

The Bear Market struck with a vengeance in March after a record long 11-year bull market and a record long 10 ½ year economic expansion: 

In addition, the drop was accompanied by record-high volatility. The S&P 500 fell from an all-time high to a bear market decline of over -20% in only 22 trading days, the quickest decline in history, even faster than during the Great Depression. Moreover, the S&P 500 set a record of eight consecutive days in which the index moved up or down by at least 4%. Then, the S&P 500 made the quickest recovery in history from a Bear Market to a technical Bull Market (up 20% from a recent low). With the price volatility at record levels in both directions, the overall investment performance has improved significantly since the March 23 lows.

Performance has rebounded since the March lows:

Although the S&P 500 fell -33.9% by March 23 from the all-time high, it is now down only -3.1% YTD as of June 30.  The first quarter had the worst performance since the 2008 Great Financial Crisis, and then the second quarter was the best performance since the 4th quarter of 1998.  This whiplash was the first time with such extreme quarterly performance since the 1930s.  U.S. small caps continue to lag behind the perceived relative safety of larger U.S. companies and are down -13% so far in 2020.   Foreign developed equity is down -11.4%Emerging markets were the big surprise during June with a gain of 7.4%.  Longer maturity U.S. Treasury bonds benefited from declining interest rates and from investors seeking a safe haven, and are up 21.6% so far this year. Corporate bonds and especially high yield declined sharply in March due to increasing recessionary fears, but have since recovered somewhat in April through June largely due to the Federal Reserve’s corporate credit support.

Some market prognosticators refer to the big Q2 price recovery as the “Hopium” Trade and the Silly Season, but the reality is that the short-term market is difficult to predict and it forces humility on us all.

Economic Statistics are coming in better than expected:

Although economic statistics initially dropped precipitously due to the government-induced shutdown, they are now showing a significant improvement.

Unemployment (at a 50-year low of 3.5% in February) spiked to 14.7% in April but has since dropped to 11.1% for June.  Although this unemployment level is still a high level, it reflects the addition of 4.8 million new jobs and it was much better than the market expected.

– The Conference Board reported that its Consumer Confidence Index rose to a reading of 98.1 for June from 85.9 in May. Economists polled by Reuters had forecast the index rising to only 91.8 for June.

Retail sales for April declined 14.7%, the largest decline since 1992 when this data series was initiated. However, May retail sales jumped a record 17.7% on a month-over-month basis, well above the consensus expectation of 7.5%.  Retail sales were impacted by pent-up demand and government checks, so it is difficult to know what retail sales level will be reported in the future.  It is important to note that the May sales report was still down -6.1% on a year over year basis.

-The Leading Economic Indicators came in at a positive 2.8% after falling -6.1% in April and -7.5% in March. These statistics point to the sudden, large shutdown of the U.S. economy caused by the unprecedented coronavirus pandemic, and then an encouraging uptick.

Progress on Vaccines and Treatments:

Vaccines and treatments hold the promise of allowing the global economy to get back closer to normal, and there are numerous reports showing progress.  The U.K. government approved the use of dexamethasone, a steroid that cuts the risk of death for patients on ventilators and for those on oxygen.  There is also preliminary evidence supporting Gilead Science’s Remdesivir, an anti-viral treatment, and by vaccines from Moderna, Pfizer and others.  Moderna was said to “show promise” in phase-one trials and is progressing to phase-two trials.  Dr. Anthony Faucci, Director of the National Institute of Allergy and Infectious Diseases, also expressed optimism regarding a relatively quick approval.  However, a 12-18 month timeline still looks more likely.  Any COVID-19 vaccine would likely be first used to protect front-line health care workers and elderly who are at most risk to the virus.  Over time, a vaccine would achieve “herd immunity”, whereby the antibodies of the majority of individuals built up, either via exposure or vaccination, are sufficient to protect the remaining vulnerable people.  In the short-term, however, there is clearly a risk of a “Second Wave.”  Broad-based testing needs to be expanded so virus carriers can be identified and isolated.

FOMO-the Fear Of Missing Out:

The recent market strength has surprised many institutional investors, and there does appear to be an element of FOMO-the Fear Of Missing Out.  Markets trade on fear and greed, and the current market strength appears to have a significant amount of momentum-based trading.  Retail trading is up sharply based on commission-free trades and accounts like Robinhood that are said to be having significant trading volumes based on inexperienced traders.

Virus Resurgence:

As states move to reopen, there has been an unfortunate surge in new coronavirus cases and rising hospitalization rates in states like California, Texas, Florida and Arizona.  This has once again overstretched the health care system, and especially ICU units.  As a result, a number of states have paused or rolled back their re-openings, especially related to bars and restaurants.  There is also the prospect of a mutated version of the virus flaring up in the fall and winter.  Consequently, COVID-19 remains a global wildcard.

Market Valuations remain rich:

At this point, markets are ignoring weak 2020 corporate earnings, and are trading on expected 2021 earnings.  Nevertheless, various valuation metrics (like Price/Earnings ratios) for 2021 are still elevated.  It is important to remember that valuation doesn’t predict short-term performance, but valuation definitely impacts long-term performance potential.  In other words, markets could continue to move up on a short-term basis, but the longer-term performance might be a 5-7% average return/year rather than the historic 10%/year long-term U.S. stock return average.  See Market Valuation

Election Volatility:

According to recent political polls, Vice President Biden is leading President Trump by a significant margin, and the U.S. Senate might shift to control by the Democrats.  In the case where the Democrats win the presidency and control both the House and the Senate, then tax increases are likely.  Joe Biden has said he would raise the corporate tax rate from 21% to 28%, rolling back Trump’s 2017 corporate tax reforms.  Greater restrictions on corporate share buybacks are also likely.  A report from Goldman Sachs estimates that such an outcome would shift 2021 earnings per share for the S&P 500 to $150 from a current estimate of $170.  It is probably safe to say that a large earnings decline caused by a corporate tax increase would negatively impact market performance.  For individuals, higher capital gains tax rates, the elimination of the qualified dividend tax rate, and/or higher tax rates on top income earners are expected.  Without getting too deep into tax policy, there is a strong argument that higher corporate taxes makes our U.S. companies less competitive in international markets.  To the extent that U.S. companies are less competitive in the international market place, then they don’t expand  U.S. operations and they don’t hire U.S. workers.

Stock Market and Economic Disconnect:

The markets were buoyed in the second quarter by progress in “a flattening of the curve”, the prospect of re-opening the economy, and early reports regarding treatments and vaccines.  Moreover, recent economic statistics show a stronger-than-expected rebound from the initial dramatic declines.  As a result, the market seems to be anticipating a V-shaped recovery.  Although a downdraft to the March lows does not appear likely, there are numerous risks that could cause market weakness.

While recent economic statistics have been stronger than expected, they may reflect more pent-up demand rather than long-term growth.  Economic growth over the next year faces significant headwinds and is not likely to quickly recover lost output.  The economic recovery still looks like a “Nike Swoosh” or even a U-shaped recovery, not V-shaped, and it looks like there is a disconnect between the recent market rebound and the broader economic landscape. Although the market was up in the second quarter, it still looks vulnerable to additional sell-offs. The current situation seems to be the opposite of what happened in December 2018. At that time, the market sold off hard based on fears of a global economic recession, even though the economic data did not show an imminent recession. In January, 2019, Cornerstone described a Market/Economic Disconnect where economic fundamentals in late 2018 were much stronger than indicated by the sharp market decline. This time, however, the economic fundamentals are very weak, but the market has been ignoring these weak fundamentals as it rebounded significantly in April through June.  Only time will tell how the coronavirus recession plays out, but it is helpful to stay grounded in longer-term economic and market fundamentals.

It is helpful to remember that Bear Markets since 1950:

-the average bear market declined -35% and lasted an average of 14 months.

-the average bull market gained 199% and lasted an average of nearly 6 years.

Bear markets are typically much shorter than bull markets, they go down less, and they have always given way to another bull market.

The Federal Reserve has been very proactive:

ensuring funding for banks and companies. The Fed re-established many of the initiatives from the 2008 Great Financial Crisis that have proven positive in the past. A major difference is that the Fed established these support programs so quickly.  The Fed cut the Fed Funds rate to near zero in an emergency meeting.

The Fed also provided a “do whatever it takes” stance to support lending for small and large businesses, money market funds, state and local governments, and global central banks for foreign investors seeking the safety of the U.S. dollar.

U.S. Fiscal Legislation:

Congress passed a $2.2 Trillion coronavirus aid package to help stabilize the U.S. economy. Key provisions include support for individuals (the Paycheck Protection Plan and increased unemployment benefits), small businesses, large corporations, public health, and state and local governments.  This package is being called a rescue plan, and many politicians say there will need to be another round to provide stimulus. As with the Federal Reserve’s timely actions, the legislation is being implemented far faster than was the case in the 2008/2009 Great Recession.

U.S. Federal Budget Deficit:

Morgan Stanley released an estimate of the U.S. budget deficit of $3.7 Trillion for calendar year 2020, and they see an additional $3T in 2021. This would make the deficit approximately 15-20% of the U.S. GDP. This is larger than the 2008/2009 Great Recession level. This analysis does not incorporate the proposed $2T infrastructure bill. Although there is a clear need for monetary and fiscal spending during this downturn, there is also a looming longer-term issue related to U.S. budget deficits.

International: 

China was the first country to lockdown its economy in January, and official data show positive economic manufacturing and non-manufacturing growth resuming in March.  These reports do not indicate an imminent global turnaround, but they do represent a measure of improvement in China.  The Eurozone is experiencing economic improvement from the lows of March and April, but they are mired in an economic recession.  Japan is also stuck in a deep recession.

On a global basis, a June International Monetary Fund forecast shows a -4.9% 2020 global economic decline and then a 5.4% recovery for 2021.

What’s Next?

There is no good historic precedent for the coronavirus given that globalization has allowed pandemics to spread much more quickly than in the past. Consequently, we are in the midst of a global recession.  The first quarter market downdraft caused a lot of economic weakness to be priced in, but the strong second quarter market performance has now priced in a fairly optimistic outlook.  Since the depth and duration of the coronavirus remain unknown, continued market volatility can be expected.  With all these crosscurrents, it remains critically important to stay focused on longer-term fundamentals that should gradually improve.

WHAT YOU SHOULD DO:

Portfolio actions that you take (or don’t take) at this point can feel highly uncomfortable but the decisions are not rocket science. Investors were bailing on investment holdings at a near-record pace and then have been charging back in.  This is no time to be part of the herd’s stampede in either direction. Although there is much we don’t know about the ultimate coronavirus impact, there is also much we do know. There is nothing unique about the list below, but it is supported by ample historical evidence.

-Stay the course. Fear and Greed are really the biggest risks.

-Don’t sell unless you have a dire need for cash.

-Rebalance the portfolio to restore beaten-down equity holdings to a weight consistent with your long-term investment objectives.

-If you have cash, then add to equity holdings on a systematic basis. This isn’t easy, but a good strategy is to make several smaller investments over time rather than one larger trade. No plan is fail-safe, but this strategy is a way to get into the market without making one big move.

– Remember that investment performance is improved by buying in bear markets, not selling.

-Dollar Cost Averaging that invests a predetermined amount of dollars on systematic predetermined dates is a method that remains a valid investment strategy.

Jeff Johnson, CFA

July 9, 2020

 

 

SEE ALL POSTS

One for the Record Books-March 14, 2020

Coronavirus Comments-March 1, 2020

Big 2019, 30 Yrs of Ups & Downs, Outlook/Recommendation, January 9, 2020

Charitable Giving Update and Comparisons-2019, October 26, 2019

Market Record, Panic, New Record-What’s Next? July 13, 2019

Educational Investment Seminar-Take Aways.  May 22, 2019

A Wild Year, A Great Decade and a Market/Economic Disconnect.  January 3, 2019

Investments:  Faith-Based & Environmental, Social and Governance.  November 9, 2018

Investment Guidelines 101-(Are Financial Advisers Worth It?).  June 22, 2018

Paul, Apostle of Christ and Economic Priorities.  April 2018

Charitable Contributions.  January 13, 2018

WHY SO VOLATILE?

If you think this market is crazy volatile, then you are right.  The market fell into a bear market (down -20%) faster than at any time in history, even including the Great Depression.  The daily price moves looked more like an out-of-control roller coaster than a rational, orderly market.

Considering this manic behavior, you have to wonder where are the grown-ups?  You also have to ask why investment people making the big bucks can change their minds so quickly and erratically.  Where’s the conviction?  Disciplined or fickle?

The COVID-19 pandemic has been called a Black Swan-a hard to predict rare event that comes as a complete surprise and has a major effect.  It has been characterized as a Known Unknown, and it has been a trigger for the market volatility and downdraft.  There have been a number of other factors that combined, however, to cause a “Perfect Storm” of Volatility.

Despite the historically high volatility level, there has not been historically bad investment performance.  So far, investment performance has been similar to a typical bear market.  It is understood, that investment performance could still get worse.

The graph below shows the incredible volatility starting in March.

Listed below is the actual S&P 500 index performance.  It is down so much because there were more large volatile down days than up days.

VOLATILITY CULPRITS:

Two key contributors to this Perfect Storm of volatility include:

-Human nature, with all the emotional euphoria on the way up and despair on the way down.

-Big, fast computers.  Algorithmic Trading, High Frequency Trading, and increasing use of momentum and volatility strategies represent the second major contributor to the volatility.  This trading was magnified by excessive financial (debt) leverage.

(Details are listed further below:)

 

WHAT DOES IT MEAN FOR YOU?

First, it is important to keep perspective.  The main priority is saving lives.  Everything else comes back.

It shouldn’t impact your Investment Objectives:  It is important to maintain a long-term perspective.  The huge volatility in March shouldn’t impact a long-term focus.  This is not a financial crisis, but rather a crisis of confidence.  The depth and duration of the coronavirus are not known, but it does not appear to constitute the fundamental, systemic problems associated with the 2008 Great Financial Crisis.  Moreover, the massive government monetary and fiscal support being implemented is much larger and coming much quicker than in 2008.

The sudden -20% market decline has been painful (especially after 11 big years), but the decline is well within the historic range for bear markets.  The market decline should also be remembered within the context of the 31.5% gain by the S&P) 500 in 2019.  More importantly, the market will come back.

A review of Bull and Bear markets since 1950 shows:

-the average bear market declined -35% and lasted an average of 14 months.

-the average bull market gained 199% and lasted an average of nearly 6 years.

Bear markets are typically much shorter than bull markets, they go down less, and they have always given way to another bull market.

It might sound flippant, but in a way the market had gone too far too fast and was due for some downside.

It is important to remember that there are wide ranges around the average length and return of bull and bear markets.  Nevertheless, history shows that all bear markets end.

Portfolio actions that you take (or don’t take) at this point can feel highly uncomfortable but the decisions are not rocket science.  Investors have been bailing on investment holdings at a near-record pace and this is no time to be part of the herd’s stampede.  There is nothing unique about the list below, but it is supported by ample historical evidence.

-Stay the course.  Fear is really the biggest risk.

-Don’t sell unless you have a dire need for cash.

-Rebalance the portfolio to restore beaten-down equity holdings to a weight consistent with your long-term investment objectives.

-If you have cash, then add to equity holdings.  This isn’t easy, but a good strategy is to make several smaller investments over time rather than one larger trade.

– At this stage in the bear, there is likely to be far more upside than downside.  Remember that investment performance is improved by buying in bear markets, not selling.

It’s Deeper than Fear and Greed — Non-Investment Observations:

It is often said that the markets run on the animal spirits of Fear and Greed.  It’s not really that simple.  It’s too early to know the depth and duration, but here are some non-investment observations:

-It would be a mistake to bet against the resilience, creativity and persistence of Americans in this time of challenge.

-Health care workers are showing incredible dedicated service despite personal risk and sacrifice and are a true inspiration.  This is especially true for the nurses who have the most frontline exposure.

-Essential workers are taking on a new meaning as we see who really is essential.

-Human ingenuity from both the government and the private sector are working furiously and there are good reasons to remain optimistic.

-Many companies are forgoing profits and are keeping employees or paying what they can.

-The general public is showing impressive broad-based acceptance and support for social distancing and quarantines.  It has changed lives, but everyone seems to recognize that we are all in this together.

-There are uncounted and often un-noticed acts of helping and compassion that add up to something much bigger.

When considering all this, I am reminded of Genesis 1:27 where it says that we are created in the image of God.  It is gratifying to see humanity set aside mundane differences and rise up to face this challenge.  These are the times that bring out the best in all of us.

 

DIGGING DEEPER-VOLATILITY DRIVERS

Human Nature-Complacency and then Panic:

Investors received stellar performance during the longest bull market in history, 11 years, and this was accompanied by the longest economic expansion in history, a stretch that ran for 10.5 years.  For years, investment performance ratcheted upward, causing a sense of complacency.  Central banks around the globe kept interest rates low, and encouraged investments in riskier assets.  Investing was characterized by the Fear Of Missing Out-FOMO.  With this benign backdrop it is little wonder that the sudden recognition of the coronavirus was a major factor that upset the apple cart and caused such volatile emotional selling.

Economic prospects-V-Shaped Recovery, or U, or L:  Epidemics historically cost lives but have not had big longer-term impacts on markets or the economy.  This time it looks different.  The speed and suddenness of the global shutdown is unprecedented and economists and others are only gradually beginning to understand the magnitude of this change and then to incorporate this into their models.  For example, Goldman Sach’s initial analysis of COVID-19 impact foresaw minimal impact to the U.S. and they saw 1.2% US GDP growth for 2020.  A subsequent forecast revised U.S. 2020 economic growth to 0.4%.  As of March 21, Goldman has significantly revised their 2020 GDP growth rate down to -3.8%.  This forecast includes a -24% annualized negative growth rate for Q2 and then a sharp Q3 recovery of 12% annualized and Q4 gain of 10%.  This analysis sees a V-shaped recovery.

The point is not to throw rocks at Goldman Sachs, because they are smart, savvy investors.  The point is that analysts are increasingly negative about near-term prospects.   Further, it warrants caution regarding how much we really comprehend about the coronavirus impacts.  Given the unprecedented nature of the shutdown, it seems that there may be more caution by both consumers and companies as we emerge on the other side and a U-shaped recovery is more likely than a V.  Finally, the coronavirus outbreak may prove to be worse than the 9/11 terrorist attacks, but it doesn’t look to be as severe as the full-blown 2008/2009 Great Financial Crisis.

COVID-19 Backdrop:  As 2020 began, investors were optimistic the economic expansion would continue, as calming trade tensions between the U.S. and China and three 2019 interest-rate cuts from the Federal Reserve lifted stocks.  The coronavirus was widely publicized by mid-January, but it was first ignored and markets went on to post all-time record highs by February 19.  For years, it paid to buy each dip in stocks and to embrace trades that bet against the return of volatility.  Then the COVID-19 virus became increasingly problematic and ultimately caused an unprecedented global shutdown.  Millions of the nation’s businesses suddenly closed their doors, international travel ground to a sudden halt, and personal interactions were sharply curtailed.  Markets reacted negatively with unprecedented volatility.  As the severity of the situation became increasingly apparent, economic and earnings forecasts were repeatedly revised down lower and lower.  The transition from complacency to a sudden, unprecedented global shutdown caused a huge emotional reaction and produced panicked selling.

ALGORITHMIC TRADING:

Algorithmic trading was the other major factor in the huge March volatility.  Algorithmic trading essentially involves computer programs that follow defined sets of instructions (algorithms) to do stock trading far faster than humans can do.  It often utilizes back-testing of technical indicators like movements of 50-day and 200-day moving averages, trend following patterns and arbitrage opportunities based on pricing anomalies.

Algorithmic trading is different from fundamentally driven trading that is based on rigorous analysis of company valuation and revenue and earnings growth prospects.  Instead, “algo” trading looks for relatively small market dislocations and inefficiencies that can be rapidly exploited with strategies related to volatility, momentum and risk parity.  Quite simply, it’s not based on strong company earnings growth or an attractive valuation level.  Analysts at J.P. Morgan said “fundamental discretionary traders” accounted for only 10% of recent stock trading volume.  Goldman Sachs analysis shows equity algorithmic trading is nearly 3 times the level from 15 years ago.

High Frequency Trading-HFT:  Algorithmic trading is often based on High Frequency Trading (HFT) that utilizes powerful computers moving in and out of markets at lightning speeds measured in milliseconds.  In normal markets HFT adds liquidity and lowers costs by reducing bid-ask spreads on trades.  In March, however, profits at the large HFT algorithmic traders were reported to be extremely high, and there is now a question about the value of HFT in times of market duress.

Volatility Trades:  The 11-year bull market was accompanied by a below-average level of price volatility.  In this environment, hedge funds and other institutional investors utilized a variety of algorithmic strategies to trade on small changes in market volatility, regardless of whether they went up or down.  Since price volatility was low, many of these strategies used financial leverage at up to 10X.  As markets moved up, low volatility caused traders to buy risky assets.  As markets fell, volatility rose and the computers began selling.  As a result, during March this computer-based trading magnified both moves upward and downward.  In another example, investment strategies were established by market participants to either dampen volatility or enhance returns based on previously reliable relationships between assets.  Unfortunately, these pricing relationships fell apart when volatility spiked and caused devastating effects in panicked markets.

Six Sigma:  The Wall Street Journal reported prices gyrating by an incredible six standard deviations from the short-term norm.  These moves were exacerbated by the presumed low likelihood of extreme market moves with risk models largely based on a period of relative market calm. Since many of these trading strategies were structured with high financial leverage, it became a situation where everyone headed for the exit at the same time.  It is easy to see how unwinding these trades caused such panicked selling.

Momentum Trades also benefit from Algorithms:  Momentum trading is an investment strategy that has a good historic track record.  Momentum traders buy the stocks that are going up the fastest.  Or they might buy the stocks that have the greatest revenue or earnings momentum.  Regardless, this feeds on itself and the more momentum traders, the more it spirals upward.  When markets (or stocks) reverse and head down, then momentum traders are selling the assets that are falling the fastest.  They essentially turbocharge the upward buying interest and then magnify the downward selling pressure.

Fundamentals prevail over Algos on a long-term basis:  Since Algorithmic trading is focused on short-term factors like volatility and momentum, it has less relevance to fundamental factors.  Fundamentals still function to differentiate the merits between various companies and future prospects, and fundamentals still determine the long-term performance of investment assets.  What this means to a long-term investor is that algorithms probably reduce trading costs by a small amount during normal market activity, but a disciplined investment process still prevails on a long-term basis.

Liquidity Dried Up:

Liquidity in the financial markets means the ability to sell an investment asset quickly without having to sell it at a big discount.  Liquid investment assets usually have a large number of buyers and sellers readily available so that a transaction is easily traded and it minimally impacts the price.  US Treasury securities normally have the greatest liquidity.  Your house is far less liquid.  The sudden shutdown of the U.S. economy was unprecedented and it precipitated an immediate dash for cash.

Dash for Cash:  Individuals suddenly faced unemployment or reduced hours, particularly in the airline and entertainment industries. Businesses, seeing markets and revenue shutting down, drew down bank credit lines.  Small business owners were particularly vulnerable because they typically lack the financial flexibility of larger firms.  Fund managers faced redemptions as investors liquidated holdings.  Traders attempted to unwind trades that had worked in a low volatility investment environment.  In many of these cases, normal cash flow patterns were disrupted and caused an immediate need for cash.

US Treasuries & Gold-Traditional Safe Havens Didn’t Work:

US Treasuries prices typically rise (and yields drop) when investors seek a safe haven.  This time, Treasurys dropped the at the same time stock prices were dropping, so there was no safety anywhere.

The Treasury market was disrupted by other factors as well.  For example, even short maturity Treasury securities (due in 30 days or less), sold off because people wanted cash, NOW!

Gold is another asset the investors buy in scary times, but gold actually declined at the same time that the stock market began falling.

Risky Assets were Crushed:

With fears of an imminent recession, investors fled riskier debt, afraid companies that loaded up on credit amid low interest rates would have trouble repaying.  These assets became extremely illiquid, and the only way to unload them was to sell at a huge discount.  As an example, the high yield (junk bond) Exchange Traded Fund- HYG quickly fell 15%.  Somewhat ironically, investment managers during times like this are typically forced to sell their highest-quality assets because the discounts on lower quality assets are so extreme.

Short Covering:

Short covering is often the cause of markets spiking upwards.  A short trader essentially uses a derivative security to sell an investment asset today with the provision to buy it later before a specified date.  For example, a short trader hopes to sell a stock today for $100, and buy it in the future at $90, a lower price.  This can be extremely risky, but it can be lucrative.  When the market is going up instead of down, this trade becomes increasingly unprofitable.  You have already sold at $100, and now you have to buy at perhaps $110 or more.  As the market goes up, short traders have to sell (Cover) before they lose even more money.  A large number of short sellers covering (closing out their increasingly unprofitable trade), means prices go up even higher.  This was a part of the reason that the S&P 500 went up 9.4% on March 24.  Many times, large upward price moves are caused by short covering.

Margin Calls:

Investors are allowed to borrow money in their brokerage accounts to buy even more stock.  This works great in rising markets, and it made you feel like a rock star in 2019 when the S&P 500 went up 31.5%.

When stocks decline, investors are required to put in more collateral.  They need to add to their margin account.  When they don’t have the cash, their broker will liquidate some of their securities to re-establish their required margin.  This is a “Margin call”.  Obviously, the more selling pressure in the market place, the greater the number of margin calls and this results in a negative downward spiral.  Margin calls were a major negative factor in the 1929 stock market crash.

Final Comments:

These Cornerstone blog posts are designed to provide education and a long-term perspective related to investments.  The commentary relies on my career experience, credible sources and hard data as much as possible. Even so, there are always many surprises and unexpected outcomes and this certainly applies to the comments listed above.  As always, your feedback is helpful and beneficial.

Jeff Johnson, CFA

April 1, 2020

 

One for the Record Books

The longest bull market in history, 11 years, ended March 12, 2020.

The longest economic expansion in history, 10 and a half years, is likely to end.

The fastest move in history for the S&P 500 index from an all-time record high to a Correction (down more than 10%) in six trading days and a Bear Market (down more than 20%) in 16 trading days.

Biggest down day since 1987 with the S&P 500 down 9.5% on March 12.

Biggest up day since 2008. A day after the ominous sell-off, the S&P 500 rebounded 9.3% on March 13.

The CBOE Volatility Index, a closely watched measure that is often called the “Fear Gauge”, rose to its highest level since 2008.

The Stoxx Europe 600 index shed 11.5% on March 12, its worst one-day performance on record. It is down 32.0% from its recent peak.

What’s Next?

No Good Precedent: There is no good historic precedent for the coronavirus given that globalization has allowed pandemics to spread much more quickly than in the past. As a result, a recession, both globally and in the U.S., looks likely.

Although a recession looks likely, the current market downdraft means a lot of economic weakness is already priced in. Nevertheless, the depth and duration of the coronavirus remain unknown and continued volatile market downdrafts can be expected.

Different than 1987: The coronavirus outbreak does not look like the 1987 market crash. Earlier in 1987 both the Dow Jones Industrial Average and the S&P 500 set all-time high records. Then by October 19, 1987, the Dow plunged 22.6% and the S&P 500 dropped 20.5%. Although economists forecast a recession at that time, the economy continued to grow and did not experience a downturn. This time, the coronavirus disruption looks likely to induce an economic recession.

9/11 Surprise: The terrorist attacks in September 2001 caught everyone by surprise. At the beginning of 2020, most investors expected continued market gains for 2020, but the coronavirus has caused another surprise. There was a mild recession associated with 9/11, but markets had already sold off hard for 18 months due to the internet/tech crash. At this time, there are too many unknowns associated with the coronavirus to assume a mild recession.

Different than 2008: The coronavirus outbreak is much different than the 2008 financial crisis and Great Recession. That downturn was driven by fundamental, systemic weaknesses that needed time to correct. The good news is that the Federal Reserve learned a lot during the 2008 crash, and they are able to apply the lessons learned to the current situation.

Liquidity: The U.S. government has stepped in aggressively to provide much needed liquidity. This is critically important for the airlines, energy companies, entertainment companies, restaurants and other small business operators who are facing short-term disruptions caused by the sudden social distancing and retrenchment in normal consumer behavior. The banks who lend to these companies are not structured to provide funds so quickly. Banks typically hold short-term U.S. Treasury securities that mature (become liquid) in weeks or months. In cases where companies suddenly need to borrow funds quickly, the banks lack ready cash. However, the banks can turn to the government to secure these “liquid” funds immediately and then lend these funds to these troubled companies. Keeping these companies afloat is important to maintaining employment.

Liquidity is also being provided to a wide range of institutional investors who are involved in a wide range of lending and foreign currency transactions.

President Trump has declared a national emergency and the U.S. government is providing broad-based support:

-to free up billions in assistance to states and provide authority as the rapidly spreading virus upends life across the country. This would also open up access to up to $50 billion in financial assistance for states, localities and territories.

-to call on every U.S. state to immediately set up emergency operations centers and every hospital in the country to activate emergency preparedness plans.

When these measures were announced on March 13, equity markets shot upward quickly.

Congress last week passed an $8.3 billion measure to help the government develop a vaccine and provide money for states to expand their lab-testing capacity and attempt to limit the damage from the virus.

-Legislation is being structured that would make coronavirus testing free and provide paid sick leave to many of those affected by the pandemic.

-Proposals are being discussed to help laid off workers, including direct cash payments that are along the lines of the 2008 policy response.

-Initiatives are in process to establish low-interest loans for small businesses.

-Consideration is being given to student debt relief.

Foreign Government actions are being crafted across the globe to provide similar monetary and fiscal stimulus packages.

There is an open question about whether these initiatives will be sufficient, or whether they are already too far behind the curve. There are also some that say these actions are over-reacting. Given the unprecedented nature of this pandemic, it seems prudent to respond as aggressively as possible.

For More Details See Below:

The Coronavirus was largely unknown in mid January, but it has since morphed into a global phenomenon. As of March 10, the World Health Organization reported 113,702 confirmed cases and 4,012 deaths. China is the epicenter of the outbreak, but South Korea, Iran and Italy are also hard hit. The U.S. has 1,267 cases and 38 deaths as of March 11, 2020. Harvard epidemiologist Marc Lipsitch has estimated that between 20% to 60% of adults world-wide might catch the disease. Although the coronavirus has spread across the globe, the newly reported cases in China are declining and Chinese workers are beginning to go back to their jobs. In addition, Reuters is reporting that new cases in South Korea are falling behind the number of patients who recovered and this could be an indication that the outbreak is slowing. There are also reports that the coronavirus is more lethal for smokers and for people living in areas of poor air quality. If this is the case, then some early cases may have overstated the risk to a broader population that has fewer smokers and better air quality.

Due to a lack of testing in the U.S., we don’t know how many Americans are infected. Although social distancing is helping reduce the spread, it is possible that the number of people already infected is far greater than currently reported cases suggest. If the number of cases exceeds current expectations, then hospitals might experience a surge in patients and the healthcare system might become overwhelmed.

Panicked Selling:  While the coronavirus has been a human tragedy, it has also negatively impacted global markets with waves of panicked selling based on the fear of the economic fallout on a global basis. For example, the S&P 500 index fell 9.5% on March 12, the greatest one-day decline since October 1987. Then the index rebounded 9.3% on March 13.

Ironically, equity markets first ignored the early reports of the coronavirus in January.  During February, new records were set for the S&P 500, Nasdaq, the Dow Jones Industrial Average, and the European Stoxx 600.  In fact, he S&P 500 set an all-time record high of 3,386 as recently as February 19, just before plummeting 13.0% in the next seven trading sessions.  As an indication of the panic, The Wall Street Journal reported that this was the fastest decline on record from a record high to a correction of below -10% and also the fastest bear market sell-off below -20%. This selling pressure has been exacerbated by President Trump’s 30-day travel ban on persons coming from Europe and continuing cancellations or suspensions of large conferences and entertainment events. The S&P 500 index is now down 19.9% from the February 19th all-time high, and down 15.8% on a year-to-day basis. Small cap stocks have been hit even harder based on the fact that they have less overall financial strength than larger, more established companies. International stocks are down even more than U.S. stocks. Meanwhile, so-called safe-haven U.S. Treasury bonds are up 13 percent year-to-date and an incredible 31% over the last year. These bonds have performed well because the bond prices have moved up sharply as interest rates declined.

Past Epidemics were historically short-lived:  Although it is difficult determine the global impact, the Severe Acute Respiratory Syndrome-SARS epidemic in 2003 reduced Chinese GDP by an estimated -0.8%.   Analysis by Charles Schwab found that for the 13 global epidemic outbreaks since 1981, the MSCI World Index gained 0.8% in the month after the outbreak, and 7.1% after six months. Morningstar examined the companies that they followed after the SARS outbreak and found no significant long-term effect. In addition to SARS, other notable outbreaks that did not have a significant global impact include the avian flu in 2006, swine flu in 2009, Ebola in 2014, and Zika in 2016. The coronavirus was categorized a pandemic on March 11th, however, and it looks like it will have a much more negative impact than past outbreaks.

History indicates that the market overreacts to short-term headlines and these previous outbreaks did not have a negative impact on longer-term performance. Nevertheless, the current coronavirus appears to have a much bigger impact because China now represents a much larger share of the global economy. Data from the World Bank shows that China’s GDP was at $1.3 Trillion in 2003 during the SARS outbreak and now GDP is $13.6 Trillion. In addition, global exports grew from $438 billion in 2003 to $2.5 Trillion in 2018. Finally, visitors from China to the U.S. grew from 157,000 in 2003 to 2.8 million in 2018.  Consequently, there is much greater downside potential than in the past.

Global Economy:  Although the Chinese economy appeared to be improving by the end of 2019, the coronavirus is clearly causing a downdraft.  The Chinese National Bureau of Statistics reported that the official February manufacturing survey declined from a stable level of 50.0 in January to 35.7 in February, the lowest manufacturing level ever recorded.  In addition, the official services data showed a decline from 54.1 in January to 29.6 in February.  Although there are reports of Chinese workers beginning to go back to work and some recovery is expected, it is clear that Chinese economic growth will be significantly impacted. The Euro area and the UK were also experiencing improving economic prospects at the beginning of 2020. Germany and Japan were the two major countries with weak year-end economic performance.

The U.S. is described as starting from a good place with solid economic fundamentals. For example, The Citi Economic Surprise Index showed a solid 69.6 rating at the end of February. In addition, the March 6th employment report showed employment gains of 273,000, well above estimates. Although this report covered a period before the coronavirus was seen as a problem, it does indicate the economic strength and momentum going into the coronavirus headwind.

Oil Price War: Russia did not agree to crude oil production cuts proposed by OPEC to support crude oil prices as oil demand fell due to the coronavirus impact, so Saudi Arabia countered with crude oil production increases. These actions essentially resulted in an oil price war between Saudi Arabia and Russia. This pushed crude prices down to $30 per barrel and it contributed to the massive March 9 stock market decline. For the U.S., lower oil prices are a clear benefit for consumers. However, lower oil prices hurt the oil exploration and production segment of the oil industry. Many of these companies have their production hedged (to lock in their prices), but these hedges will roll off going into 2021. If oil prices do not improve over the intermediate term, then many companies will face defaults and even bankruptcy. On an overall basis, there is significant economic analysis showing the benefit of lower oil prices to consumers is roughly offset by the losses to the exploration and production companies.  Consequently, falling oil prices may impact short-term U.S. market volatility, but the net longer-term impact to the U.S. economy should not be large.

Deteriorating credit conditions are the clear issue. High yield funds that hold non-investment grade “junk” bonds will experience increasing defaults and bankruptcies, and this will lead to weaker investment performance.

Forecasts:  The term Unknown Unknowns might seem appropriate to describe the current environment because it is difficult to know the depth and duration of the spread of the coronavirus. It now seems clear that previous analysis and forecasts from Goldman Sachs, Deutsche Bank and others were too optimistic, as they projected a direct short-term impact on Chinese GDP but minimal impact to the global economy. Recent forecasts are now recognizing a greater negative impact. For example, the Organization for Economic Cooperation and Development-OECD reduced their 2020 global growth forecast from 2.9% to 2.4%. Given the fact that the coronavirus is still spreading and there is no way to know when it peaks, it seems likely that global growth will be reduced by at least 0.5% and the global economy may even dip into recession.

The Wall Street Journal consensus forecast (conducted March 6-10) shows a 49% chance of a U.S. recession in the next twelve months compared to a 26% chance a month ago. On an annual basis, the WSJ survey shows U.S. GDP down -0.1% in Q2, and up 1.2% for the full year. Based on recent data and analysis, it appears that the short-term economic downdraft may be deeper, but prospects for 2021 should be much less impacted. Initially, many economists saw a V-shaped recovery, with a negative impact in the first quarter and then a second quarter recovery.  More recently, there is more commentary about a U-shaped recovery. A prolonged L-shaped economic period is also possible if the coronavirus proves worse than expected. It needs to be said that forecasts often initially understate the magnitude of significant declines. For example, practically no one foresaw the depth or duration of the Great Recession. The reality is that there is also an epidemiology factor that is new to economists’ models. Only time will tell, but a global recession appears likely.

Interest Rates:  One notable aspect of the current market decline has been the precipitous decline in interest rates.  The 10-year U.S. Treasury bond interest rate declined to a record-low level of 0.5% on March 9.  Part of this decline is due to concerns of weaker economic growth, but a flight to quality is a greater factor.  When market participants grow fearful, they seek safe havens by buying U.S. Treasury bonds.  These panicked purchases drove the price of the bond up and the yield down and caused long U.S. Treasury bonds to gain over 30% in the last year.  As fears eventually subside, the price will go down and the yield will rise, setting the stage for huge Treasury bond losses.

Federal Reserve:  In reaction to the coronavirus economic threat, the U.S. Federal Reserve executed an emergency half-percentage point rate cut to a range of 1.0% to 1.25%, down from the previous range of 1.5-1.75%. The Fed is also likely to reduce interest rates even further at the upcoming FOMC meeting on March 17th and 18th.  The difficulty is that the Fed is best positioned to deal with weak aggregate demand, and the coronavirus represents a supply-side shock related to disrupted supply chains.  Lower interest rates would help keep the U.S. dollar lower (to help maintain U.S. exports), but lower interest rates don’t create what is really needed-a vaccine. If economic prospects weaken, however, then Fed-induced interest rate cuts will help support aggregate demand. The Federal Reserve has also been an active buyer of short-term Treasury securities to maintain liquidity and an orderly market.

Fiscal Policy: Countries around the world are playing catch-up to the fast-paced coronavirus developments. President Trump has signed an $8.3 billion emergency spending bill. There is also discussion related to payroll tax reductions and low-interest small business loans, but political realities may hamper any significant bipartisan legislation. Globally, there are numerous fiscal policy initiatives that may prove beneficial. Since interest rates in the developed world outside the U.S. are extraordinarily low or negative, there is less potential monetary support. From an economic perspective, tax cuts have the greatest multiplier effect.

It’s not 2008:  While the market sell-off has been reported as the worst decline since October 2008, it should not be compared to the 2008 global market meltdown and Great Recession.  Back then, there were significant fundamental issues related to over-valued real estate, highly speculative financial transactions and insufficient capital for the global banking system.  We don’t know when the number of global coronavirus cases will begin to decline, but it does not appear to be on a scale similar to the massive systemic breakdown from the past.

A Good 30 Years:  The quick 2020 sell-off erased significant portfolio value through mid March, and it could get worse before it gets better.  That being said, it is helpful to remember that the S&P 500 gained 31.5% in 2019.  In addition, it is up 422% on a total return basis (and up 14.0% annualized) as we pass the 11th anniversary of the bull market that started March 9, 2009. Market complacency had become pervasive over the past 11 years. The U.S. has been in the longest economic expansion on record, and the S&P 500 has been in the longest bull market without a -20% bear market. It is important to remember that historically going back to 1950, market corrections (down more than -10% from a recent high) occur once every 2.5 years and bear markets (down more than -20%) occur every 7.8 years. Based on these averages, it puts the current decline in perspective.

Additional Thoughts: Although there has been panicked selling, there is also cash on the sidelines waiting to get into the market and these two factors can cause increased price volatility. Moreover, the market is forward-looking and is attempting to front-run “Peak Virus.” In other words, when new cases and deaths begin to diminish, then this will indicate less economic downside and better corporate earnings. However, there is likely to be a series of negative news reports about downgraded economic forecasts and corporate earnings reductions. This will likely include the prospect of a global recession and a recession in the U.S. These negative reports will provide continuing market angst and downside market volatility. Given that the depth and duration is not known, this peak virus event might be in a month but it will probably be much further out. On the plus side, the sell-off has driven market valuation levels much lower and recessionary risks are already partially priced in. For investors with cash, now is the time to begin buying equities. Rather than trying to nail the bottom, it can be advantageous to average in with several investment moves over the course of time.

WHAT YOU SHOULD DO:  Although there is much we don’t know about the ultimate coronavirus impact, there is also much we do know:

-First, remember that emotional reactions to short-term headlines are the biggest risk.  As hard as it is, investors should not abandon long-term investment objectives.

-Use the current market volatility to rebalance portfolios back into alignment with your long-term investment objectives and asset allocation plan.

-If you have cash to be invested, then this sell-off looks like a good time to invest potentially one third of your idle funds.  Then set a date in three months to invest another third or if the market drops another 10%.  Finally, set a date in six months to invest the last third or sooner if the market drops by 20%.  If the market declines further, you will be getting in at lower prices.  If the market moves upward, your first purchases will be at lower prices.  No plan is fail-safe, but this strategy is a way to get into the market without making one big move.

 

Jeff Johnson, CFA

March 14,2020

Coronavirus Comments

The Coronavirus was largely unknown six weeks ago, but it has since morphed into a global phenomenon.  At this stage it is hard to know if the media pundits are providing a valuable public service or are hyping a story for more viewers and Likes.  Fortunately, we have sources like the Centers for Disease Control and the World Health Organization to give perspective.  Through the end of February, there have been over 87,000 reported cases and nearly 3,000 deaths.

Panicked Selling:  While the coronavirus has been a human tragedy, it has also negatively impacted global markets with waves of panicked selling.  Equity markets have sold off hard based on increased reports of the coronavirus spreading outside of China.  Although there are reports that the number of new cases in China is declining and Chinese workers are beginning to go back to their jobs, there is a greater fear of the economic fallout on a global basis.  Ironically, equity markets first ignored the early reports of the coronavirus in January.  During February, new records were set for the S&P 500, Nasdaq, the Dow Jones Industrial Average, and the European Stoxx 600.  In fact, he S&P 500 set an all-time record high of 3,386 as recently as February 19, just before plummeting 13.0% in the next seven trading sessions.  As an indication of the panic, The Wall Street Journal reported that this was the fastest decline on record from a record high to a correction of below -10%.  Markets across the globe suffered similar declines.

Past Epidemics:  Although it is difficult determine the global impact, the Severe Acute Respiratory Syndrome-SARS epidemic in 2003 reduced Chinese GDP by an estimated -0.8%.   Analysis by Charles Schwab found that for the 13 global epidemic outbreaks since 1981, the MSCI World Index gained 0.8% in the month after the outbreak, and 7.1% after six months. Morningstar examined the companies that they followed after the SARS outbreak and found no significant long-term effect. In addition to SARS, other notable outbreaks that did not have a significant global impact include the avian flu in 2006, swine flu in 2009, Ebola in 2014, and Zika in 2016.

Forecasts:  Recent analysis from Goldman Sachs and Deutsche Bank indicates that the virus will reduce Chinese GDP by -1.5% for the first quarter of 2020 and by -0.3% for calendar year 2020. US GDP is seen being reduced by as much as -0.5% in the first quarter and by -0.1% for the full year. On a global basis, GDP is seen down -0.2% for 2020. This analysis essentially sees a negative impact in the first quarter and then a recovery. Only time will tell.

History indicates that the market overreacts to short-term headlines and these outbreaks do not have a negative impact on longer-term performance. Nevertheless, the current coronavirus may prove to have a bigger impact because China now represents a much larger share of the global economy. Data from the World Bank shows that China’s GDP was at $1.3 Trillion in 2003 during the SARS outbreak and now GDP is $13.6 Trillion. In addition, global exports grew from $438 billion in 2003 to $2.5 Trillion in 2018. Finally, visitors from China to the U.S. grew from 157,000 in 2003 to 2.8 million in 2018.  Consequently, there is much greater downside potential than in the past.

Chinese Economy:  Although the Chinese economy appeared to be improving by the end of 2019, the coronavirus is clearly causing a downdraft.  The Chinese National Bureau of Statistics reported that the official February manufacturing survey declined from a stable level of 50.0 in January to 35.7 in February, the lowest manufacturing level ever recorded.  In addition, the official services data showed a decline from 54.1 in January to 29.6 in February.  Although there are reports of Chinese workers beginning to go back to work and some recovery is expected, it is clear that Chinese economic growth will be significantly impacted.

Market complacency had become pervasive over the past 11 years.  The U.S. has been in the longest economic expansion on record, and the S&P 500 has been in the longest bull market without a -20% bear market on record.  It is important to remember that historically, market corrections (down more than -10% from a recent high) occur almost once a year and bear markets (down more than -20% from a recent high) occur every 4.5 years.  Based on these averages, it puts the current decline in perspective.

Interest Rates:  One notable aspect of the current market decline has been the precipitous decline in interest rates.  The 10-year U.S. Treasury bond interest rate has declined to a record-low level of 1.13%.  Part of this decline is due to concerns of weaker economic growth, but a flight to quality is a greater factor.  When market participants grow fearful, they seek safe havens by buying U.S. Treasury bonds.  These panicked purchases drove the price of the bond up and the yield down and caused long U.S. Treasury bonds to gain over 30% in the last year.  As fears eventually subside, the price will go down and the yield will rise, setting the stage for huge Treasury bond losses.

Federal Reserve:  In reaction to the coronavirus economic threat, the U.S. Federal Reserve is likely to reduce interest rates at the upcoming FOMC meeting on March 17th and 18th.  The difficulty is that the Fed is best positioned to deal with weak aggregate demand, and the coronavirus represents a supply-side shock related to disrupted supply chains.  Lower interest rates would help keep the U.S. dollar lower (to help maintain U.S. exports), but lower interest rates don’t create what is really needed-a vaccine.

Recovery:  Although the U.S. is described as starting from a good place with solid economic fundamentals, it is difficult to know the ultimate outcome.  Many economists see a V-shaped recovery, with a negative impact in the first quarter and then a second quarter recovery.  If the coronavirus proves worse than expected (and worse than historic epidemics) then there may be an L-shaped recovery.

It’s not 2008:  While the market sell-off has been reported as the worst decline since October 2008, it should not be compared to the 2008 global market meltdown and Great Recession.  Back then, there were significant fundamental issues related to over-valued real estate and highly speculative financial transactions.  We don’t know when the number of global coronavirus cases will begin to decline, but it does not appear to be on a scale similar to the massive systemic breakdown from the past.

A Good Run:  The quick sell-off erased over 10% of value through the end of February, and it could get worse before it gets better.  Nevertheless, it is helpful to remember that the S&P 500 gained 31.5% in 2019.  In addition, it is up 490% as we approach the 11th anniversary of the bull market starting March 9, 2009.

WHAT YOU SHOULD DO:  Although there is much we don’t know about the ultimate coronavirus impact, there is also much we do know:

-First, remember that emotional reactions to short-term headlines are the biggest risk.  As hard as it is, investors should not abandon long-term investment objectives.

-Use the current market volatility to rebalance portfolios back into alignment with your long-term investment objectives and asset allocation plan.

-If you have cash to be invested, then this sell-off looks like a good time to invest potentially one third of your idle funds.  Then set a date in three months to invest another third or if the market drops another 10%.  Finally, set a date in six months to invest the last third or sooner if the market drops by 20%.  If the market declines further, you will be getting in at lower prices.  If the market moves upward, your first purchases will be at lower prices.  No plan is fail-safe, but this strategy is a way to get into the market without making one big move.

Investment Performance:

Last 3 Last 12
Major Benchmark Performance:  Months YTD Months
Since: February 10/31/19 12/31/19 1/31/19
As Of: 2/29/20 2/29/20 2/29/20 2/29/20
US Large Cap-S&P 500 -8.23% -5.50% -8.27% 8.21%
US Small Cap-Russell 2000 -8.42% -8.81% -11.36% -4.93%
Foreign Developed-MSCI EAFE -9.04% -8.05% -10.94% -0.58%
Foreign Emerging Mkts-MSCI EEM -5.27% -2.95% -9.68% -1.88%
US Bonds-Barclays Aggregate 1.80% 3.68% 3.75% 11.69%
Long Treasury-20 Yr+ US Treasury Bonds 6.87% 11.04% 14.34% 32.48%
High Yield-Bloomberg -1.41% 0.59% -1.38% 6.10%

For more information see: Cornerstone Investments LLC

Jeff Johnson, CFA

March 1, 2020

 

Big 2019, 30 Years of Ups & Downs, Outlook/Recommendations

What a difference a year makes.  By Christmas Eve 2018, markets were filled with despair at the prospect of a global recession, and the S&P 500 plunged nearly 20%.  Since the panic selling at the end of 2018, markets generated stellar 2019 gains, led by a 31.5% total return for the U.S. S&P 500 index.  At this time the market narrative is giddy and euphoric based on fading fears of a global recession, less concern of a trade war and more accommodative central banks.

WHAT A BULL-WHAT A YEAR!

 

Not Interested in All the Details?  See 2020 Outlook & Recommendations

 

 2019 WAS UNIQUE IN MANY WAYS:

-The year started in the midst of a 35-day U.S. government shutdown that ended January 25, providing a negative backdrop to start the year.  Economic forecasts were downgraded, but this was soon forgotten (markets often have a short attention span) as the government resumed operations.

-The economy generated the lowest unemployment rate at 3.5% since December 1969, 50 years ago when Richard Nixon was President.

-Inflation remained below the Federal Reserve’s 2% target.

-Ongoing recession fears were stoked in late summer by an “Inverted Yield Curve” and then ignored and forgotten.  An Inverted Yield Curve is a phenomenon where long-term government interest rates are lower than shorter maturities.  This situation infers that longer maturities are low because investors are pessimistic on a longer-term basis, and it is typically a precursor to a recession.  Solid consumer spending negated this indicator, however, and markets continued upward.

-The year closed out by continuing the longest economic expansion on record.

-This was the only decade on record without an economic recession.

-Although consumer spending remained robust, manufacturing and capital spending remained weak.

-The year continued the longest bull market on record.

-For 2019, all major asset classes produced above-average returns.  This has never happened before according to Schwab.

SECTORS:

Biggest Winners:  The broad-based technology sector gained 47.9%, and the semi-conductor sub-sector was up 60.0%.  Big stock gainers included Apple up 85% and Microsoft up 55%.

Laggards:  Energy was the weakest sector, up only 4.7%.  The Exploration & Production sub-sector was particularly weak with a decline of -10.6%.  Continuing low oil prices negatively impacted drilling revenues, particularly for the “fracking” drilling companies.

IPOs:

Although the overall market did exceptionally well, some highly anticipated Initial Public Offerings-IPOs were disappointments.

Lyft-LYFT went public in March at $72 and ended the year at $43.02, down -40%.

Uber-UBER debuted in May at $45 and closed down -34% to $29.74.

Beyond Meat-BYND made headlines with their IPO that priced at $25 in April, it soared to $225 by July and then settled at $75.60 by yearend.  Nevertheless, it was up over 200% from its IPO.

-Other notable disappointments included Pinterest and Peloton.  Most of the year’s large technology listings traded below their opening prices.

 

U.S. SMALL CAPS:

US small capitalization stocks have trailed US big caps in the recent past, but the Russell 2000 Small Cap Index still advanced a very respectable 25.5% for 2019.  Although small caps have trailed large caps in recent years, small caps still have higher performance over the time of their long-term history.

 

FOREIGN DEVELOPED:

Foreign developed markets stocks hit their all-time-high of 2,186.65 on January 25, 2018, well in advance of record high levels for the U.S. stock market.  Although foreign stocks trailed U.S. stocks, gains were still respectable at 22% for the broad developed market MSCI EAFE index.  The European STOXX 600 index was up 23.2% and the Japanese Nikkei 225 index was up 18.2%.

 

EMERGING MARKETS:

Emerging markets were big winners in 2017 and the MSCI Emerging Markets index peaked at 1,273.07 on January 26, 2018.  Emerging markets have trailed other markets more recently but finished 2019 up 18%.  Part of the reason for the weaker emerging markets performance is that China is experiencing the slowest economic growth since they began reporting quarterly GDP in 1992.  Nevertheless, the mainland Shanghai stock exchange gained 22.3% in 2019.  Despite Hong Kong’s political struggles with China, the Hang Seng index still managed a 9.1% gain.  Other emerging market notables:  Brazil was up 31.6%, Mexico was up only 4.6%, and South Africa registered a -2.8% decline.

 

INTEREST RATES:

Interest rates continue to confound both investors and economists.  At the beginning of 2019 there was a broad consensus that rates would trend modestly upwards.  Instead, interest rates on the 10-year U.S. Treasury bond moved from 2.66% in January to 1.46% by September 4th.  Rates rebounded somewhat to 1.92% by yearend, but a sharp upward spike above current levels does not look imminent.  It may sound trite, but the phrase “Lower for Longer” has been an apt descriptor and it warrants consideration for the upcoming year.

 

THE LAST30 YEARS-VOLATILE BUT GOOD:

The Last 30 Years:  Much perspective can be gained from taking a longer-term perspective.  The last 30 years have been highly volatile but very good on a longer-term basis.

The Decade of the 1990s began with the emergence of the internet and culminated with the dot com mania.  By the end of the decade there was also the Y2K hysteria related to computer programs not being programmed to handle the transition for dates changing from 1900s to the 2000s (too many software programs supposedly lacked the first two digits of the year.)  Despite alarmist predictions, electric utilities did not encounter shut-downs and planes did not fall from the sky.  In the end, the real winners were the doom and gloom consultants who benefitted from a once-in-a-century opportunity to charge high fees.

The Decade of the 2000s:  While our computer systems handled the transition to the new millennium, we learned belatedly that our internet and “New Economy” fascination was unrealistically optimistic.  Consequently, we suffered a new millennium hangover and an inevitable Tech Wreck.

-The tech-heavy Nasdaq Composite index declined 78% from the March 10th 2000 peak to the October 9th bottom.

-The decade of the 2000s not only suffered from the tech debacle at the beginning of the decade, but also the financial crisis and the Great Recession at the end of the decade.

-The combination of these two downdrafts resulted in the S&P 500 generating a total return of a negative -0.95% for the entire decade.

-Ultimately the decade, known as the “aughts”, came to be characterized as the “Lost Decade.”

The Decade of the 2010s:  After the tech and financial crises of the 2000s, the 2010s followed with a spectacular recovery.

-the decade closed out with the longest economic expansion on record (and still counting.)  It should be noted, however, the current recovery at a 2.3% annualized growth rate is the slowest of all recoveries since 1950.  The average recovery growth rate since 1950 is 4.1%.

-This was the only decade on record without an economic recession.

-The 2010s also included the longest bull market on record and it is still going strong at year-end 2019.  In fact, 2018 was only negative year for the S&P 500 index.  The total return (including dividends) for the S&P 500 since the beginning of the bull market is 490%.

 

INVESTMENT PERFORMANCE:

The previous section provided a graph and high-level comments.  This section provides a table format and additional comments.

Table Below:

Long-Term Equity Performance:  Equity performance was strong but an examination of historic performance shows the importance of diversification.  Asset classes have experienced long stretches of both outperformance and underperformance.  It is important to avoid making investment decisions based solely on recent performance.

U.S. stocks have been the strongest performers over the last 30 years.  Although data is not listed above, foreign developed stocks outperformed US large company stocks in the decades of the 70s and 80s.

Emerging markets outperformed in the 90s and 00s but significantly underperformed in the 2010s.

Long Bonds WERE Great But:  The U.S. Treasury 20 Yr + Index is a long-maturity treasury index that is very sensitive to changing interest rates.  Historic performance has been strong because rates have declined to historically low levels and this forced bond prices to move up.  (This is the inverse relationship between interest rates and bond prices.  Although interest payments are fixed for the life of the bond, declining interest rates cause bond prices to rise.)  If interest rates move up to more normal levels, then bond prices will go down and the total return will be very negative.  (In the case of rising interest rates, bond prices go down.)  For example, if you hold a 10 year bond that pays 2% interest and then interest rates rise to 3%, then you would have to reduce the price of your previously purchased 2% interest bond to a low enough bond price so that the interest earned would match the current market-determined 3% level.

Junk Bonds:  The Bloomberg High Yield “Junk” Bond Index is very sensitive to the economy and defaults in a recession.  Consequently, this asset class performs well during economic expansions, but it underperforms heading into recessions.

 

2020 OUTLOOK & RECOMMENDATIONS:

Outlook Rationale:

Lessons to be Learned:  There are many lessons from both the recent past and also on a longer-term basis that impact the 2020 Outlook.

First, it is highly unlikely that 2020 performance will match the extraordinary 2019 gains.

-Although the U.S. SP500 large cap index WAS the place to be in 2019, it is unlikely to repeat this stellar performance.

-Remember, historic performance is not a good predictor of next year’s performance.

Market Fundamentals:

It is important to remember that market fundamentals are modestly positive, and don’t appear to be in bubble territory.

-Corporate earnings are a key driver of stock market gains.  Although 2019 earnings growth was slightly negative, earnings were up 22% in 2018.  More importantly, corporate earnings are projected to increase 9.6% for 2020 according to FactSet.

-Valuation is another consideration related to stock market performance.  Although the current trailing 12-month Price/Earnings ratio is relatively high at 20 times, it is less over-valued when looking at P/E ratios during periods of low inflation.

-The Price/Earnings ratio is certainly not as extreme as in 1999 when the “New Economy” mindset was the vogue.  The trailing PE in 1999 was 30X compared to 20X today.

-Earnings growth over the last ten years has actually accounted for two-thirds of annualized S&P 500 total return while multiple expansion due to rising P/E ratios accounted for one-third according to BCA Research and the Wall Street Journal.  The current consensus forward Price/Earnings ratio for the S&P 500 is a more reasonable 18X compared to the higher trailing 20X P/E.  As long as earnings growth stays strong, there is more support for equity markets.

-Higher Price/Earnings ratios are not a good predictor of shorter-term investment performance, but they do help predict future longer-term investment returns.  What this means is that current above-average valuation levels may not cause weak short-term investment performance, but these higher valuation levels are likely to cause below-average future long-term performance.  As a result, current higher valuation levels do not indicate an imminent market decline, but they do indicate that future long-term returns are likely to be lower than the historic 10% return level.

-Don’t assume that the big 2019 gains will lead to 2020 losses.  Analysis by Mark Hulbert, a Market Watch columnist, shows that when the Dow Jones gains over 20%, in a year, there is a a 65% chance that the next year will also be positive.  In other words, the market is highly efficient and making investment decisions on a single factor is generally counterproductive.

Wall Street Expectations:

Although institutional investors have a spotty track record in predicting future short-term market moves, the rationale for their predictions is useful.  Based on positive fundamental consensus expectations, Wall Street money managers expect modest 2020 gains.  According to the December 2019 Barron’s portfolio manager tally, the S&P 500 is expected finish yearend 2020 at 3,300, up 2.1% from the 2019 year-end close of 3,230.78.  Similarly, the CNBC Market Strategist Survey shows the S&P 500 ending 2020 at 3,330.

Reasons to track these big money investors include:

– They do good fundamental analysis and their consensus forecasts provide a reasonable baseline.

– It is not wise to categorically ignore the consensus forecasts.  No one is able to consistently predict short-term market moves, but the consensus forecasts indicate what is priced into the market and what might happen as market conditions change.

-It is important to remember that their investment horizon is typically much shorter, and individual investors have the benefit of being able to take a longer-term perspective.

-The FactSet consensus of money managers for the S&P 500 index shows 9.6% earnings growth for 2020.  If corporate earnings are reasonably close to this 9.6% level, then this provides significant market support.

Although these forecasts and outlooks have merit in a base-case scenario, there are reasons for caution.  Unexpected negative surprises happen and can cause significant short-term negative performance.  As a result, it is critical to stick with long-term objectives.

Recommendations for 2020:

Stay diversified.  Don’t be tempted to overweight your big winners.  It is certainly not the time to overweight yesterday’s winners.

Rebalance your portfolio-Your big cap portfolio exposure is likely overweight due to relatively strong performance and should be trimmed.  Funds taken from your large cap holdings could be rebalanced into US small cap, foreign developed and emerging markets.  Investors who rebalanced by trimming their technology holdings in the late 1990s had far better performance than those who blindly rode over the tech wreck cliff.

Don’t try to time the market and make big swings in portfolio weights.  Selling everything and

“going to cash” is not a prudent strategy and neither is “going all in” by abandoning your long-term objectives.  Don’t over-react to either the bullish polyannas or the doom and gloom Perma-Bear crowd.

Tactical adjustments.  Large market timing bets that take your portfolio asset allocation away from your long-term Investment Objectives needs to be avoided.  However, smaller incremental tactical adjustments could be considered.  For example, you could modestly underweight the overall equity weight, and modestly overweight the cash holdings weight.

-Recognize that volatility and bear markets (down over 20%) are a part of investing.  There have been18 bear markets since 1950, and they have all ended with subsequent bull markets.  Although they occur on average roughly every four years, they are notoriously difficult to predict (and profit from.) Since returns are often greatest leading up to a bear market and they are also very strong shortly after a bear market, a market timing strategy might easily miss these periods of significant gains.  Remember, time in the market is more important than timing the market.

-Avoid longer-maturity bonds.  Although longer maturity interest rates are not expected to spike upward, the longer maturity bonds are extremely volatile.  For example, the US Treasury 20-year bond had a total return of 23.4% from the beginning of 2019 through August 31 as interest rates dropped.  Since that time, interest rates have trended upward modestly and that index lost over 8% from September through December.  As a result, the 23% gain through August was reduced to 15.1% by yearend.  A helpful rule of thumb to project future long-term bond returns is to take the current bond yield as an indication of the future annualized performance.  For example, the current 10-year U.S. Treasury note has a yield of 1.92%, and this implies that you might expect a return of not quite 2% a year for the next ten years.  This would not likely be a good investment.  With the 30-year US Treasury bond trading at 2.3%, a return of 2.3% for 30 years would even worse!

To summarize, don’t react to isolated factors, but rather take a broad-based long-term perspective related to investments.  History going back to the 1930s shows a 6.5% S&P 500 earnings growth rate through a wide range of economic and market conditions, and earnings growth is a key driver of market performance.  This 6.5% expected return is less than the long-term historic average of 10%, but it takes into consideration the current relatively high valuation levels.  In addition, this level is supported by numerous successful long-term investors.  Finally, a 6.5% long-term expected return makes sense for reasons of conservatism.  An investor is better off planning for a lower return and then being wrong because the market did a little better.  Having a return expectation that is too high and then coming up short is a much worse outcome.  A diversified portfolio, a long-term perspective and a 6.5% equity return expectation should provide be a reasonable investment approach.  For bonds, current low interest rates mean that a 3% expected long-term return makes sense.  Combining long-term expected returns for a typical 60% equity/40% bond portfolio comes to a 5.1% return on an overall portfolio.

As always, there are no sure things in the investment world, but hopefully this content provides helpful perspective.

Back to Top:

Jeff Johnson, CFA

January 9, 2020

 

Charitable Giving Update And Comparisons-2019

As 2019 winds down, it is important to remember charitable commitments.  The first Cornerstone blog post in January 2018 covered charitable giving, and a key objective of that blog was getting the biggest bang for the (charitable) buck.  Whether consideration is given to charitable Multipliers, Cost/Benefit analysis, or Impact criteria, charitable giving provides immense benefits.  For example, what is the impact of $1,000 invested in education for children within a Christian environment in Haiti compared to consumption of an expensive $1,000 bottle of wine?  Charitable giving also gives the donor a greater sense of purpose and meaning compared to additional portfolio investment gains or consumer spending.  For additional content See original blog Charitable Contributions

Listed below is an update.

America is a very charitable nation:

Americans on a per capita basis voluntarily donate about seven times as much as Europeans and twice as much as Canadians according to the Philanthropy Roundtable.  Philanthropy Roundtable Statistics

Charitable Giving was up 0.7% in 2018:

Americans made $427.71 billion of charitable contributions in 2018.  This was up 0.7% from 2017, but down -1.7% on an inflation-adjusted basis.  This giving accounted for 2.1% of US GDP.

Giving went to the following major groups:

Religion remained the largest charitable category in the U.S. at $124.52 billion and 29% of total giving.  Giving to religion (Christians and all other faith groups) was down 1.5% from the prior year.  This decline is partly explained by negative 2018 stock market performance, but the 2017 tax law changes were another significant factor.  (More commentary below in the Tax Law Change section below.)  A longer-term factor is that religion continues to lose market share to other charitable categories over the last 30+ years.

Education (14%),

Human Services (12%),

Grantmaking Foundations (12%),

Health (9%).

Charitable Giving USA

Charitable Giving by Source:

Individuals contributed 68.3% of total giving at an estimated $292.09 billion.  Individual giving declined 1.1% in 2018 compared to the year before, and much of this decline can be attributed to the stock market decline and the 2017 tax law change.

Foundations increased contributions by an estimated 7.3%, to $75.86 billion in 2018.  Data on foundation giving are provided by Candid (formerly known as the Foundation Center).

Bequests totaled an estimated $39.71 billion in 2018, remaining flat with a 0.0% increase from 2017.

Corporations charitable giving is the smallest category at 4.7% of total giving.  Corporate giving for 2018 came in at $20.05 billion, up 5.4%.  Although the stock market was negative in 2018, corporate profits were up.

Charitable Giving USA

Other Charitable Statistics:

Giving by income level:  As one would expect, wealthy individuals give the highest $ amount, but the lower-income group (households making $25,000-$45,000 in current dollars, not the truly poor) gives more than middle-class Americans based on a percentage of income.  While only about a third of low-income individuals give any money at all, those that give are extremely generous and are highly motivated by religion.

Religious practice is highly correlated with generous giving.  Although religious givers (Christians and all other faith groups) strongly support religious causes, they are also more likely to support secular causes than the non-religious.

Red state versus Blue state:  “The electoral map and the charity map are remarkably similar” with red states correlated with higher charitable giving.  Or to quote the Chronicle of Philanthropy’s 2012 summary of its giving research, “the eight states that ranked highest voted for John McCain in the last presidential contest…while the seven lowest-ranking states supported Barack Obama.”

Philanthropy Roundtable Statistics

2017 Tax Law Change Impact:

One important change affecting individual 2018 giving is the drop in the number of individuals and households who itemize charitable and other deductions on their tax returns. This shift came in response to the federal tax policy change that doubled the standard deduction. More than 45 million households itemized deductions in 2016.  Various studies indicate that itemizing tax deductions may have dropped to roughly 16 to 20 million households in 2018.  Given that more individuals and households (using the higher standard deduction) received no tax benefits from charitable contributions, it is somewhat reassuring that individual charitable giving declined by only 1.1%.  This is a complex issue with many variables and it will take several years for a more definitive understanding of the tax law change on individual contributions.

Volunteering:

Approximately 30% of the adult population,77 million Americans, volunteer their time, talents, and energy to making positive contributions according to the National Philanthropic Trust.

Americans contribute $167 billion of their time to communities, assuming the 2017 national value of volunteer time is $24.69 per hour.

The top four types of organizations that use volunteers are: religious (32.0%); sport, hobby, cultural or arts (25.7%); educational or youth service (19.2%); and civic, political, professional or international (6.2%).

The top four national volunteer activities are fundraising or selling items to raise money (36.0%); food collection or distribution (34.2%); collecting, making or distributing clothing, crafts or other goods (26.5%); and mentoring youth (26.2%).

Charitable Giving Statistics

Sites for checking Charities:

Since we all want the “Biggest bang for the buck”, it is helpful to view websites that rate various charitable entities.  These sites help identify key factors including giving effectiveness, fund-raising costs and overhead costs.  Some good ones are as follows:

http://givewell.org/

https://www.charitynavigator.org/

http://charitywatch.org

http://guidestar.org

Center for High Impact Philanthropy-CHIP is the University of Pennsylvania’s multidisciplinary nonprofit center that focuses on maximizing social impact.  https://www.impact.upenn.edu/

Charitable Giving Tax Requirements, Considerations and Strategies:

Request a receipt if you make a donation of $250 or more to a single charity. But if the donation is in cash, you’ll need a receipt or supporting bank records, regardless of the amount.

-Tax Deductibility.  If your standard deduction exceeds your charitable contributions and other deductible expenses, then you likely won’t itemize deductions on your tax return.  Even though the standard deduction precludes charitable tax savings, your favorite charities still benefit, and this generosity likely greatly exceeds any income tax savings.

Long-term capital-gain property:  You can deduct the full fair market value of appreciated long-term assets (like stocks or mutual funds and Exchange Traded Funds) that you’ve held for more than one year.  In addition, if you donate stocks or other investments, you pay no capital gains tax.  Donating highly appreciated securities–instead of cash can be a very effective and tax-efficient way to support a charity. Generally, if your assets have appreciated in value, it’s best not to sell securities to generate the cash you need for a donation because you pay tax on the capital gains.  Contributing the securities directly to the charity increases the amount of your gift as well as your deduction.

If you are holding securities with a loss, it’s usually better to sell first. By doing so, you can take the capital loss for tax purposes and then donate the cash.  The tax aspects of charitable giving can be complex and it is good to discuss your personal situation with a tax professional.

Donor Advised Funds:  Given the fact that the 2017 tax law doubled the standard deduction, some individuals may consider “bunching” their charitable contributions to enable them to itemize deductions only in some years.  A Donor Advised Fund-DAF can be used to accomplish this bunching strategy whereby you contribute multiple years-worth of giving into one year in the DAF.  These bunched contributions can rise to a level that allows itemizing deductions and getting a tax reduction in that year.  This aggregated amount can be contributed to a DAF maintained by a financial institution like Schwab Charitable, Fidelity Charitable or many others.  A DAF contribution in a particular year may enable eligibility for itemizing deductions in that year and thus a deduction for the DAF contribution.  Then in subsequent years the donor can direct that the funds in the DAF be distributed to certain organizations over a number of years in the amounts and at the times desired.

Donations Directly from your IRA Account:  Individuals who have attained the age of 70 ½ are required to make Required Minimum Distributions-RMDs.  However, instead of making these RMDs and paying taxes on these IRA withdrawals, tax law allows qualified charitable contributions up to $100,000 to be directed from IRA accounts to a preferred charitable entity.  This allows a reduction of your taxable income if you do not itemize deductions (and thus do not receive a benefit for charitable deductions).

 

Charitable giving has many dimensions and broad-based benefits.  Hopefully this update and the original blog are helpful.  As always, your comments and feedback are appreciated.

Jeff Johnson, CFA

October 26, 2019

Market Record, Panic, New Record-What’s Next?

The table above shows the strength of the U.S. stock market, and especially the large-cap S&P 500 Index.  Despite weakening global economic growth and continuing trade war fears, U.S. and foreign equity markets are up double digits so far in 2019.  Fixed income performance has also been strong based on falling interest rates and corresponding bond price increases.

 

The U.S. stock market set an all-time record last September, then it panicked on fears of an imminent global recession, and now it is at a new all-time high.  This volatility shows the market’s animal spirits working in both directions.  At this point, the gains are based on expectations for lower interest rates and trade talk progress with China.

President Trump continues to criticize Fed Chair Jerome Powell, but Powell recently said the central bank is “insulated from short-term political pressures”.  Regardless, the Federal Reserve looks certain to cut the Fed Funds rate by 0.25% in their July 31 Fed Open Market Committee meeting.  Second quarter earnings reports will also help determine second half performance.  It is interesting to note that strong earnings growth in 2018 and 2019 has helped keep the market valuation at moderate levels.  The current 16.7 forward Price/Earnings valuation is in line with the 16.6 average PE for low inflation (range of 0-2%) time periods since 1950.

Beyond Meat-BYND was a notable IPO.  The company sells plant-based burgers and is up over 360% since its May 2 opening price.  This is an interesting business model, but it also shows a fair amount of investor euphoria.

 

The Russell 2000 Small Cap Index is nowhere near the 2018 highs but it is still up 17% YTD.  The small caps haven’t rebounded like US large caps.  On a longer-term five-year basis, small cap stocks have trailed the large cap S&P 500 by nearly 4% annualized.  This under-performance is likely to be reversed in the future.

 

Trade and central bank monetary policy continue to be critical to the outlook for global stocks. A comprehensive trade deal between the U.S. and China is unlikely in the near-term, notwithstanding the June 29 “truce” between Presidents Trump and Xi Jinping. The hope is that there will be a resumption of serious negotiations between the two sides.  The European Central Bank recently indicated that the ECB will consider monetary easing.  In the UK, economic growth continues to lag due to Brexit uncertainty.  For example, the June Manufacturing Purchasing Managers Index came in at 48.0, down from 49.4 in May.  This is the lowest level since February 2013.

 

Emerging markets led all major markets in 2017 with a 37.3% gain but they fell 14.6% in 2018.  Emerging markets are up a respectable 10.6% so far in 2019.  Emerging markets are very cheap and will be a big beneficiary as the US reduces interest rates.

 

The 10-year US Treasury interest rate closed at 2.00% on 6/30/19.  Interest rates for longer maturity bonds have been relatively volatile in recent years.  For example, the 10-year US Treasury recorded an all-time low of 1.36% on July 8, 2016.  Then it moved up to a 3.23% closing yield on October 8, 2018.  Since then, the 10-year interest rate has trended downward again.  Although longer-maturity interest rates may move up modestly, muted expectations for economic growth means that the phrase “lower for longer” looks appropriate.

The strong high-yield bond performance, so-called junk bonds, is largely the result of less fears of an imminent recession and the corresponding bond defaults.

 

What To Do Now:

It is nearly impossible to consistently call short-term market moves, regardless of whether you are a big-money institutional investor, a CNBC talking head, or an individual investor.  It is more important to ignore the daily “Breaking News” and maintain your focus on your long-term Investment Objectives.

The large market moves, however, do require the disciplined practice of rebalancing your portfolio.  With US stocks leading the market, it is an opportune time to take your US equity holdings down to 70% of total equity holdings.  US large cap stocks in particular should be rebalanced into foreign developed and emerging markets.  Your overall equity weight is also likely above your investment objective and this necessitates moving holdings into fixed income and cash.

The current market strength provides an excellent time to make charitable stock gifts.  If you are retired, this is also a great time to refill your cash bucket.

This is clearly not a time to abandon your Investment Objective.  If you have an investment adviser, then find out your portfolios’s asset allocation compared to your Investment Objective.  If you don’t have an adviser, then you need to determine your current asset allocation. See DIY  Regardless, you need to prune any high-cost funds in favor of low-cost index mutual funds and ETFs.

Remember, high market levels promote euphoria, or at least complacency and these higher levels usually have more downside risk than negative markets.

Jeff Johnson, CFA

July 13, 2019

 

 

Educational Investment Seminar-Take Aways

This past March I held an educational investment seminar based on my career experience as an institutional and high net worth investor. The seminar content was also based on my Cornerstone Investments website. Since I am retired, this was simply a labor of love to provide investment and financial planning guidance and recommendations. There was no revenue to me and there was no effort to get business or clients, but rather an effort to provide independent and objective advice. Although the bulk of the seminar content covered typical investment and financial planning items, I also included sections on charitable giving and impact investing from a Christian perspective.   CornerstoneInvestmentsLLC

See Topic Content Here.

(The content is also listed further down this post.)

This was not a typical investment seminar with a fancy “gourmet” dinner and a pitch for an annuity or a stock strategy guaranteed to make you rich. Instead of a typical 2-hour dinner/presentation with a maximum of 6 Powerpoint slides, we started on a Friday evening and then continued Saturday morning. The seminar included a 77-page course book, and I tried hard to get through as many slides as possible. Not really. Actually, the plan was to cover items in the book that had broad interest. Ultimately, we covered about half of the content of the book. The seminar was held at my home church (Peace Church, 2180 Glory Drive, Eagan MN.) Attendance included 16 individuals with ages ranging from the 40s to 80. Most attenders were from Peace but there were several others as well. This proved to be a good-sized group that allowed time for discussion during the formal presentation and for additional comments during breaks.

Although there was no revenue to me, there was a recommendation to make a charitable contribution to the Peace Church General Fund. It felt good that the event generated $840 for the General Fund. “Professional” was a key seminar objective. My wife, Carol, has an IT background and she designed the professional marketing materials and formatted the course book for the seminar. She also played funny and engaging YouTube videos to provide light moments after complicated topics. Although there was no fancy dinner, there was plenty of good healthy food and ample leftovers that went to our Lao congregation for their Sunday morning lunch.

Although a broad group like this had different levels of interest and knowledge, we primarily focused on topics of common interest. Nevertheless, some topics that were covered had an interest level ranging from “High” to “Extremely Low.” For example, stock valuation elicited a range of reactions from enthusiastic to “when is he going to end?”

It was certainly a busy Friday night and Saturday morning. The Q&A portions were particularly beneficial as participants and I shared experiences and perspectives. Feedback showed a need for less jargon and more definitions. Another comment related to action steps on how to get started investing with the first $5,000. Some thought topics were covered too quickly, but there was a broad consensus that the content was applicable to real-world situations. I was told that I needed more of Carol’s funny YouTube videos, but I was not told what to cut out. Referrals were also provided for estate planning and a couple local advisers. Unsurprisingly, Pastor Tim and the Deacons welcomed the unbudgeted additional funds! On an overall basis, the evaluation responses were very positive and there were numerous requests for additional course books that necessitated a second printing. The word-of-mouth channel generated multiple requests to do it again. The feedback was constructive and it should be helpful as I consider a seminar targeted at millennials.

Highlights of Topics with the Most Interest:

Advisers/Brokers, Robo-Adivsors, Do-It-Yourself and Fiduciary:
This part of the seminar generated the most interest and discussion. Although many people might prefer a root canal to dealing with investment and financial planning items, there was a clear understanding of the need for a rational approach to retirement, education and other priorities. Most individuals would not attempt brain surgery on themselves, and they take their car to a local professional for overall maintenance, but they still remain uncertain about investment services. Here are a few key points:

The Do-It-Yourself (DIY) approach, sometimes called Self-Directed, is possible with a disciplined approach but it is not recommended for most individuals. Do It Yourself

-I think that most individuals need a trusted adviser that is a fiduciary. This service can be provided through either the traditional Registered Investment Advisor-RIA model or the robo-advisory services model.  See Outside Advisors

-I believe the new Robo-Advisory services that include access to an adviser are services that provide the right solution for many, and I also believe that these services will become increasingly popular and effective. See Robo Advisors

-Some brokers provide good service, but there is reason for caution for brokers due to potential conflicts using the commission-based model. See Brokers

Indexing:
Indexing is a an increasingly common and effective investment strategy. Indexing essentially uses low-cost index funds and it is generally best for most investors, whether large or small. Indexing is characterized as a passive form of investing that seeks to replicate all the stocks and their weights in an index like the S&P 500 index without attempting to pick outperforming stocks. Passive indexes stand in contrast to Active Investing. Active investing involves mutual fund portfolio managers who pick individual stocks with the expectation of generating a higher return than their benchmark or index. Most studies conclude that a passive index strategy generates higher returns than active strategy. See Active & Passive Investing.

Rebalancing:
Rebalancing a portfolio is necessary to keep the investment holdings in your portfolio at the appropriate weights. Since the various investment holdings within the portfolio generate different percentage returns over time in volatile markets, the overall portfolio increasingly deviates from your overall investment objective. As the portfolio gets increasingly skewed away from your investment objective, the portfolio is ncreasingly likely to generate lower returns and higher risk. Link in Terms. See Rebalancing

Financial Planning Accumulation Phase:
Analysis from Fidelity and JP Morgan show investment guidelines and mileposts for individuals at different ages and investment levels. For example, the analysis provides guidelines for investment levels for a 40 year-old seeking a specified portfolio level at retirement. See Asset Accumulation/Retirement MilePosts

The 4% Rule of Thumb for Retirement:
The 4% rule for retirement withdrawals is widely cited within the financial press and the financial planning community/industry. Although every situation is different, the 4% rule is a good starting point. However, I believe that a 4% withdrawal rate is too high due to current low fixed income interest rates and higher equity valuation levels. As a result, a 3.5% withdrawal rate offers more long-term security.

Social Security Claiming Break-Evens:
The Social Security section covered different social security claiming strategies based on analysis from Morningstar. Examples showed breakeven age levels for claiming social security at age 62 and at age 70. See Social Security into Website.  See Social Security

Charitable Contributions:
A primary objective of my Cornerstone Investments website is to bring a Christian perspective into the investment process. As a result, charitable contributions and stewardship are key factors. Items covered in the seminar focused on the benefits of giving to the local church, local missions and international missions. A key point of the seminar focused on economic studies showing the benefits of early-childhood education. Economic analysis also showed child sponsorship in foreign countries as having the biggest bang for the buck. Finally, websites were listed that rated charities based on their effectiveness, administrative costs, etc. Charitable Contributions

Values-Based Investing:
Values-based investing became prominent in the U.S. in the 1980s as Socially Responsible Investing sought to restrict investments related to the anti-apartheid movement in South Africa. In addition, Faith-Based investing developed based on religious convictions and the strategy generally avoids sin-stocks centered around alcohol, pornography, tobacco and gambling. Abortion, weapons and nuclear power are other common screens. Many faith-based investments also consider workplace issues and environmental factors.

Environmental, Social and Governance Investing-ESG is becoming increasingly common. ESG includes:
-Environmental-Climate change, emissions and waste, and resource efficiency.
-Social-Diversity, human capital & safety, product integrity and supply chain management, and community relations.
-Governance-Board & executive diversity, corporate structure, accounting & transparency, executive compensation.

Various mutual funds and ETFs were included in the analysis. The Vanguard ESG US Stock-ESGV, is a Cornerstone recommendation and a personal holding for Carol and I.  See Values-Based

Other Topics:
Other topics covered are listed in the Cornerstone website including Investment Objectives, Budgeting, Annuities, Fees & Expenses, Historic Investment Returns by Decade back to the 1920s, Expected Future Investment Returns, Stock Valuation and Markets & Economics. These topics are included in the CIA website.

Final Comments:
This seminar was an effort to Major on the Majors and to provide independent and objective investment advice. The Cornerstone website has even more content. Moreover, there are many professionals who can provide services for complicated and unique needs and objectives. Needless to say, I hope that this blog post and the links are beneficial for readers. Comments to this blog are always appreciated and helpful. At this point, I am considering a seminar targeted for millennials. And who knows, maybe the presentation will be updated and presented at Peace Church again.

Jeff Johnson, CFA
May 22, 2019

A Wild Year, A Great Decade and a Market/Economic Disconnect

A Wild Year:

The year started optimistically with an expectation of continued synchronized global growth, benefits of U.S. tax cuts, and a forecast for 20% earnings growth.  Based on these optimistic assumptions, the markets shot up to an all-time high in January, then plunged in February, then set a new all-time high record in September, then cratered by Christmas Eve and then finished with a modest, belated year-end Santa Claus rally.  The year looked schizophrenic and December was the worst December since 1931.  The wild seesaw swings makes one wonder if the so-called investment pros have convictions that last longer than 10 minutes.  Through it all, it is hard to believe that the S&P 500 total return was only down -4.38%.

 

Major Benchmark Performance: Last
December Year-To-Date 10 Years
US Large Cap-S&P 500 -9.03% -4.38% 13.12%
US Small Cap-Russell 2000 -11.88% -11.01% 11.97%
Foreign Developed-MSCI EAFE -4.85% -13.79% 6.32%
Foreign Emerging Mkts-MSCI EEM -2.66% -14.58% 8.02%
US Bonds-Barclays Aggregate 1.84% 0.01% 3.48%
Long Treasury-20 Yr+ US Treasury Bonds 5.62% -1.98% 3.37%
High Yield-BA Merrill Lynch HiYld Bonds -2.19% -2.26% 10.99%
12/31/2018

Some Notable Highlights/Lowlights:

First, the FAANGs were De-Fanged.  Facebook, Apple, Amazon, Netflix and Google (the FAANGs) were darlings for many years.  Apple’s market value briefly exceeded $1 Trillion, but it took a tumble when iPhone sales and pricing didn’t match lofty expectations.  Facebook took the biggest slide (down over 39%) as the company faced slowing growth and increasing security/data privacy issues.

The “crypto craze” also imploded as BitCoin fell 80% from over 19,000 last December to 3,747 by year-end 2018.

Ultimately, most asset classes declined and there was nowhere to hide.  As interest rates rose and stocks declined, the decade-long stock mantra “There Is No Alternative”-TINA lost its luster.  By the end of the year, the cash is trash crowd was de-throned, and the cash is king stalwarts were rewarded.  Market psychology turned sour and the “buy the dips” trade was replaced by “sell the rallies.”

The Best & Worst Sectors:

U.S. economic growth exceeded expectations and resulted in the best growth rate in over a decade, but only two sectors were able to achieve positive performance:

-Health care was up 4.6% and utilities were up 0.5%.

Meanwhile the biggest losers were:

-Home builders which were down -35% as rising mortgage rates crimped housing sales.

-Energy fell -20.6% as crude oil fell -26% to $45/barrel by yearend.

The Best and Worst Regions:

Although most international markets were down, Brazil was a surprise winner with a 15.0% gain.  This was based on the election of President Jair Bolsonaro and the prospect of a more business-friendly environment.

The Chinese Shanghai Composite was the biggest loser at -24.6% due to the looming trade restrictions and a slowing economy.  Germany’s DAX was down -18.3% as tariffs hurt their automakers and other global exports.  Finally, Brexitmania uncertainty caused the UK FTSE 100 to drop by -12.5%

A GREAT DECADE:

Despite the December 2018 carnage, the current decade proved to be very respectable.  This is especially true when we think back to the intra-day low of 666 (yes, 666) in March 2009.  In reality, 2018 was the only negative year in the last decade for the S&P 500.  Moreover, the 10-year return was an above-average 13.12%.

 

A MARKET/ECONOMIC DISCONNECT:

The sharp December market decline was largely precipitated by a fear that the Federal Reserve was raising interest rates too quickly, and by a fear of an imminent recession.  A trade war with China was another wild card that could make any recession even worse.  The rise of algorithmic trading also exacerbated the downside volatility.  According to the Wall Street Journal, roughly 85% of all trades are now completed based on algorithms, quantitative models and passive trading.  These trades are on autopilot and they essentially sell more when markets are going down and buy more when markets are going up.  This amplifies both downside and upside market moves.  Historically, markets traded more on fundamentals of the economy and individual companies.  Finally, the lower stock prices caused a wave of tax-loss selling.

Meanwhile, economic data and corporate earnings reports were far stronger than what was happening with the markets.

-The economy is on track to grow at a 3% rate this year, the highest growth rate since before the Great Recession.

-Corporate earnings are on track to grow by a hefty 20% for 2018.

-Employment is at the highest level since the 1960s.

-Consumer spending is strong, and MasterCard just reported U.S. retail sales surged this holiday season (Nov. 1 through Dec. 24), rising 5.1% from last year’s level and the strongest growth rate in six years.

-Market valuations have become cheap.  Although stock market valuation levels were elevated at the beginning of the year, the combination of unexpectedly strong earnings and lower prices means that valuation levels are cheaper than average historic levels.

Looking to 2019, there are signs that growth rates are moderating:

-Europe and China are clearly experiencing economic growth rates that are slowing.

-Although 2018 corporate earnings came in at a blistering pace of 20 percent, earnings for 2019 are still projected to be a respectable 7.9% according to FactSet.

-GDP growth, meanwhile, likely will fall from its 3 percent pace this year, but most economists are still looking at gains in the mid-2 percent range for the year ahead.  If this growth rate turns out to be correct, then it would be the second strongest GDP growth in the past decade, after only 2018!

It is noteworthy that economic data and forecasts can be wrong, and a downside scenario is clearly possible.  Further, the talk of recession could be a self-fulfilling prophecy.  When the drumbeat of negative commentary becomes excessive, it impacts consumer and business confidence.

Finally, it needs to be said that Corrections (down between 10 and 20% from the previous high) and Bear Markets (Down more than 20% from the previous high) are normal.  The post-war period saw 31 corrections and 11 bear markets.  the average decline from the peak to the bottom has been 18.7%.  Within that context, the 2018 market decline was typical of the risk inherent in the overall stock market.

WHAT TO DO NOW:

No one knows for sure how the market will perform for 2019.  There are too many variables and too many unknowns to make precise forecasts.  Nevertheless, market/economic fundamentals and history provide guidance:

-History shows that large downdrafts like we saw in the 4th quarter are likely to be followed by above-average performance in subsequent 1, 3 and 5 year time periods.

-Current valuation levels are modestly below long-term averages, and these cheaper valuation levels are usually followed by periods of stronger performance.

-Although it is never easy, it is helpful to remember the sage advice from Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful.”

So, don’t be a seller at these levels.  Do not abandon your long-term strategy based on these short-term price moves and headlines.  Rebalance your portfolio so that you maintain target weights for the various asset classes.  Finally, remember that the long-term averages were filled with numerous unforeseen declines and gains.

Jeff Johnson, CFA

January 3, 2019