The Fed vs Mother Nature
As we entered 2020 market pundits proclaimed that the US economy was strong and firing on all cylinders. In fact, the headline of the Barron’s (a popular investment magazine) January 13th “Roundtable” edition was “2020 Roundtable: Almost No Chance of Recession.” Statements like these don’t cause markets to collapse. But it is virtually impossible to have a major (30%+) market collapse without this sort of extreme optimism and complacency.
Only 3 months later, we find ourselves in the most incredible of economic predicaments. The risk that COVID-19 may overwhelm the healthcare system has forced governments all around the world to put their economies into a medically induced coma. The Fed is desperately trying to keep the patient in stable condition with massive amounts of monetary narcotics.
It is quite literally the Fed vs Mother Nature. Normally, we would bet on the Fed in a situation like this. With the ability to change the supply of money, interest rates and regulations on the economy, the Fed can change the way we perceive the economy and risk. However, the lockdown is forcing us all to suspend the vast majority of the very economic activity that the Fed normally hopes to induce with its tools.
The potential damage would be manageable in an economy with low debt levels and short, resilient, supply chains. However, Mother Nature is forcing us to confront the reality that the US economy is woefully unprepared to confront hardship. After 10 years of the Fed manipulating prices and perceived risk in order to prevent recessions, US corporations grew accustomed to the good life. In what seemed to be an ultra-low-risk world the choices to increase corporate debt levels to all-time highs and pursue ever cheaper, but ever more complex, supply chains were hard to resist. Managers with the will to resist such temptations were passed over or thrown out in favor of those who would take more risk on behalf of investors. But those decisions look painfully short-sighted now. Truly strong businesses and economies are resilient to unexpected shocks. We are certain that US corporations are already are on their way to becoming much more resilient. The process will not be painless, but we will be a better country for it. We hope the Fed and our other leaders in government are ready to work toward building a more resilient economy too. If not, then Mother Nature may still have more to teach us about assessing risk and the value of resilience. In the meantime, rest assured that we will continue to respect the risks in asset prices and that all the portfolios we manage are prepared to be resilient through this challenge.
- The Quarter in Review
- Sentiment & Value Update
- Dealing with Volatility
- The Recovery Alphabet
Relevant Index Performance
Total Returns as of 3/31/20
Sentiment & Value
The chart above shows our opinion on where various markets are as of March 31st, 2020. Many of the best purchase decisions are made when prices are cheap and sentiment is bearish or depressed (bottom left quadrant). Conversely, many of the best sell decisions are made when prices are expensive and sentiment is bullish or euphoric (top right quadrant). This chart and the comments below are intended as a behavioral guide, not as a timing tool.
Markets are struggling to keep up with the pace of change as both stimulus efforts and economic destruction proceed at warp speed. As of this writing, the Fed just announced an additional $2.3 trillion of support for markets. Notably, this support involves buying corporate bonds, including some below investment grade bonds. While this plan reduces the near-term risks to investing in US stocks, in the long-term it raises many important questions.
Will the inevitable losses be paid for with higher corporate tax rates? Or, will the US government simply cancel these unpayable loans? Higher tax rates or higher inflation rates both seem like real possibilities and both suggest that stocks will not be valued as richly in the future.
What about international economies? Many businesses have customers and suppliers all around the world. If bailouts are not available in other parts of the world, how will these economies recover?
Despite all the uncertainty, we continue to have our stock “buying hats” on and will continue adding to US stocks below 2,600 on the S&P 500.
Dealing with Volatility
The chart above details one of the most volatile periods in history for government bonds, typically considered a “safer” investment than stocks. From 1980 through 1987 long-term government bonds experienced massive price swings as the market struggled to figure out if inflation was likely to continue rising or finally subside. Swings of 30%+ whipsawed investors mercilessly. At first glance, point “D” looks like an absolutely terrible time to buy a 10-year treasury. However, investors who simply held on for the full 10 years experienced an annual return of 10.22% per year. Despite terrible timing, it was still a pretty good investment!
Massive volatility like we experienced in March, and as depicted in the chart above, happen when markets have no idea how to price assets. Huge opportunities emerge during these episodes, but they can be difficult to hang on to when markets violently turn against those opportunities. Here are some guidelines that help us keep our heads, they may help you too.
- The mistakes you DON’T make are just as important as the mistakes you do make. Count your blessings, it can always be worse! Imagine buying into the weakness in early March!
- Maintain optionality, stay diversified, cash is king. Eventually volatility can make any trade look foolish. Every “mistake” you make is a new buying opportunity somewhere.
- As long as you maintain optionality, time is on your side. Just like point “D” above, well thought out, but TERRIBLY timed trades can turn out to be winners in the fullness of time.
- Make sure your plan suits your needs & risk tolerance, then stick to it at all costs. The worst mistakes are made when you capitulate and change the plan. We resisted many requests from clients to ratchet up risk exposure in the past 2 years. Sticking to the plan works.
Issue: The US government is rolling out a series of “bailout” packages in order to dampen the economic impact of lockdown. These programs are truly massive in size with the first wave of support totaling $2 trillion. At least two more waves of similar size are anticipated.
Impact: Theses bailout packages will help support many households and small businesses. Investors are racing to position themselves to cash in on bailout support too.
FC Advisors’ Take: There is no question that a massive amount of support is necessary to keep households and small businesses solvent. We support expanding unemployment benefits and even more direct aid to households.
However, our feelings about bailing out large corporations with access to public debt and equity markets are different. The rules of the risk game in public markets are well understood. The equity capital (stock) of a company is supposed to bare the first risk of loss if the business falls on hard times. The US bankruptcy process is incredibly effective at maintaining productive assets and preserving productive jobs. Moreover, it also very effectively assigns losses to parties that accepted risks and may have benefited from poor decisions in the past.
At the moment, investors are racing to get in front of bailout money, causing massive rallies in some of the weakest and most hopeless businesses. In the fullness of time, we expect bailout recipients to be forced to pay a penalty for their excesses and/or submit to strict new regulations on their businesses. This trade may work out for quick buck artists, but we will continue to avoid these parts of the market.
We continue to avoid airlines, hotels, cruise operators and over-leveraged businesses in general.
The Recovery Alphabet
Market pundits often describe recoveries for both the economy and the stock market as being shaped like certain letters. Here’s what they are talking about with our sense of their probabilities assigned and our take on things.
We have no doubt that the combined effort of the world will find a way to overcome the scourge of COVID-19. While our outlook for the recovery may not be the most optimistic, we do think that it is realistic. Challenging economic times will continue to present opportunities to prudent investors who are diversified and have cash to deploy. Stay healthy and safe!
If you have questions about these topics or any other financial needs, please contact
FC Advisors at:
Following Claire Advisors, LLC DBA FC Advisors is a Registered Investment Adviser. This brochure is solely for informational purposes and is not intended to provide investment advice. Advisory services are only offered to clients or prospective clients where FC Advisors and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by FC Advisors unless a client service agreement is in place.