Eye of the Storm
An Important note from Jaco Jordaan, CFP®, CFA, CRPS®, ChFC®, CAIA, EA, Opus Financial Solutions LLC
A little over a month ago, market indices were sitting at all-time highs, economic forecasts called for continued growth in the U.S. and global economy, the consumer was financially strong, and unemployment was near all-time lows. As the Coronavirus has taken hold outside of China, the world has responded by idling non-essential businesses and industries, and the global economic picture has turned bleak.
Taking stock of where we are today, markets have rebounded somewhat on the basis of governments globally coming to the rescue. The S&P 500 is off about 19% on a year-to-date basis after a surprising rally today, having recovered from a decline which had reached about 32%.[i] The rebound is based, in part, on expectations that here, in the U.S., Congress will pass a stimulus bill which will amount to a little more than $2 trillion in support for the newly unemployed and businesses. At the same time, the Federal Reserve has been aggressive in providing policy responses to allow bond and securitized markets to continue to operate. They seem to have learned at least some lessons from the depths of the 08-09 financial crisis.
The jubilance may be somewhat premature. There is still so much uncertainty with respect to the duration of continued stay at home and social distancing orders, and so much uncertainty around the rate of infection and whether the draconian measures being taken will prove effective to flatten the curve and to allow the economy to reopen sooner rather than later.
My view is that perhaps we are now in the eye of the storm. We’re through the first phase of the storm and everyone is adjusting to a new life where we’re suspicious of a sniffling neighbor and nervous about our food supplies, but we’ve all sort of collectively decided that this is our new normal, to be taken one day at a time. There’s also clearly some optimism that our government is doing something - despite some early missteps.
Nowhere does this seem more apparent than in today’s trading. On a day where the number of new unemployment filings came in at roughly 3.2 million, more than four times higher than the previous worst day for new filings, the S&P 500 closed up more than 6% on the optimism of government support.
The eye of the storm is generally calm, but the backside of the storm approaches. The second phase of the storm will bring more negative data as we evaluate how deep a recession will emerge and how quickly we may rebound. Most economic data is unfortunately lagged. We know the data is going to be bad, we just don’t know how bad. On this point estimates vary widely, but the base case seems to be a 20-30% annualized decline in GDP for the second quarter, with a similar and swift rebound through the third quarter (note that a decline of 20% and a rebound of 20% does not get you back to even).
These modeled scenarios by various financial institutions have evolved significantly over the last several weeks. Where expectations initially called for the U.S. to avoid a recession or to only experience a shallow recession, as businesses were idled and the expected duration has stretched, point estimates declined rapidly. If the virus continues to spread at an exponential rate, and if the health system shows signs of being overwhelmed, the duration of a closed economy likely continues to extend and stocks likely will resume a down leg.
There have been various prognostications from investment strategists, with some suggesting the draw-down provides a good opportunity to buy and others suggesting there may be more downside ahead. This reflects the reality of the duality we’re facing – if our social distancing works to flatten the curve, if a few of the hundreds of drugs being tested prove effective, if the arrival of warmer temperatures ends up reducing cases, markets likely respond positively and yes, under that scenario, current market valuations likely provide a buying opportunity. However, if our social distancing proves ineffective and we must idle the economy for longer, stocks may yet prove to be overvalued. On balance, in the absence of near-term progress against the virus, it seems the uncertainty currently outweighs the opportunity.
What Should Investors Do?
Stock investments are intended to be held for long periods of time. The time horizon is necessary to make it through periods of volatility. Over 10 years, 20 years, and more, companies adapt to challenges and figure out how to make money. According to Vanguard, since 1980 and prior to the current downturn, we’ve experienced 11 corrections (10%+ losses) and 8 bear markets (20%+ losses). Through the middle of February, we had recovered from every one of these declines. However, a recovery can take some time to allow the event to pass and for markets to rebuild. For this reason, most investors should remain diversified so that there is a component of the portfolio which is more stable than stocks. Furthermore, investors should have 6-12 months of cash on hand to limit the need to draw on a portfolio during a downturn.
As I’ve written previously, staying the course and maintaining a strategy does not mean failing to take any action. For example, upgrading the fixed income side of the portfolio to increase credit quality can make sense to hedge against increasing default risk in lower grade corporate bonds. Utilizing securities which have shown some ability to have more limited drawdowns than the market also could improve outcomes. This could include focusing on lower volatility stocks, stocks with higher quality balance sheets, and those which might show stronger relative profitability. To be sure, these latter categories may still be volatile, but they could help to produce better outcomes.
Beyond portfolio allocation, there are actions which can be taken from a planning perspective. For example, revisiting the living expense budget and making cuts in discretionary expenses can help to limit the draw on a portfolio (some of these cuts likely are already happening as we can’t go to restaurants or the local watering hole). For some investors, the drawdown may also present an opportunity to take advantage of ROTH conversions or for tax efficient rebalancing of a portfolio which previously may have had too much in gain to take action. And finally, we are learning more about potential opportunities being offered by the government, such as eliminating the requirement for mandatory distributions for 2020, or the ability to take hardship withdrawals from retirement plans. Where appropriate, we will reach out if there is a relevant strategy created by government response.
If you have any questions regarding the information above, please reach out.
Jaco Jordaan, CFP®, CFA, CRPS®, ChFC®, CAIA, EA
Wealth Manager, Opus Financial Solutions LLC
[i] Yahoo!Finance after market close on 3/26/2020