Just ten weeks ago, investors were coming off one of the best years in a decade for a broad swath of financial assets. The S&P 500 rose by 31.5% and bonds, as measured by the Bloomberg Barclays U.S. Aggregate Index, increased by a dramatic 8.7%. Almost everything good that could happen for investors did happen. What a difference a couple of months makes. With each passing week, markets now seem to be confronted with yet another unexpected piece of news or negative turn of events. The list over the last three weeks alone would be enough to fill an entire year:
- The rapid spread of COVID-19 outside of China not only led to volatility in stock and bond markets, the likes of which we have not seen since the Global Financial Crisis, it has also severely disrupted daily life and travel plans for many around the globe.
- The tenor of the U.S. presidential election shifted substantially as a more moderate candidate emerged to challenge progressive frontrunners at the same time the economic outlook darkens.
- Instead of bolstering confidence, an unexpected emergency interest rate cut from the Federal Reserve confirmed investor concerns of an underlying shift in corporate and economic fundamentals and signaled a potential return to zero interest rate policy.
- Over this past weekend, an alliance of oil producing countries known as OPEC+ fractured, leading oil prices to decline almost 25% in a single day and causing significant declines in the prices of stocks and bonds issued by many well-known energy companies.
Collectively, these events have had a significant impact on the equity positions within investor portfolios and driven long-term interest rates to record lows in the U.S. Uncertainty and worry have turned the market upside down in short order. The speed of the transition suggests the market has gone from pricing assets as if nothing negative would ever happen again to pricing them as if the worst possible outcome is now unavoidable. As risk gets re-priced and sentiment turns negative, government bonds are trading at levels more consistent with a recession environment and stocks are trading slightly above levels that would mark the first official bear market in over 12 years.
It’s important to remember that RGT has been in business for 35 years and has the requisite experience to manage through market disruptions such as this. While each disruption is different, experience is valuable when navigating turbulent market environments.
RGT is preparing for a longer grind than many market pundits are indicating today and one with more frequent bouts of volatility. A technical recession, defined as two quarters of negative GDP growth, or even something more protracted are real possibilities. While we view many of today’s events such as COVID-19 as transitory, economic damage has been inflicted. Corporate investment is slowing, and consumer spending is shifting while risk aversion increases. While the ultimate length of time required for markets to find a bottom, and the ultimate level of that market bottom is unknowable, there are a few silver linings in play.
RGT client portfolios came into this environment balanced and well-positioned. Not only have bonds helped mitigate losses and reduce volatility during this market turmoil, high-quality bonds have performed very well. Our investment philosophy is guided by thoughtful asset allocation and diversification, two pillars that we have stood by when many abandoned them during this period of low interest rates and an uninterrupted bull market. Consequently, we have what we believe is a solid foundation from which we can manage portfolios through this environment as there are no dramatic, rash decisions to be made. Like sailing through choppy waters, marginal adjustments are much better (and easier to make) than wholesale portfolio changes.
We utilize a platform of experienced investment managers continuously focused on improving their portfolio’s risk and return profile. We regularly speak with these managers and are currently deep in the process of speaking to them about the present landscape. These conversations, which are already bearing fruit and informing our views, have reminded us of the value our managers bring in helping us make more informed, marginal changes to portfolios during volatile periods. We believe utilizing managers as a resource to stay current on how the economy and specific companies are performing is an advantage. We loathe the thought of having to look at a portfolio made up entirely of ETFs, quantitative strategies, and index funds that don’t say a word, and make no changes to their portfolios, when times are tough.
Given the significant performance differential over the last month between bonds and stocks, we are now actively looking for rebalancing opportunities between asset classes and other strategies where performance has diverged. We expect a series of smaller changes to be made over the course of months, not days. While this process can be tedious and is often dependent on individual client or family circumstances, it is a disciplined and unemotional act of strategically working to buy low and sell high. Rebalancing also allows us the opportunity to reset portfolio exposures back to longer-term targets.
Finally, it is worth noting that as riskier assets, such as stocks, decline in value they inherently become cheaper. This ultimately improves future returns, perhaps dramatically if the decline is steep or growth ends up surprising to the upside. The ultimate length and depth of economic disruption is anyone’s guess, but stocks have improved return prospects on both an absolute basis and relative to bonds, especially as interest rates plumb record lows. An investor with a long-term time horizon and no need for immediate liquidity will thus be more appropriately compensated for owning risk assets going forward.
As markets continue to fluctuate, sometimes wildly and unpredictably, it is important to remind yourself that these types of environments often give rise to significant opportunities. Current losses aren’t permanent when markets decline despite how uncomfortable it can be along the way. Maintaining a disciplined and deliberate approach centered around a long-term strategic asset allocation increases the probability of participating more fully in higher-returning environments. Responding from a balanced position also makes it easier to identify and invest in compelling opportunities when they arise.
Please let your RGT advisor know if you would like to discuss these ideas.
“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” U.S. Secretary of Defense Donald Rumsfeld, February 12, 2002.
We began the year 126 months into the longest economic expansion in U.S. history. On February 19, 2020 the S&P 500 closed at an all-time high of 3,386.15 (as a point of comparison, the S&P 500 reached its nadir following the Great Financial Crisis on March 9, 2009 at a closing level of 676.53). Most market concerns at the beginning of 2020 centered around volatility due to contentious U.S. elections, continued tensions around trade, somewhat stretched valuations for financial assets, and the simple fact that the expansion, and the bull market, were getting somewhat long in the tooth.
Typically, though, it’s not the things that the market worries about, the “known unknowns,” that bring about violent downturns in financial markets. A great example of a “known unknown” is the Y2K crisis. We were warned about Y2K years in advance. It received large amounts of media attention, but because it was known and years had been spent addressing the problem the impact of Y2K was negligible. Instead it’s the event that no one sees coming, the “unknown unknown,” that is potentially the most problematic for markets. The Coronavirus, now known as COVID-19, is a perfect example of the kind of shock that the “unknown unknown” can have on markets.
When an “unknown unknown” shock occurs markets often react in dramatic fashion. That’s because mar
kets are forward-looking, and they now must add a variable that they had heretofore not considered. But beyond that, the simplest explanation is that most humans fear the unknown. And fear has a way of creating quick and extreme reactions, which often turn into overreactions.
Financial markets are a perfect environment in which to see this sort of human behavior on display.
- Since the market close last Friday, February 21, the S&P 500 has dropped 11.4% through the close of trading on Friday, February 28. Foreign stocks, as represented by the MSCI-EAFE fell 6.7% over that same time frame.
- The last week has been the worst week in the U.S. stock market since the 2008 Financial Crisis.
- The 10-year Treasury is at all-time lows dropping from 1.46% on Friday, February 21 to 1.17% on Friday, February 28.
- Oil prices have fallen over $8/Bbl, or more than 15%, in a week’s time.
The last week has been a prime example of a reaction driven by the fear of the unknown. Let us stress as strongly as possible, almost everything about COVID-19 and its ultimate impact on financial markets is unknown. Another point worth noting is that reacting to unknown threats is not illogical. In fact, it’s an important human survival trait. However, it is not necessarily the best way to respond in your investment portfolio.
If indeed COVID-19 turns into a pandemic, it will not be the first pandemic of this sort with which markets have had to deal. The 2009 Swine Flu Pandemic (H1N1/09), which lasted from early 2009 to 2010, is the most recent example. Somewhere between 10 million to 200 million people are estimated to have contracted H1N1/09[i]. The exact number of deaths are not known, though one estimate puts the estimated number of deaths worldwide at somewhere between 105,700-395,600[ii].
Negative views make for great media fodder and feed into the market sell-off frenzy. But the latest news out of China, which has been the nation hardest hit by COVID-19, is beginning to seem more positive. While there will no doubt be an adverse impact on Chinese demand and output, it appears that the containment efforts by the Chinese government are starting to make an impact on the rate of transmission of the disease, which should be encouraging. Nonetheless, there is no visibility into the duration of the health crisis or to what extent this disease will ultimately spread.
What can we learn from history?
- These types of events are transitory. The key question becomes how the event lasts.
- Currently investors view the risks as to the downside, thus the violent sell-off of stocks and other “risky” assets and the rise in prices for U.S. Treasuries and other safe-haven assets. And as often happens, once markets begin to sell-off, pressure for other investors to sell rises.
- The long-term risks faced by investors are more about how the economy (and thus revenues and earnings) is impacted and for how long. If this follows the most recent global pandemics, then the economic impact should be temporary and it’s possible that markets rebound nearly as fast as they sold off.
Key Takeaways for Investors
- Right now, there is no visibility into the length of the health crisis. Thus, attempting to make a call on how this plays out from an economic and market perspective would be futile. Assuming the worst outcome is no more helpful than assuming the best outcome.
- Asset allocation is showing itself to be valuable during the latest market sell-off. Make sure your investment plan and asset allocation fit your circumstances. Well diversified portfolios are designed to lessen the impact of stock market losses, not to eliminate them entirely. The key is to be able to help mitigate your losses thereby easing your compulsion to feel the need to sell at market lows. If you can do this, you should you be better position to participate when markets recover.
- Cash for defense is just that, cash. But right now, you earn very little on cash. So, if you feel the need to get defensive in this way, you can’t concern yourself with return.
- Rebalancing and tax loss selling opportunities may present themselves. If you have a long-term outlook you should avail yourself of these opportunities, without an emphasis on trying to have perfect timing.
- Remember, you own stocks for a multi-year time horizon, not for what happens in a week, a month, or even a year. If you have cash to invest, market corrections like this can provide an opportunity to put it to work at lower valuations, thus potentially enhancing prospective long-term returns.
If you have any questions or concerns about these matters and how they impact your portfolio and your financial situation, please contact your RGT advisor.
[i] “Report of the Review Committee on the Functioning of the International Health Regulations (2005) in relation to Pandemic (H1N1) 2009” (PDF). 5 May 2011. Archived (PDF) from the original on 14 May 2015. Retrieved 1 March 2015.
[ii] Dawood FS, Iuliano AD, Reed C, et al. (September 2012). “Estimated global mortality associated with the first 12 months of 2009 pandemic influenza A H1N1 virus circulation: a modelling study”. The Lancet. Infectious Diseases. 12 (9): 687–95. doi:10.1016/S1473-3099(12)70121-4. PMID 22738893.
What just happened?
Since 1990 the S&P 500 has declined more than 10% in a calendar month on five occasions:
- December 2018 -10.1%
- February 2009 -10.6%
- October 2008 -16.8%
- September 2002 -10.9%
- August 1998 -16.8%
U.S. and many foreign stock markets declined over 14% in the 4th quarter – the most in a quarter since the financial crisis of 2008. Because of recent declines, valuations of equity indices are nearing their long-term historic averages. Some sectors of the U.S. stock market, such as technology and financial stocks, traded 25-30% lower at year-end than they did earlier in 2018.
Interest rates increased for most of the quarter. However, over the last few weeks of the year intermediate and long-term interest rates declined as concern mounted over the prospect of slowing U.S. and worldwide economic growth. Despite the volatility surrounding the level of interest rates in 2018, high quality fixed income securities and other capital preservation strategies provided a positive return during the fourth quarter. The 10-Year Treasury yield peaked at 3.2% on November 8th before declining to 2.7% on December 31st. On the other hand, short-term rates continued to rise, due to the Federal Reserve hiking rates another 25 basis points in mid-December. This action reinforces the reality that while the Federal Reserve exerts significant influence on short-term interest rates, it is the market that sets longer term rates.
Markets appear to be going through a transition from an extended period of zero interest rates, low inflation and readily available credit to an environment of higher interest rates and more difficult credit conditions. In addition, there is a growing concern that Federal Reserve policies (raising short-term interest rates and allowing U.S. treasury securities/agencies to mature, thus reversing previous quantitative easing) over the coming year may add to the current volatility and potentially hinder 2019 – 2020 economic growth. While short-term interest rates have risen, and credit conditions are tightening, inflation continues to be benign, with the consumer price index rising at an annual rate of 2.2% as of the end of November. Low levels of inflation, along with low and stable unemployment, registering 3.9% as of January 4th, do not currently support the fears of a weakening economy, nor does the strong December jobs report of over 300,000 new positions created during the month.
Geopolitical tensions and uncertainty continue to be a driver of market volatility. Midterm elections changed the political party in control of the U.S. House of Representatives, increasing policy uncertainty going into 2019. Across the Atlantic, no viable path to ease Great Britain’s exit from the European Union, known as BREXIT, exists despite a deadline in less than three months. Additionally, tariffs and harsh trade rhetoric, specifically between the U.S. and China, escalated late into the end of the year, and are still unresolved. During what is typically a holiday-induced calm, these uncertainties played out in the markets, with significant year-end tax loss selling further pressuring equity prices.
How does the environment of 4th quarter 2018 compare to the environment of previously volatile periods?
The current level of stock market volatility, while difficult to stomach, is not that unusual. The extremely low levels of volatility seen in 2017 and other recent years are more the exception than the norm. The last time the stock market experienced this level of decline in such a short period of time occurred during the financial crisis of 2008 and, prior to that, in 2000 – 2002 following the bursting of the technology bubble market speculation.
While it may be tempting to draw parallels between the recent market sell-off and other prior sharp market declines, there are some significant differences in the circumstances surrounding each of these events:
- In 1999, the technology and internet bubble led to widespread overvaluation of companies with little, or even zero, revenue, much less profits. The entire sector was overvalued and driving the performance of the broader index. Today, the group of stocks driving the market are companies with substantial revenues, significant cash flows, healthy earnings and dominant market shares. While their valuations may be stretched, they are very different from the numerous dot.com companies and failed internet stocks that precipitated the bursting of the technology bubble.
- In 2007-2009, the financial system was extremely fragile which does not appear to be the case today. Banks and other large financial institutions are much better capitalized and the issues that led to the financial crisis do not appear to be as much of a current problem. Most analysts don’t believe a similar crisis is likely now because the financial and banking system appear to be on much firmer footing.
There are a few areas in today’s environment that are worth noting, despite the fact that some conditions that preceded previous bear markets, as mentioned above, do not appear as concerning today:
- High levels of debt on corporate balance sheets, particularly debt used for share buybacks as opposed to debt borrowed for investment and growth, may be a cause for concern in the event of a significant economic slowdown.
- Private market and asset valuations are now stretched as capital has poured into venture capital, real estate, and leveraged buy outs. In addition to elevated valuations, many of these companies/investments also carry significant amounts of debt.
- Debt levels on government balance sheets are higher than ever before. In a rising interest rate environment, this can lead to significant debt servicing costs, hampering government spending and leading to greater geopolitical uncertainty. This problem is not unique to the U.S. and has the potential to be a widespread problem.
Has the recent market volatility created opportunities for long-term investors?
In prior time periods, volatility has often provided opportunity for investors. After December’s selloff equities are trading closer to more normal historical market valuations. Some sectors, such as energy, technology, financials, and consumer staples, are becoming relatively more attractive. For investors adding to their portfolios, the entry point during this period seems to be more attractive from a valuation perspective than it has been in several years. While not all equity sectors are trading at attractive levels, some areas of interest are developing.
Investors not currently adding to or systematically withdrawing from their portfolio can rebalance and effectively take advantage of volatility while maintaining their asset allocation. And as stated, tax loss selling is an important strategy for investors in volatile markets and may contribute to the overall long-term after-tax portfolio return.
A lingering concern in the market revolves around predicting the next recession; however, US economic growth is currently running over 3% with other large economic powers such as China experiencing 6%+ annual growth rates. Given inflation levels are stable in the 2-3% annual range, the need for further interest rate hikes is diminishing.
Unemployment in the U.S. remains under 4%, a level which encourages consumer spending and should support economic growth further into 2019. Finally, U.S. median and average real incomes continue to rise at annual rates above 3%, which is well above historical averages dating back to the late 1960s.
What strategies does RGT recommend given the current environment and how are client portfolios positioned if a significant downturn occurs?
One of the guiding principles of RGT’s approach to portfolio management is that we are long-term and goal-oriented advisors. We are focused on helping our clients achieve their long-term financial goals, not simply on beating a benchmark or unmanaged index. Thus, a cornerstone of the investment process is to develop an investment policy statement and asset allocation for each client that we believe will maximize the probability of the client reaching their financial goals, while doing so in a manner that is aligned with the client’s personal tolerance for risk and ability to make sound decisions during periods of heightened uncertainty. The strategies mentioned below will be implemented in different ways throughout RGT’s client portfolios, depending upon each client’s personal circumstances. And as a result, all client portfolios will not necessarily perform in an identical fashion, particularly during periods of market volatility.
Another guiding principal that RGT utilizes in developing and managing portfolios is related to this long-term strategic approach. To achieve long-term success, we believe investors are best served by developing a broadly diversified asset allocation adjusted to best fit their particular risk tolerance. Well diversified portfolios typically maintain exposures across geographies, industry sectors, market capitalization, and investment styles. Maintaining these exposures over time through disciplined monitoring and rebalancing of the portfolio reduces the risk of portfolios becoming over allocated to any particular sector or investment style. During periods where particular investment styles or market sectors become richly valued relative to history or to other sectors or styles, maintaining this discipline helps limit exposure to these more expensive parts of the market.
Several of the strategies mentioned below are directly taken from the investment principals and long-term approach described in this section. RGT believes it is important to understand that periods of volatility, like the one experienced by investors in December 2018, are part of the normal course of events which we expect portfolios to encounter and are part of the long-term planning and strategy embodied in each client’s investment plan. Should there be any specific risks or opportunities that develop along the way, we still have the flexibility to adjust client portfolios and adapt if we believe other strategies are prudent.
The combined experience of RGT partners and employees includes over 60 previous equity cycles (“bull” & “bear” markets) dating back to the 1970’s and thus, we have experience managing through several previous volatile periods.
Prior to the most recent market decline – RGT purposefully de-emphasized and limited allocations to areas of investment which experience excessive speculation and higher risk. Thus, investment strategies which are perceived to be more “at risk” were naturally limited in portfolios.
During the current market decline – RGT continues to make progress in its due diligence efforts with managers focused on some of the most affected areas of global markets. We are starting to see some outside RGT equity managers find good buying opportunities in the latest period of volatility. Also, RGT portfolios are designed to be under-allocated to areas where valuations are high. Typically, as volatility increases, outside RGT equity managers find it challenging to outperform market indices due to “indiscriminate” selling across the board. Once markets correct for an extended period, RGT believes its managers will seek to take advantage of opportunities that have arisen during this difficult market.
If markets continue to be volatile – RGT consistently reviews areas for opportunistic investment. For example, if interest rates continue to rise, clients are able to earn more income from capital preservation/fixed income strategies given higher expected forward rates of return. Similarly, if stock markets decline further from current levels, more rebalancing opportunities will present themselves. Additionally, for the first time in several years, investors will be presented with the opportunity to consider shifting their overall portfolio allocation to a more aggressive stance at much lower valuations.
In the last 10 years there have been 4 other quarters when equities (both U.S. as measured by the S&P 500 and global equities as measured by the MSCI ACWI index) experienced similar declines as this past quarter – the 1st quarter of 2009, the 2nd quarter of 2010, the 3rd quarter of 2011, and the 3rd quarter of 2015. The recovery in equities after each of these declines was positive in the immediate twelve months following. While there are no assurances that this will occur again, the historical record points out the importance of having the discipline to remain committed to your long-term strategic investment plan.
Thank you for the opportunity to provide this information and analysis. Please contact RGT with additional questions.