Q1: A QUARTER WE WON’T SOON FORGET
A distant memory now, 2020 began with a remarkably promising burst (up nearly 6% thru mid-February). What has since ensued can only be characterized as unprecedented and historic. Long before Covid-19 and social distancing were household terms, many investors were encouraged by what they saw.
The US consumer entered 2020 in great health, with a decades-high savings rate, record low unemployment, and with pent-up demand for housing. Couple that with expectations for robust corporate earnings and low interest rates and it’s easy to see where the optimism was rooted.
Innovation and American ingenuity found themselves on the precipice of some amazing breakthroughs as we enter a new decade. People entered 2020 more “connected” and more mobile than at any time in human history. Genetic research, 5G, 3D printing, AI, and Big Data seem destined to further change the ways we spend our days as businesspeople and consumers alike.
Many in the industry expected 2020 to come with its share of volatility—after all, it’s an election year. Nobody expected to see volatility readings surpass those recorded in 2008-09 and be sustained near those levels for a full month. In just 20 trading days we saw the Dow drop from its all-time high to a Bear market (a -20% decline). And it wasn’t over there, extending losses by another 12% before posting gains during the week of 3/23. For Q1, the S&P posted a loss of -20%, while the EuroStoxx 600 was down -23%.
Make no mistake, we are not suggesting that the selling is fully behind us. But for perspective, let’s take a look at some of the extreme activity and pricing dislocation we witnessed during the past 6 weeks:
- AAA-rated municipal bonds traded more than double same-dated US Treasuries on March 19
- Investment-grade mortgage debt, mid-month, was pricing in implied defaults more than 50% higher than was experienced in the Financial Crisis
- Airlines, travel and leisure, and other discretionary names traded 75% or more lower
- Oil dropped by over 50% during the quarter, including a nearly 30% drop on March 8
- The VIX (measure of market volatility) hit an all-time high of 85.47, surpassing its 2008 peak. In layman’s terms, this meant that the market was pricing in a 2/3 chance of an 85% annualized move (in either direction).
Suffice it to say, Q1 offered little warning for investors and nearly indiscriminately repriced assets across the board, from blue chips to tech stocks and mortgage bonds to AAA-rated short-term municipal offerings. As you will read in the coming pages, we do believe there are reasons to be encouraged.
“VOLATILITY IS TELLING US THAT WE CAN NOW BE COMPENSATED FOR RISK.”
– MICHAEL GRANT
VOLATILITY & WHAT LIES AHEAD?
Volatility, while rarely enjoyable for an investor, most often presents opportunity for the disciplined investor. As many of you may recall, it was during the extreme volatility of the Financial Crisis that Warren Buffett orchestrated some of his most masterful deals with GS, GE, and BAC.
Buffett saw the dislocation between price and value and acted to benefit his shareholders, striking some extremely lucrative preferred stock deals. We believe there have been similar opportunities created for our investors over the last 6 weeks.
While we are directly looking to capitalize on a couple of these, we also have heard regularly from managers we employ. They too are finding opportunities that were absent 30 days prior. Some who were holding cash have been deploying it. A manager who was market neutral has transitioned to a net-long stance. Some who had been challenged for new growth ideas have found several to select from.
“BUY WHEN THERE’S BLOOD IN THE STREETS, EVEN IF THE BLOOD IS YOUR OWN”
– BARON ROTHSCHILD
For a moment, let’s consider the cations taken by Central Banks and governments across the globe in the last 6 weeks:
- US government $2 Trillion Aid package designed to help households and small businesses, along with vulnerable industries
- Federal Reserve dropped rates to effectively 0% for second time in history
- TALF 2.0 (designed to provide/enhance liquidity of the asset-backed and mortgage securities markets)
- Federal Reserve expanded QE to “the amount needed” to support liquidity in the corporate bond and money market space
- Interest rates have been cut in Canada, China, the UK, and a host of others
One of the core questions investors are now wresting with is the economic implications (and longevity of) the virus. Will the economy resume “normal activity” in the back half of Q2, or will the impact spill over longer? The US government, clearly recognizing the importance of stabilizing and preserving the American worker, has created emergency measures to plug the gaps for Q2 (extending unemployment terms and supplementing the available amounts).
Having listened to many conference calls from leading industry experts (including JP Morgan, Goldman Sachs, Morgan Stanley, First Trust, and more), there’s a strong agreement that there will be a positive response on the other side of this challenge. We have yet to find anyone who suggests that the damage done by Covid-19 is irreparable.
If anything, as a society we will likely emerge more aware of the world around us. As investors, we are wise to emerge with a greater appreciation of risk. As our team has shared many times over the years, “Risk is neither bad nor good, but rather it is either compensated or it isn’t.”
As we enter the second quarter, we believe there are a few key items to reinforce for our clients:
- We believe active management will again matter
- Strategy Diversification works o Our technical strategy moved significant cash to the sidelines long before we would have actively chosen to make such a move
- Proper asset allocation and alignment of risks is critical
- During a sharp decline, cash is ultimately “king”
- Balance sheets matter (not just familiarity of name)
We don’t expect the headlines to turn positive any time soon, but we do believe there is money to be made. As Baron Rothschild quipped over a century ago, “Buy when there’s blood in the streets, even if the blood is your own.”
SO WHAT HAS CHANGED?
During the longest Bull Market run of our lifetimes (March 2009 – March 2020) the markets pushed relentlessly higher. During that span, investors were forced to face many challenges:
- US Debt downgraded
- PIIGS debt default concerns
- 2 US Elections
- 2 New Federal Reserve Chairs
- Oil Crisis of 2015
- FAANG stocks emerge dominant
- Flash Crash
- VIX Spike in Feb 2018
- Christmas Eve 2018 selloff
Any of the above could have sparked an end to the Bull Market, but instead it was a novel virus that caught the world off guard.
During the 11-year bull run, simply staying “in the game” rewarded investors with a return of well over 10% per annum. Passive investing, share buybacks, low interest rates, reduced government regulations and reduced Federal tax rates all helped to elongate the rally.
So what has now changed?
Though there are lots of comparisons being drawn to the 2008-09 Financial Crisis, a look back at the late 1990’s is a great place to begin. When the Tech Bubble burst in the Spring of 2000, not everything fell apart. In fact, despite the index falling for three consecutive years, long is the list of managers who made money during that span.
There was significant value in security selection in the early 2000’s. We feel the same is true today. On the heels of the market’s recent selloff, we believe there is value in being selective in what you own. For purposes of illustration, if you consider each S&P 500 company like a fantasy football player, which ones would you draft? Would you simply pick randomly? Does it make sense to own them all?
“PRICE IS WHAT YOU PAY; VALUE IS WHAT YOU RECEIVE”
– WARREN BUFFETT
What we expect to become much more evident in the coming months is who the winners and losers will be. Rather than just owning the index, we believe nimble, experienced managers with a disciplined process can add value. We believe, perhaps as much as at any time since the Tech Bubble, that skill will again emerge critical for overall portfolio results.
While evaluating anything during a quarter may seem short-sighted, we are pleased with how many elements of our portfolios fared during the quarter. Below are a few examples:
- Market Neutral Strategy -3.8% YTD
- MTT (our tactical tilt strategy) +11.4% vs. S&P 500
- Buffered & Power-buffered ETFs
- Structured Products (defined “buffers” against principal loss at maturity)
Furthermore, having raised cash in our Tilt strategy, we now sit ready to redeploy capital into a market that is discounted from its previous highs.
The greatest change we see as investors is that the pain inflicted by the Covid-19 virus and the global response has created new investment opportunities. Many of these are investments that simply fell in value. A few are new discoveries or technologies that will emerge as a result of the virus. We are ready to capitalize, as are the managers we have selected. We sit with cash and patiently wait. After all, volatility often creates opportunity.
A FEW VISUALS…
Below is a visual of what investors felt the 22 days leading up to 2/21 and the 22 days that followed…