A careful reading of Pinnacle’s fourth quarter investment review will find no mention of a pandemic that would, within a matter of weeks, create the conditions for a global recession. The necessary closing of economies around the world has resulted in the first ever recession by proclamation, where market participants everywhere and at the same time realized that markets were overvalued based on the easy forecast that corporate earnings were about to evaporate. The result was a record-breaking collapse in both equity and credit prices as liquidity dried up and markets seized, reminding many of the Great Financial Crisis in 2008.
The decline in the S&P 500 Index was breathtaking for the speed (rather than the magnitude) of the sell-off. From February 19th to March 23rd, the Index fell by 34%, eclipsing the amount of time it took for other famous (or infamous) peak to trough declines, including the Great Depression and the 1987 crash. Notably, a 34% decline is well within the parameters of historical bear markets where the average bear market decline is -35%, and the average decline after the stock market had just made a new all-time high is -39%. Fortunately, only about 1% of all Pinnacle clients are invested in a portfolio that is allocated to 100% in risk assets, with the remaining 99% of clients owning a balanced portfolio designed to significantly reduce client exposure to the risks of unexpected stock market declines. And while returns for the first quarter of 2020 were certainly disappointing on an absolute basis, they may not lead to a disaster that requires a change of lifestyle for Pinnacle clients.
The cause of all of this, as all of our readers know, is the COVID-19 virus. Interestingly enough financial markets watched the virus and its impact on China for several weeks with no real inclination to sell. However, once it became clear that the virus had escaped the borders of China and that the only way to contain it was to implement the kind of draconian steps undertaken by Chinese authorities, market participants commenced a quick re-rating of the prospects for global growth, and the stock market rout was on. In our view, the U.S. may follow a path for virus cases that is more similar to Italy than it is to China—and hopefully even less invasive—and that the peak in new cases in the U.S. will occur somewhere between mid-April to early May. It certainly didn’t help that in the middle of all this, Saudi Arabia and Russia decided to engage in an all-out price war in oil by flooding the market with more supply than it can handle, causing prices to crash and exacerbating market volatility. In any event, we are focused on the point when economic activity will revive after the virus recedes, and how policy makers will balance sound public health policy with the obvious problem that the U.S. (and the rest of the world) can’t remain in economic lockdown for too long without creating catastrophic economic losses.
For what it’s worth, we currently believe that the earliest economic restraints could be lifted would be late May or early June. Notably, many commentators suggest that even this is too soon, considering that the U.S. is a large country and that the virus could surge in different cities at different times. It’s hard to know how national, state, and local policy will impact our ability to return to the workplace, and how consumers will behave once they are told it is safe to do so. We believe that the notion of a Post-WWII-style “party in the streets” once the government announces an all-clear is unlikely. We expect Americans will remain cautious at least until there is a proven, efficacious treatment for the virus, proper testing and surveillance for outbreaks, and proof that the healthcare system is not overwhelmed by virus cases. Of course, the best case will be the development of an actual vaccine, which we expect to take eighteen months or more. How this plays out will undoubtedly have an enormous impact on corporate earnings and consequently, stock prices.
To their credit, policy makers in the U.S., as well as around the world, are doing what they can to stabilize the financial markets and the global economy. In the U.S., the Federal Reserve has announced a blizzard of programs designed to provide liquidity to credit markets (and others), in partnership with the U.S. Treasury, that will provide grants and loans to U.S. small businesses. The Federal Reserve Chair, Jerome Powell, has announced unlimited Quantitative Easing, which is a nice way of saying that the Fed stands ready to create as much money as necessary to prevent the economy from collapsing. Many of the policy tools being used by the Fed were first created during the Great Financial Crisis, so dusting them off and implementing them will be relatively easy compared to when they were first created in 2008-2009. It is hard to overstate the impact of this new policy over time; it is a river of liquidity designed to assure investors that markets will continue to function normally, and that systemic risk is properly managed. (Note: The Fed added an additional $2.3 trillion of stimulus on April 9th.)
Just as impressive as the Fed’s $2 trillion of policy relief (now $4.3 trillion) is the $2 trillion fiscal package recently passed by the U.S. Congress and signed into law by President Trump. The CARES Act is a comprehensive package of grants, loans, debt relief, employment benefits, investments in certain critical U.S. industries, and checks paid directly to U.S. taxpayers, all designed to offset the staggering shock that is expected to the U.S. economy in the second quarter. Congress is already targeting the next stage of relief since experts have no way of accurately forecasting just when restrictions on social behavior will be lifted and U.S citizens can get back to work. In our view, although the total of U.S. monetary and fiscal relief equals a whopping 30% of U.S. GDP, both the monetary (Federal Reserve) and fiscal (U.S. Congress) programs will do no more than keep the U.S. economy afloat for the next four to five months. We question whether these programs will act as stimulus, but do believe that they will keep us from falling into a more serious economic depression. Of course, whether or not investors view these programs as stimulus for the stock market is an entirely different matter.
When markets crash, as they did from February 19th to March 23rd, one problem that investors face is to find data to evaluate whether the change in prices is rational or if the markets have overshot or undershot in waves of panic selling. In this case, the 34% decline in the S&P 500 Index occurred with little corresponding data regarding U.S. economic performance or corporate earnings. We know that analysts who follow corporations usually rely on guidance from the companies they follow in making their forecasts, and we know that companies will have a very difficult time giving investors any help in light of the unprecedented halt to business activity. Consequently, we expect consensus analyst estimates for the second quarter and the rest of the year to be all over the map. Historically this amount of uncertainty is not typically supportive of higher stock prices.
The equation of bad COVID-19 news + bad earnings news + bad economic news offset by news of overwhelming policy intervention both on Main Street and on Wall Street = a dilemma for investors, and certainly for Pinnacle. That’s especially true when considering the magnitude of the bear market decline we’ve already gone through, and the over 20% stock market rally we are experiencing as of this writing. We executed a series of trades once the market began selling off to take the portfolio to (what is for us) a significantly defensive posture. Our current investment thesis is that we expect, in the short-term, the stock market will digest the upcoming earnings news and gradually grind its way back to the prior lows set on March 23rd. At that point (and perhaps even earlier) we may use the opportunity to begin adding risk back into the portfolio in anticipation of better news ahead, both on the virus front and the economic and financial market fronts. Notably, we may already be seeing some better news on the virus front as it appears the peak in cases may be occurring earlier rather than later.
Importantly for our clients, we expect markets to normalize over the next year or two, with significant potential for us to opportunistically find investment ideas to earn excess returns. While the current recession was created by proclamation, once health authorities give the “all clear” for us to get back to normal, the question isn’t whether the markets will recover, but how quickly they will recover. Considering the amount of stimulus in the pipeline and the flexibility and creativity of global business, much better times lie just ahead.