More than 250 years ago our founding fathers founded this republic to make life better for their fellow citizens. Our constitution starts with the following preamble:
“We the people of the United States, in order to form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity, do ordain and establish this Constitution for the United States of America”.
This was a indeed a bold experiment, and our founding fathers knew the challenges would be great but they had faith in the American Spirit. As a country, we have overcome tremendous adversity. While not an exhaustive list, our country survived Revolutionary War, the War of 1812, the Civil War, World War I, the Spanish Influenza, the Great Depression, World War II, the Cold War, 9/11, and the Financial Crisis of 2008. Instead of breaking the country apart, these challenges actually brought us closer together.
Lately, our country has been more divide than ever. The Coronavirus pandemic is the latest challenge to be presented to us. As we look around, we can see the dramatic steps being taken to battle this silent killer. We see our country setting aside its differences and banding together as we have in so many past crises.
This will test our collective resolve, but we are confident that our fellow Americans will come together as they have in the past to defeat this like we have all the other challenges we have faced as a nation. Together, we as Americans are unstoppable and will win this silent war.
Wild swings in both stocks and bonds reinforced the market’s unpredictability in response to the Coronavirus pandemic; the day-to-day change in the S&P Index over the last 10 trading sessions included 9 days in which the Index rose or fell in excess of 4.0%. The markets settled down on Thursday and Friday, and we have been assessing ways to take advantage of dislocations in the markets. Some areas of the market have pricing we may never see again. Our challenge is to put together a recovery strategy that will get our clients’ portfolios moving in the right direction while reducing the risk we are taking in their portfolios.
On Friday, we believe the stock market was volatile because of options expiration in all markets. We believe this contributed to the strength we saw in the morning. Traders were rolling their option positions. By mid-day most of those rolls would have taken place and the market began losing steam again. In volatile times like this, traders do not want to go home for the weekend with positions open because of what we call “headline risk”. With developments changing quickly and a compound increase in reported cases of Coronavirus, our thoughts were that the “headline risk" this weekend may be higher.
At this time, there are two main items weighing on the markets. The first and obvious risk is the economic uncertainty as to what the worldwide shut down will do to economies in both the short and the long term. The second is the oil war between Saudi Arabia and Russia. With no agreement between these two oil producers to limit production and stabilize oil pricing and inventories, energy prices have been in free fall and are at prices we have not seen since the early 1970’s.
The price for West Texas Intermediate (WTI) slid 11% on Friday to reverse the largest one-day gain ever that it had on Thursday. Comments by President Trump suggesting potential actions to support oil prices failed to stem a 40% decline in prices for WTI and Brent crude following the recent breakdown of discussions between OPEC and Russia over production cuts. In a potentially interesting development, an OPEC representative was scheduled to meet on Friday with a spokesperson for the Texas oil industry.
We see opportunities in the market to rebalance our portfolio assets to reduce risk and increase potential return when the market sentiment becomes more positive. We have begun, and will continue to make the following adjustments:
Swapping Master Limited Partnership (MLP) to Preferred Stocks. We are taking this action because the government has suggested that its now $2 Trillion stimulus package will fund companies that need assistance through Preferred Stock investments, much like they did in 2008 during the height of the Financial Crisis. This will give the government an equity position in these companies, and if they issue the stock the way they did in 2008 to the financial industry, they will backstop all the other preferred securities that have been issued by the companies getting the assistance. The government will also be able to make a profit in these investments the way they did after the federal intervention in 2008.
We know one of the key questions investors are asking is, "Will the government every be able to dig out of this stimulus spending?" We believe the answer is yes; they will dig out of much of it the same way the did with their investments into the banking sector in 2008 - through their profits on their investments.
On Friday we began trimming our equity positions for our Research driven equity portfolios to reduce any possible “headline risk” over the weekend and to have cash available to rebalance to take advantage of current market dislocations. Early this week we will put some of that cash to work and rebalance the portfolio into the following sectors:
Energy: This is the market where we see the most value but also the greatest volatility with our rebalance. Oil prices have sunk to levels we have not seen since the early 1970’s. We had trimmed our exposure to energy and MLP’s in September from an overweight to an underweight. As of the close on Friday, oil is trading at less than $20.00 per barrel. We believe the oil war will be over soon and oil is a tremendous value at this time. Oil is not just a product for our automobiles, but oil touches nearly every facet of our lives. You cannot make anything plastic without oil products. You cannot even drive electric cars without oil; oil is used in the rubber for their tires. Even though demand has fallen over the last few weeks, we believe demand will pick up, and at these prices producers are losing money. We will overweight Energy and oil based on the oversold conditions of the oil market. We will make investments in the United States Oil Fund and we will be making an investment in the Alerian MLP Index currently paying a dividend of 21.59%. This dividend rate looks a lot like the dividend rate we saw on preferred stocks in 2008 and early 2009 at the height of the financial crisis.
Preferred Stocks: We have maintained a position in Preferred stock since the financial crisis. We had stopped adding to preferreds and in fact were exiting out of them in some cases many of them were trading at premiums to par value and because many were approaching call dates. Before the Coronavirus, we believed we would see many of them call in the coming year. However, the stress on the financial system and a drop in the price of preferreds has greatly reduced the risk of them being called. Because preferred stock is higher rated in the capital structure than common equity, preferred stocks should not sell off the same way that common stock does. However, between March 4, 2020 and March 18, 2020, we observed that the iShares Preferred Stock and Income Securities ETF had sold off almost 9% more than the S&P 500. We saw this same irrational behavior in 2008 and early 2009. Interesting, with the mere mention of the government's stimulus plan including preferred investments in struggling businesses, the iShares Preferred and Income Securities ETF (PFF) has trade up almost +14.5% relative to the S&P 500 over the same period. Again, we saw this same behavior between Preferred Stock and Common Equity (i.e. the S&P 500) in 2008 and early 2009. At Friday's close, PFF's yield was 6.74%. With the potential for Government guarantees in the current stimulus legislation, we think Preferred’s are oversold and buying now will get us a much higher yield than the S&P 500, be a rock solid investment because of the Government Guarantee, and will still maintain the ability for capital appreciation when the market rebounds as well. We will once again dramatically overweight preferreds as a recovery strategy for our portfolios, like we did in 2008 and 2009.
REITs: In September, we reduced our exposure to REIT’s and locked in some nice profits. Using the Vanguard Real Estate Index Fund (VNQ) as a benchmark for REITs, we have seen VNQ sell off 10% more than the S&P 500 since March 4, 2020. The yield in REITs have increased for the time being to over 6% (using VNQ as the index). With the Government guarantees in the current stimulus legislation, we also think REITs are oversold. Buying now will get us a much higher yield than the S&P 500 while still maintaining the ability for capital appreciation when the market rebounds. We will increase our investments in REITs to an overweight position, increasing portfolio yield and maintaining the ability for capital appreciation when the market rebounds.
The economy has not yet bottomed yet, and may not for some time. We expect -10% q/q annualized real GDP for the U.S. in 2Q. Policymakers need to get ahead of the damage (health+economic) before markets can stabilize. The U.S. stimulus package is up to $2 trillion now, almost 10% of U.S. GDP. Germany also announced planned stimulus of roughly 10% of GDP yesterday. It is important to note that the market and the economy DO NOT bottom at the same time. In the Financial Crisis of 2008, the market bottomed in March, 2009, but the economy didn't bottom until February 2010. The market is FORWARD LOOKING. It typically bottoms long before the economy does, and will usually make significant progress long before the bottom is reached. In the case of the Financial Recession of 2008, the market was up over 70% before anyone know the economy had bottomed. It is important to understand this because investors who wait for the economy to bottom will miss a substantial amount of the recovery. We wrote about this on March 16, and if you did not read it, we would encourage you to now. You can follow this link to our web page to read the article:
Johns Hopkins University is tracking the global COVID-19 cases on their website (coronavirus.jhu.edu/map). The non-China cases are still rising rapidly. However, China and South Korea have stabilized and started to reduce new infections. We are following their social distancing protocol and expect similar results here in the next few weeks.
U.S. weekly jobless claims spiked last week to 281,000 and this week’s report could be well over a million. Unemployment is climbing rapidly, after hitting a cycle low of 3.5% last month. Over 500,000 applications for Canadian unemployment benefits were made last week, versus just under 27,000 in the same week last year. (Reuters). This is not setting up as your typical recession. The economy was very good before it came to a sudden self-imposed stop . If the economy opens back up soon we think this will be very much a V shaped recession and markets should respond accordingly. The longer business is shut down, the greater the odds of a U shaped recession. It is imperative we get this right.
We are asked almost hourly when we think the markets will calm down and move to recovery. Our opinion would be to look at the Presidents 15 days to slow the spread initiative as a guide:
As the President and his emergency council, led by Vice President Pence, have said (as of Sunday 3/21/20). “We are on day 7 of the 15 day plan”. It is our opinion that this time line is close to when we should have a much better handle the questions regarding the self-imposed economic shut down.
We think we will have a much better look at the contagion curve in the next week or so. First, testing has increased dramatically, so we now "KNOW" we have the cases that we already had, but didn't know we had. Further, if we are able to flatten the contagion curve over a 15 day period, we can likely avoid an extensive overburdening of our health care system. Additionally, there are new therapies that have been approved by the FDA using old solutions that have been previously vetted by the FDA that are showing very promising results and are available in large quantities that can be broadly distributed. Some of these solutions are Hydroxychloroquine, chloroquine, and remdesivir. There are also many vaccines being developed and some that are already in use for Malaria that show very good promise. If one of these solutions lives up to its promise, we would expect to see a dramatic rebound in the market, like what we witnessed when "Mark to Market" accounting was announced in 2009. Market to market accounting ended the contagion of "financial sickness" in 2008, and the market's response was a 70% appreciation in the 12 months following the announcement. It is impossible to "time" when the solution will be presented, but there is evidence to suggest it may be soon. Again, the presentation of a solution will not end Coronavirus within weeks (and maybe not even in months), and it will not mean the economy has hit bottom, but it may very well mean that the market hits bottom and begins its rebound. We have heard countless stories of investors who got of the market well into the 2008 selloff, and their primary regret is that they WERE NOT in the market for the rebound. Emotions are powerful things, and we understand how emotional this bear market has been. But it was emotion that drove countless investors out of the market in 2008 and 2009, and it was emotion that kept so many of them from re-entering the market until much of its rebound had already passed.
If we can follow what's happened in a number of Asian countries, business’s may be able to start re-opening sooner than we think, and we may well ease out of this social distancing the way we came into it.
We may be battling the virus for the next several months. However, we do not believe that will stop us from restarting Americas economic engine in the weeks to come. Much of this heath care crisis is currently priced into the market. Bottoming is a process and may take a few weeks until we see light at the end of the tunnel. We do see some light and do not think it is a train coming to run us over. We think the markets may see some relief when we see the more than $2 trillion stimulus passed by congress and signed by the President (hopefully on Monday).
These are unprecedented times and we are confident that when Americans pull together; we can move mountains, and we will overcome this current crisis. In an unprecedented move, the Treasury, IRS, and Labor have announced a dramatic plan to help small business and individuals. You can read their comments here:
If our hospital become over-run, like what Italy is experiencing, our cruise lines have offered to convert their ships into floating hospitals. Our auto manufacturers are gearing up to make respirators and ventilators. A growing list of companies have begun converting their operations to increase the production of much needed hand sanitizer. We have seen social media users coordinate to help neighbors know where they can buy essential goods. Amazon is delaying (and in the hardest hit areas suspending) the delivery of non-essential goods so that they may ship the most essential goods. We see much less coverage of these acts in the media than we do of lock-downs, school closures, infection rates, and the death toll, but America, and Americans are rising to the occasion as we always have.
Please feel free to call or email us with any questions you may have at any time.