These are truly unprecedented times. Over the last few days we’ve stepped out of the traditional wealth management playbook and have sold significant portions of our clients’ holdings. What started as a supply chain issue has rapidly turned into a health crisis followed by demand issues and a budding debt crisis. The sequence does not make a lot of sense now but it will eventually play out in full in the financial markets. As it becomes clearer that there is an incredible degree of unknown risks at play, here are some things to consider:
How Much Cash
Unless they didn’t already have the cash balance on hand, we are making sure all clients have two years of living expenses in cash. There are few exceptions.
The intensity and extent of this correction is unprecedented. Many companies have lost a full -75% of market value in just 30 days time. As witnessed in the past, bear markets usually come in three stages – a sharp correction down, a reflexive bounce and a drawn-out fundamental downtrend. Traditionally the final recovery follows after the worst of the fundamentals have been published. We feel that this is a ways away.
We all have already witnessed the “Phase 1” selloff, and it has been fast and furious. A lot of the selling has been accelerated by the algorithm and momentum traders where each sell signal has led to another sell signal, and so on. We’ve experienced continuous market volatility over the past few weeks of up and down 5% and 10%. The up days are often only due to short-covering, suggesting the current selloff is not over yet. However, this sharp selloff sets up “Phase 2”, the reflexive bounce. The reflexive bounce tends to be based more on hope and momentum than reality.
When markets fall sharply, eventually traders turn to buy the dip. In order for these bumps upward to be meaningful, they should be paired with legitimate positive news and not best-case scenarios or press conferences. This “Phase 2” relief rally can be tempting but beware of getting caught up in a further selloff. Things to watch during Phase 2 are: an eventual deterioration of fundamentals such as earnings, rising jobless claims and the depth of the government’s response in terms of monetary and fiscal relief packages. This will set the tone for “Phase 3” where the real bad news is published and digested.
We’ve experienced the simultaneous collision of two black swans: a pandemic and an oil price war between Saudi Arabia and Russia. With the U.S. now shutting down and in full-blown response to the virus, the economic impact will be worsened.
These two black swan events occurred in just the past 30 days. The current earnings and economic data are lagging and we mostly only have numbers that were pre-virus. The reports over the next couple of months will reveal the extent of the damage. While asset prices have declined significantly from the recent highs, they have likely not fully accounted for the impact on earnings, permanently lost revenues, and the falling consumer confidence. These unknowns continue to add to volatility on a daily basis.
The spread of and responses to COVID-19 are in the early stages. We don’t actually know what will happen and the range of outcomes is extreme. We are experiencing rapid societal learning at this moment that will someday make us much more resilient as a society. Expect key takeaways from this experience that allow us to be more flexible and more prepared to weather the next disruption.
Too Many Unknown Unknowns
Only when it seems that real progress has been made in scientifically neutralizing COVID-19 will markets begin to realize a sense of stability. In the meantime, markets are likely to continue with rapid moves up and down based on how the daily “war” on coronavirus looks to be proceeding. As I mentioned above, no one really knows how that will turn out.
As the image of this article suggests, we are entering into an environment consisting of dense fog. Markets are designed to price “normal” risks like earnings volatility and leverage. Markets are not designed to price in school closures and societal shutdown, however temporary they may be.
We have taken steps to take risks off the table. By selling some to all non-US exposure within all asset classes we do not have to rely on the ability of foreign governments to respond to this crisis. We no longer think it is even prudent to own many traditional US asset classes. The credit markets have developed significant cracks. Public real estate investment trusts are another example of significant risk as many residents and companies will likely stop paying their rents.
We believe that personal circumstances come first when making investment decisions. As we’ve written for many years, we make changes when markets change and when personal circumstances change.
Easing Back In
Investors are still hanging on the hope that the bull market will revive itself. We are looking for real investor pessimism to set in, a drop of -50% from the peak in the US markets, more clarity on fundamentals and (importantly) more clarity on the coronavirus health impact. So far, we have seen certain sectors get hit harder than others for obvious reasons such as travel, lodging, airlines, energy stocks, etc. However, the most favored stocks have shown relative strength compared to the rest of the market.
We do believe the U.S will lead the recovery as it did in the Great Financial Crisis. Please email us if you have any questions.
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