Special Memo: March 16-20

Victor Levinson Comments

As the coronavirus continues to raise major issues related to people’s health, to the general economy, and to the financial markets, we are writing again with an updated discussion. This is our fifth Special Comment (in addition to our regular February Monthly Comments) on the subject, which will draw from the earlier material and feature some new content. The primary caveat to all this is the presumption that, at some point in time, with tremendous public cooperation and governmental coordination, the disease is likely to run its course sufficiently to allow for some return to normalcy. This appears to be happening now in China, where it all began, providing some timeline of hope for the countries suffering the most now.

In our first Special Comments, dated Feb 25th, we presented a chart with the history of the five most recent serious contagious diseases since 2003, and stock prices during those periods. The chart showed that the negatives were modest and not long lasting, and we added the following comment: “while we certainly understand the past is not necessarily predictive, and ‘black swan’ events do occur, it is also worth having the information to consider.”  We now know that this disease is doing far more damage than the previous five, noting also that over time, factors other than the disease itself come into play.

In our second Special Comments, dated Feb 27th, we discussed corrections (declines of 10% or more from the previous high), and bear markets (declines of 20% or more from the previous high).  The US stock market (S&P 500) is in a bear market now, down approximately 32% from its all-time high reached in mid-February 2020 and following the year 2019 when US stocks rose approximately 29%.  Almost all the gains from the start of Trump’s presidency are now gone (for the S&P 500 and Dow Industrials; NASDAQ is still up approximately 25%). But history also suggests recoveries from these kinds of declines. There have been 12 bear markets since World War II (1945), with an average decline of 32.5%, lasting an average of 14.5 months, and taking an average of two years to recover.  The most recent was October 2007 to March 2009, when US stocks dropped 57% and then took more than four years to recover.

We also noted that “your asset allocation away from stocks reduces the impact of the declines.  A 50-50 allocation to stocks and bonds means that a 30% stock market decline should have a 15% impact on your portfolio.  The allocations are intended to allow you to get through sharp stock market declines and take a long-term view of your investments.”

In our regular February 2020 Monthly Comments, we discussed how “PPA advises clients on allocating manageable portions of their investment portfolios to stocks, behaving as long-term investors looking to grow their portfolios at rates above low interest rates and the rate of inflation.  What we avoid is acting as traders, who seek to profit from short-term price movements by being in the markets when prices are rising, and out when they are declining; or selling stocks short and then trying to buy back at lower prices. We refer to all of these trading activities as “market timing.”  As appealing as market timing appears, the record shows it is extremely difficult to make two correct decisions — the time to sell, and the time to buy back in.” The adverse consequences of missing the best performing days for stocks are discussed.

We also quoted extensively from Ron Lieber’s NYT article, “Freaked Out by the Stock Market? Take a Deep Breath,” (NYT 2/27/20, page B1), which advocated taking a long term view of investing, measured in multiple years,  rather than days or months. “Ignore predictions and seek perspective. When the stock market falls, as it has all week, there is a natural desire to search for explanations and consult crystal balls. While the spread of the coronavirus has been a catalyst, nobody knows exactly why the market moved the way it did, including whether underlying economic troubles are contributing to the severity of the gyrations. And nobody can tell you how the virus will affect the US, including whether the outbreak’s short-term economic impact will reduce long term profits. And you are a long-term investor, right? Most of us fall into that category… We invest in stocks because doing so has consistently proved to be a good way to buy a little piece of capitalism. Hold on long enough to a diverse collection of stocks, and the system has tended to generously repay patient people over six or seven decades of working, saving, and drawing down a portfolio.” Further, we noted that even people close to or in retirement can have many years to go in their need for money, and therefore some growth potential in their allocation is in order.

Bonds are the major asset class used to diversify away from stocks, and the focus of our Special Comments dated March 9th.  Bonds pay interest and have historically experienced much lower price volatility than stocks.  At PPA, we divide the bond (or non-stock) category into: (A) cash equivalents/money markets: shortest maturities, no price changes, pays the least interest, currently close to zero because of recent Federal Reserve interest rate reductions on the rates it controls); (B) high credit bonds (HCB): short and intermediate maturities (one to six years); price changes based on maturities, interest rate changes, and changes in credit quality; interest payments and prices determine yields to investors; prices determined by the activity of bond market buyers and sellers establishing prices in much the same way stock prices are determined by the activity of stock market buyers and sellers; and (C) high-yield bonds: various maturities, which pay more interest because they have more credit risk. Their prices are also set by buyers and sellers in the bond market.

PPA uses substantial bond allocations for older clients, as a source of money needs, one main reason being to avoid selling stock positions when stock prices are declining.  Clients can have five or ten or more years of their spending needs invested in a mix of these three bond categories, usually mostly HC bonds. In the current market environment, when HC bonds are coming under increased credit scrutiny and HC bond interest rates have declined, there is some discussion about selling some of the HC bonds and buying the money markets.  In doing so, the bond sellers would have to accept lower prices from the buyers than would otherwise be the case in more normal times, with the extent of the lower prices determined in the markets. The alternative is to hold the bonds, use them as needed in small increments for cash needs, and eventually have the yields to maturity restored to normal levels.  This idea of going from HC bonds to money markets is a form of market timing that would normally not be considered by long term investors drawing monthly money needs from their portfolios.  The bond investments PPA makes are primarily in Vanguard funds, with bond funds from Dimensional Fund Advisors (DFA) added more recently. These major financial institutions do the credit analysis for the bonds in their fund portfolios.  As usual, our advice regarding bonds is to maintain the allocation of short and intermediate maturities, with some high-yield mixed in, all providing an allocation away from the stock market.

Our most recent Special Comments, dated March 12th, returned to the stock market declines, which were becoming more severe at that time, and have increased in severity through March 20th.  As we have written many times previously, “the long-term overall gains in stock prices come with the risk of periods of significant declines.  No one is promised that the high for stock prices will be their particular exit point.”  These Comments referenced a separate New York Times article by Ron Lieber advising people with long-term investment goals to remain focused on the long-term and try to avoid taking action based on short-term fluctuations. Lieber wrote again on the same subject (NYT 03/10/20, page B4) as follows: “Current stock market activity, driven in part by out of control algorithms and professional traders with wildly different goals from every day investors like you… Have your long-term goals changed today? If not, there is probably no reason for your investments to change either… Your actual asset allocation may mean that the declines in your portfolio aren’t as bad as those flashing red numbers.”

As stock prices continue to decline and the response to the coronavirus is to shut down a great deal of economic activity, the idea that the US economy, and many economies throughout the world, are likely to experience a recession has become widely accepted.  A recession is defined as two quarters of negative economic growth (measured by GDP). Even if this happens, the length and severity of recessions are always variables, unknown until the recessions end, and historically their impact on stock prices is not always direct. Indeed, some of the current stock price declines may well be pricing in the expectation of recession, as stock prices are often a forward-looking guide to what investors/traders see in the future.

Another subject is whether to rebalance your portfolio. Rebalancing refers to the idea of selling the higher performing asset class (these days bonds) and buying the poorer performing asset class (these days stocks), to return your portfolio to a previously established allocation.  Selling stocks and buying bonds or money markets is not rebalancing, since you are selling the poorer performing asset class to buy the higher performer. The sell low/buy high activity (“flight to safety”) is more closely related to market timing. While we are not necessarily suggesting rebalancing, because of the current extreme level of uncertainty, we also recommend retaining the stock allocation, albeit at a reduced level. No one knows when these declines will stop or at what prices, and how long a recovery might take. That said, we do continue our advocacy of appropriate allocations both to and away from stocks, and a long-term time horizon when considering what that allocation should be. While we should all be aware that history may not repeat itself, and that the history we know is only one of many variations that could have happened (see Nick Taleb discussed in January Comments, and Larry Swedroe quoted every month in our Monthly Comments), PPA’s view is that all the history we present to support a point of view is at least worthy of consideration.

In the absence of a better indicator, we repeat our consistent bottom line suggestion: stay the course and think long-term. Please feel free to contact your advisor for additional conversation.