March 11, 2020
Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer
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We are in the midst of another historic week in equity markets, which started Monday with a shock to oil prices following an unproductive weekend meeting between Saudi Arabia and Russia. Russia’s unwillingness to cut production led to Saudi Arabia flooding the market with oil and pushing oil prices down to nearly $30 a barrel. The S&P was down on Monday -7.6%, partially due to oil prices and partially reflecting ongoing concern about COVID-19. This was a massive loss in a single day, but it was followed by a strong recovery of 4.9% on Tuesday. Wednesday, with continuing news of the spread of COVID-19, markets were struggling early in the day, but turned for the worst once the World Health Organization (WHO) declared COVID-19 a pandemic.
Classifying COVID-19 as a pandemic means it is an outbreak of a disease that occurs over a wide geographic area and affects an exceptionally high proportion of the population. Last week we wrote to clients that the key to stabilization in markets was a curtailment of the outbreak of COVID-19. The WHO’s declaration would imply that we may be far from that moment.
While this doesn’t change the fact that, historically, the market recovers well from global disease outbreaks, there are extenuating circumstances to consider this time around. First, as stated last week, markets were at higher-than-normal valuations coming into this event. Second, the beginning of this week marked the 11-year anniversary of the current bull market, one of the longest in history. The outbreak of COVID-19 after 11 years of a bull market will have a different impact than if it happened in year three of a bull market.
From an economic standpoint, we continue to see responses to stem the outbreak, which have direct effects on future earnings of many companies. With conferences, sporting events, and travel all but halted across the United States, many sectors and companies are going to be affected for some time. Added pressure on energy companies from low oil prices and decreased demand due to the virus outbreak further exacerbates lower earnings expectations across S&P 500 companies. What had the potential to be short term in nature is now affecting longer-term expectations.
Stress is already appearing in bond markets, with spreads between the safest bonds (U.S. Treasuries) and riskier bonds (corporate or high yield) increasing materially. Bond markets usually reflect the first signs of a broader economic downturn, as investors become concerned that interest payments may be impacted by slower earnings growth. A company can endure a decrease in stock price, but the company missing a bond payment can lead to bankruptcy. As we talk to our investment partners, bond market operations remain stable; however, given the growth in the size of the bond market over the last decade, operations could deteriorate quickly. That would lead to greater volatility across all markets and the broader economy as a whole.
Wednesday’s market action reflects a greater than 20% decline from market peaks, which officially qualifies as a bear market. Since 1990, the S&P has had six declines greater than 10% (including the current decline through yesterday), but only two declines greater than 20%. There is a big difference in magnitude and length once you exceed 20%. Even if COVID-19 subsided or was contained in the near future, the economic impact of defaulted bonds in the riskiest part of the market or decreased earnings expectations could mean that we’re in for a longer-term challenging market.
MRA portfolios are prepared for this, with broad diversification across asset classes that are largely unaffected by declining stock prices. While we don’t expect complete immunity from negative returns for non-stock holdings in portfolios, we do expect them to suffer far less than equity allocations. Should we see a prolonged downturn, it means portfolios will eventually become out of balance. Clients will own more bonds and non-traditional assets than intended, and less stocks than intended.
This will prompt one of the most difficult conversations for advisors to have with clients, which is to rebalance in the face of bad equity markets. Frankly, this is where the money is made. It is the old adage “buy low and sell high” at its core. If we’re in a prolonged downturn, we will have plenty of time to discuss this with every client, and we intend to because it can be a very emotionally charged decision. We also plan on having options to rebalance beyond just buying stocks that should still do well in a recovery.
We don’t know if this is truly the beginning of the next bear market and, if it is, how long it could last. However, the stack of reasons why it could be has been growing for some time and continues to grow. We have been preparing client portfolios for this environment for years, in many ways giving up the sky-high returns stock investors have experienced recently. Investors concentrated in the S&P 500 have seen 15 months of returns evaporate in 16 days. We don’t think any of our clients want to experience that, which is why we invest the way we do. Our plan going forward is to benefit from the protection we’ve built into the portfolio and take advantage of the opportunities that present themselves if this truly is the next bear market. To that end, we should talk more frequently, whether you (our clients) feel nervous or concerned, or you want to discuss what that plan looks like. Now more than ever, please reach out to a member of your engagement team to talk. And if you’re reading this but you don’t have a relationship with MRA, please feel free to get in touch. We’re here to help.