Market Update for March 13, 2020

3.13.2020 Market Update

Betsy Pierson:  Well good morning, everyone. So myself, John and Tracey have been talking feverishly over the last couple days about everything that’s been going on, along with the rest of the group. And it's certainly been a very painful move down with yesterday's Dow decline being the largest point total decline since 1987 and the largest percentage decline since 1987 in one day. It's not the largest because in 1987 the Dow actually declined over 20% in one day.

Fear has definitely taken hold which can be seen by some of the volatility indexes with the VIX at 72 yesterday which is its high. It hit 80 in 2008. It hasn’t seen that high since then. The Fear & Greed index, which is another sentiment indicator is at 2 when its range is from 0 to 100, with 100 being very positive and greedy and 0 being extremely fearful, so we're near all-time lows in that. In addition, we’ve seen huge outflows from equity funds in the last 3 weeks through Wednesday. So this doesn’t even include yesterday, but we’ve seen about $47.5B pulled out of global stocks, mutual funds and ETFs. And bond funds have seen $26.2B in inflows in that same time. There's definitely been a flight to safety and fear has taken over. Yesterday was maybe the beginning of capitulation, but we're not sure that it's the absolute bottom or that we won't test it again. I know this morning we were limit up on the futures and they opened lower through that and we’ll see where we end the day. We could be very volatile back and forth today as people realign their percentages of equities to bonds. We had a large number of margin calls yesterday and people are selling the most liquid things and that's when you looked at yesterday, there was no disparity between anything. Everything was negative. Even bonds were negative and we were seeing spreads widen and John will go into that in a little more detail. People were selling the most liquid things to cover margin calls and to get out of the market. So that may be the beginning of the end, but we’re not sure we’re there yet, so we’re continuing to monitor that. Is this overblown? Maybe it is, but the uncertainty and the duration of what’s going on here and the impact on the economy leads people to be hesitant to anything they’re doing, so we’re continuing to monitor that. As we look at this, why is all this happening? We all know it’s really the coronavirus. The fear and the uncertainty around it, I think we’ve really hit that point where we've hit the pandemic level is named from a global standpoint. We’ve had all sporting events cancel, we've had Disney World close down starting this weekend, Disneyland closing down, Broadway is closing down. They're trying to stem the tide of the virus being spread and that's just led to this extreme fear. And what that does though with that extreme fear is it’s also slowing down the economy. People don't really worry about team owners of the NBA or the players in the NBA suffering, but what it really is going to impact is all the workers that support those services and all the things that have been closed down, from the people who work at the venue to the people who work at the hotels where people stay, the airline industry, even the Uber and transport services that people take back and forth to games or to Broadway or wherever.

If this was just a 2 to 3-week thing, I think we'll move on fairly quickly. But who knows. We don’t know what the impact is. If you look at how China and South Korea have worked through this, it seems that China hit a peak after about 2 or 3 weeks and then they closed down the country. They're coming back online now. South Korea seems to have gotten ahead of it. But we’re shutting down entire countries; France, Italy. So it’s really a global event and we would say we'll probably have a recession. Will it be short? Depending on what happens, it probably will. We were very strong going into this economic environment. People were employed. Things were good. The economy was doing well. So we’ll just have to see, but there’s been a lot of fear out there. What can we do about it? We looked at it and the bond markets responded. John, do you want to step in and cover a little about the bond market?

John Culhane:  The Federal Reserve of our country is trying to lead the way to ease the pain that's been in the bond market. It's not that they can do much but what has happened in the bond market is there’s been kind of a freeze. Some extra risk particularly when it comes to credit risk and liquidity risk. When you’ve got everybody trying to sell their securities, whether stocks or bonds, all at one time, it's kind of a bottleneck. So the Fed is stepping in and trying to ease the pain. They came in last week earlier to push interest rates down, particularly in the short end. And as such they're not quite doing the job that they should be able to do, because the market still has this risk tolerance that’s pretty high right now. And because of that, liquidity and credit is pretty bad right now. What I mean by credit, I’m talking about credit spreads, particularly instruments that aren’t treasury. You get compensated for taking on extra risk. We're basically playing in the investment grade field and as such, I’ve seen those AA type credits, those credit spreads have doubled over the course of the last week or so. Mortgages, which are usually pretty sound instruments, those things have doubled in the last week or so. It's kind of interesting because obviously the 10-year yield got down to 31 basis points earlier this week and now we're closer to 92 basis points but there was a surge of refi activity to a point where banks who were processing the mortgages weren’t even answering their phones because they were getting so many inquiries. And as such the yields or the spreads on those instruments started to increase. We also saw it in the junk bond arena, particularly because the energy sectors are being hurt because of low oil prices. There are a lot of small companies out there that issue debt in order to start pumping oil in those shale oil areas of the United States and they are at risk because if oil prices are down, they aren’t collecting enough revenue in order to pay off their debt service. So those yield spreads will widen out almost doubling themselves. They were probably as low as 320 some basis points over the 10-year yield and now they're over 700 basis points, so you can see them doubling there. So the Fed is trying to relieve some of that pressure. And you know I'm just looking at the market share right now and we have a Fed meeting next week. The Fed, according to the Fed Funds Futures, has a good chance of reducing rates by 100 basis points that would probably bring our Fed Fund target level which right now is at 1-1.25% to 0-0.25%. And I'm not sure that's going to do much; it's going to be more psychological. Betsy was talking about how some of the long bonds sold off yesterday in light of the stock market falling off; particularly because I think there's a point where they're just trying to sell anything they can get. If you can sell something and you can sell it at a decent price, you sold it yesterday and the day before. And we saw that particularly in the bond market. Normally the bonds, the treasury bonds, would have a very narrow spread between the bid and offer prices, that’s between where you can buy it and sell it, you might see maybe a half point difference. I'm looking at the screens right now and I'm seeing it as wide as 5 ticks, which are 5/32 of a point, which is pretty wide, considering the liquidity that is supposed to be in the treasury market.

Overnight and the last couple days, we've had other central banks coming into the marketplace easing monetary policy, reducing rates. I was kind of disappointed that the European Central Bank did not cut rates yesterday. They kind of jaw-boned it. I think Lagarde, who runs the ECB, is probably realizing he missed a chance in order to ease the marketplace a little bit. The Fed is going to continue to do what it can. They promised to, basically we call it QE or quantitative easing; they’ve come into the markets announcing yesterday that we’re going to possibly do up to a trillion and a half dollars’ worth of purchases over the course of the next couple weeks. Part of this is to relieve the short-term liquidity problems that's happening right now, but at the same time they think they recognize that these credit spreads, particularly in the mortgages are starting to widen out, so we hope we can start having them start buying those again in order to get those credit spreads to decrease. I'm still worried that if I don't see these credit spreads start to unwind or at least start to decrease that we might be actually getting into a situation similar to 2008 when the credit markets kind of seized up. But I’m pretty optimistic. I think the Fed is on top of it. They don't have much in ammunition, particularly because interest rates are so low right now. And somebody asked me just the other day did I think the Fed would allow interest rates to go negative? Well the market basically would move rates to the negative, not the Fed; but I think that once the Fed does basically use up all their ammunition by moving the Fed Funds rate down close to zero, that we’ll probably see some flight to quality into the short T-bill portion of the treasury curve and we may actually see some negative interest rates in the very short-end, like up to 3 months.

Betsy: Tracey, do you want to cover a little bit about the equity markets and earnings expectations and the impact?

Tracey Garst: And I would just add to John, listening to some things this morning, there's a number of other tools the Fed has and it sounds to me what I heard this morning and Mnuchin’s going to talk later today, they're on top of this already. They’re kind of taking the playbook from ’08, which is a good way to start. This is not 2008 and 2009 all over again. This is totally different. That was almost looking like the global central banking system was completely going to collapse and that is not the case. U.S. banks are in extremely good shape. And that’s where the housing bubble, remember unemployment was taking off, homes were being foreclosed on. This is a lot different. Consumers are in pretty good shape right now, so I won’t go into all the economics. I kind of thought about it and this is probably something that is maybe between the 9/11 situation and the 2008 situation. But of course this is going to be more severe than 2011, because I think the biggest concern of the market is, and I’ll get into the earnings, is that nobody knows. If we knew the duration and the extent of this shutdown and coronavirus, you could make some decisions on is the market properly priced where it is today? And that’s what investors are trying to figure out right now. What should the proper level be for the S&P 500 once we come out of this? And a lot of companies are coming out, they can’t give you any guidance going forward, which is probably understandable. So I think the markets are definitely trying to price that in and earnings are going to be a huge question mark, particularly in the first half of this year. So that’s where a lot of the fear is coming in. Is this thing overblown? And I wrote maybe the coronavirus situation is, but the market trying to figure out what the realistic levels for stocks and earnings is probably not overblown. This is an exogenous event that we really don’t have a playbook for. I do think that, next to 1987, and some of us were there sitting in the office watching the S&P go down 22% in one day, this is the steepest decline in stocks we've seen since 1987. This has basically happened over about two weeks. We’ve said all along, we felt we were due for maybe a 5-10% correction and the market was ahead of itself. Now the question is what is a reasonable correction? Betsy mentioned is this the beginning of the end, she didn’t mean the beginning of the end of the market, she meant are we seeing capitulation that maybe this is getting near the bottom of the selling? I don’t know if we’re there yet, but a lot of damage has been done. A lot of the selling has already been done. Maybe it goes a little bit lower, but we’re going to be looking at is when we want to step in and start picking away and increase our equity exposure, sell some bonds, increase equity. We’re probably getting closer to that point. The market is limit up this morning, we’re going to have a rebound, then you’ll probably see the sellers come in and still want to get out and probably take it back down again.

Betsy: It’s only up 3% as of right now and it was up 5.

Tracey: I think what we have to remember when we’re talking with our clients, when you get into these bear markets or any huge correction like this, the bottoming is a process. It doesn’t happen overnight. During this recovery, we’re going to have some positive rallies in the market, but we’re likely going to test the lows we saw yesterday, if that was the low. It’s too early to decide if that’s it. We may start to piece in a little bit and maybe put a couple percent in equity. The market’s down 26% on the S&P, you start wading in; you don’t put in all the funds at once. This is a process that’s going to take several months and it’s not going to come right back, but we do think there’s some opportunity out there as we move forward. There’s still a lot of unanswered questions.

I think the other thing when we’re talking to clients and I’ll refer to one of the questions asked, at what point do you pare back on equity holdings? Well this happened so fast and everyone’s trying to make heads or tails out of the coronavirus, but I think that what we need to tell clients, too, is that we cut back on equities 3 times last year. We went overweight and went back to neutral, we went overweight and went back to neutral, and we did it again in January this year. So where did that money go? That money cut back and it went into the bond market and the Merger Fund which has held up very well. So we have actually cut back on equity over the last year as it has run up, but bonds seem to be getting overvalued, stocks seems to be getting oversold, but they can continue to get oversold. So at this time now, if you look at a 50/50 portfolio or 60% stock portfolio, we’re probably 5-7% underweight equity. We’re going to gradually move back into equity. So I would say if you have clients who are really worried, are they in the right asset allocation? Those people may need to pull back on equity and maybe a 60% stock portfolio, should be at 50%? So that’s something we might want to change the allocation on right now, so that we’re not adding back into equity and if we’re wrong and the market goes down again, then they’re not going to be too upset. So really focusing on what is that proper asset allocation is very important or if you have clients averaging in, starting to put some money to work right now makes a lot of sense, not all of it, but beginning to pick away at it.

We really have not had a major bear market since 2008. Over the last 50 years, there's been 14 bear markets, so that's roughly a bear market every 3.6 years. The median decline of those bear markets are 28-29%. We’re near that, so this is comparable to a bear market, but remember over that 50-year period, the average return in stocks, including all those bear markets, is a little over 10%. It doubles roughly every 7 years. I think this is a little different, because we haven’t had that extreme. I would say we’ve had 2 bear markets. We had a bear market in 2011, European debt crisis; we were down about 20%. And if you look at 2018, that was close enough, 19.6%. 2016 was about a 15% drop, but this is more severe. Like I’ve said, we don’t know if this is over yet. The bottoming is a process and that’s what we’re looking at. There are indicators that you watch. The VIX and some of these other sentiment indicators that are at their most extreme levels since 2008 and some even lower, so there’s no doubt the panic has set in. If we’re not at capitulation, we’re probably close. But the biggest thing is we have to figure out where earnings are and the market is going to be unsettled by that. And the reason I say we have a few months for this to work out, we have to get through this closing process, then open the economy up and get people back to work. Then the question is, is this going to increase again, the coronavirus? That’s going to be a concern. So those are still uncertainties that aren’t going to go away. So I think it’s not going to shoot right back up, but we’d like to see a stabilizing of the market and a Fiscal Policy stimulus put in place as a backstop for the market and the economy.

Betsy: The other thing that's out there is what's the government going to do with us and I think the speech the other night by the president did not calm markets at all. Overnight, Pelosi stated they were getting closer to a deal. This morning, Mnuchin was on TV saying that they're working very closely together and looking at ways to support this. So I think if we get a fiscal move from the government side, it will give some support to the market. It doesn’t mean it’s the end. As Tracey said, it’s a bottoming process we have to work through it, but you have to put a floor in. We do have to think about where we’re at, what’s going to happen. I don’t think we’re going to have a V-shaped recovery in the equity market. And I think John or Tracey would agree with that. It is the uncertainty. And we’re not going to know what earnings are and what the overall impact of shutting down an economy for 2-4 weeks when you look at it. Some steps we’re taking, yesterday we did sell our Oakmark position; really to get into why we did that. We have been talking for the past 2 weeks how we want to position, when we want to add to the portfolios and add into equities. The Oakmark portfolio was going to be coming out no matter what and we figured it’s time to do it. Why is it coming out? It has lagged its peer group. It doesn’t perform well in up markets; it doesn’t perform well in down markets. It’s not doing what we want it do. We have another option out there. For the time being, we just moved it to cash until we decide how we want to rebalance and when we want to start that process. But that is the primary reason; it is not meeting our expectations. It was going to be removed from the portfolios no matter what. Just so you know that when talking to clients and they wonder why we made that change. We have been talking about how we're going to add to the portfolios, how we want to be structured, how we're going to do it. We had talked about doing a couple percent here, a couple percent there. We're still in that process. I would say we're not ready to make that move. It might happen in the next week. Depending on what happens, it could be two weeks. As we do that, we will send out notices to everyone and will let you know what's going on and why we're doing it. But it is a process, as Tracey said, it’s a bottoming process. The credit markets, as John said, we have to make sure they're working. Because if credit markets don't work, equity markets don't work and the economy doesn't work. So we need to make sure all these things are somewhat in order. We can't say, we will not call the exact bottom. We don't promise we’re going to call the exact bottom but we are monitoring signs of when the bottoming process is starting. When you look at this morning, it started limit up over 5% and the Dow is only up 2.5% right now. There’ll be some buys and sells. It can be a very volatile day, on top of it being Friday, the 13^th, so we’re going to monitor that and we are looking at that. John and Tracey, do you have any other comments to add to that?

Tracey: I would just say that nobody can call a bottom. It’s impossible. There’s a question on here, somebody asked, are you personally investing or did you liquidate from equities? I’m assuming they’re asking us individually that. I can’t pick a bottom, but I did have some cash; I put some cash in on Monday. There’s a question came in here, what are your thoughts on a recession?

Betsy: I think we're going to have one, a short one.

Tracey: I think it’s going to be short and shallow. It’s not going to be a deep recession like ’08, unless something unexpected happens, it’s probably not going to be a deep one.

Betsy: And the ’08 one was a deep one and that was due to leverage and housing. And leverage is a much harder type of recession to come out of when it’s caused by that than it is the type of recession that we would anticipate right now. It’s really just kind of closing down an economy for 2 to 4 weeks, people getting back into the circuit, people not as stretched as they were coming out of 2008.

John: I think our government officials have learned a lot from 2008. They were kind of slow to react, generally when it came to congressional problems that they had trying to pass the major bills back then. I think now we have to see more work between basically Washington and Congress, the President and monetary policy owner to get the best bang for their buck for the recovery. Because what we’re doing is kind of slowing down the magnitude of this slowdown. I mean this is not just us slowing down. This is a global slowdown. And I’m not saying everything is being shut down per se, but it is going to affect us. Monetary policy will help the recovery. It’s not going to help it stop everything from falling apart. It’s not a cure. It’s there to help them when we do get out of this funk, if not when we start seeing lesser infections in the globe and United States, lower interest rates will give that base for the recovery going forward, which should, as I think we can all agree, the three of us, when we get this recession, if we get one, it’s going to be a smaller one and hopefully we’re going to have a quick recovery.

Tracey: Betsy, I had one more thing here. We can’t pick a bottom. You’ve got to know your client. I had a client yesterday, I thought he was going to sell; we talked a little bit and he said he didn’t need the money right now, so we didn’t. But something to remember here, we talk about the market moves, most of your market moves are in very few days of the year. So you can’t time it, you have to be invested. But interesting, half of the market’s best days in history have happened during bear markets. So when you sell out, some of those upward moves are huge. And that’s what we talked about yesterday, he and I didn’t want to really miss the upward move. We can’t tell you how much downside there is, but there can be significant upside. So just because we’re in a bear market, doesn’t mean you can’t have really strong upward moves in the market and you need to be there to take advantage of them. And then 30% of those best days have happened in the first two months of a recovery. The problem is we don’t know when that first month recovery is. Know your client, have the right allocation, but probably not the best time to liquidate.

Betsy: I would say in summary, we’re still hesitant to say we’ve hit a bottom, but we think we’re closer to it than we were probably a month or 4 weeks ago when we were hitting all-time highs. And we will be moving into the market gradually as we see fit. We will keep everyone informed. If clients have questions and you need to include us on calls, feel free to contact us. We’re all available. So if you do have any other questions, feel free to reach out to us. We will be glad to answer them. We’re always at your disposal and we know that it’s a volatile time for clients and assure them that we are attempting to stay on top of this as much as possible. It’s a moving target. And our expertise is here. John, Tracey, and the rest of the staff, Steve, Dan, Michele, and the assistant portfolio managers; they’re all on top of it and can be open to talk with clients. Thank you everyone for taking time this morning and have a great Friday.

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