The coronavirus pandemic and resulting economic shutdowns caused the S&P 500 to record its worst quarter since the end of 2008. From peak to trough, the market dropped 34%, making it the quickest decline of 30% in history. You would have to go back to 1934 to come close to that speed and, believe us, no one in this business wants to go back to the 1930s. Despite the magnitude of the decline, it was not a straight line down. There are many technical ways to measure volatility but these daily percentage changes in the S&P 500 speak for themselves:
3/09/20 -8% 3/17/20 6%
3/10/20 5% 3/18/20 -5%
3/11/20 -5% 3/19/20 0%
3/12/20 -9% 3/20/20 -4%
3/13/20 9% 3/23/20 -3%
3/16/20 -12% 3/24/20 9%
The damage was not limited to stocks. The price of West Texas Crude oil declined by over 60% as a price war between Saudi Arabia and Russia added fuel to the pandemic’s fire. Credit spreads on investment grade bonds widen to levels not seen in a decade. In a flight to safety, the yield on 10 Year Treasuries fell to about a half of a percent which is the lowest we can find on record. However, they did not go negative which we view as encouraging.
With over 90% of the country’s population under some form of a stay at home order, it is clear to investors that economic activity will fall dramatically. We have seen credible estimates of over a 30% sequential decline in second quarter GDP and mid-double digit unemployment rates. Corporate earnings will be even harder hit due to fixed and financing costs. Simply put, even large corporations with no revenue due to shutdowns still have expenses to pay. As drastic as this sounds (and is), it is crucial to recognize that this is the reason the stock market sold off in the first quarter. It does not necessarily tell us about the future. In fact, the market has rallied over 20% despite 6 million unemployment claims being filed in a single week. With the near-term outlook so bleak, how can this happen?
First, the Federal Government and the Federal Reserve stepped up to support the economy with a “whatever it takes” approach. Without going into detail, the programs are measured in trillions of dollars and include unprecedented support of corporate and municipal debt. These measures are designed to bridge consumers and businesses over the current disruption. No one knows the depth of this recession but government’s aggressive response served to reduce the tail-risk of a depression in investors’ minds. This enabled the first leg of the rally.
The second leg of the rally was driven by investors gaining conviction that the pandemic can be contained through social distancing. Italy’s experience is probably the most applicable to the United States. Although total coronavirus cases continue to increase, daily new cases dropped from the mid 6,000 level to roughly 3,000 over twelve days (3/26-4/7/20). It took three to four weeks from lockdown to a peak in new cases. New York’s new cases appear to have peaked on April 4th and the market took another leg up shortly after. Of course, the availability of testing for the virus plays a heavy role in the reporting of new cases.
The depth of economic damage remains to be seen but a consensus of a restart by the end of May appears to be emerging. Of course, the United States did not have a uniform lockdown so reopening dates may be on a rolling basis. However, there is no consensus as to what a restart actually looks like. There is little precedent to guide us. China has reopened but their lockdown was so draconian compared to the West that drawing comparisons is not simple. There is a clear tradeoff between economics and health. We envision a staggered restart akin to a red light, yellow light, and finally green light approach. This unpredictability creates some expectational risk. It is difficult to pinpoint what earnings are currently discounted by the market or what time frame is most relevant. Our sense is that an “earnings power” (earnings in a normalized environment) based approach is appropriate as long as progress towards normalization is seen. Regardless, consumer and business behavior is likely to be impacted at least until a vaccine is widely available which may be a year and a half away. Our stock selection during this crisis has in large part been driven by this thematic.
We have focused on selling stocks directly in the path of the virus and redeploying into businesses with intact secular growth drivers. Sales included travel related exposure such as credit card companies, restaurants, and aerospace manufacturers. We added to several internet retailers as we anticipate that the lockdowns accelerated the existing trend towards online shopping. The adoption of 5G wireless may be somewhat delayed by the COVID-19 crisis but we believe in the importance of this innovation nonetheless. Exposure was added through semiconductor companies and cell phone tower operators. It may take time for our upgrades to pay off on a relative basis as stock correlations have been extremely high and lower quality companies tend to initially bounce the most. That said, we like these themes’ prospects looking out over the next year.
We also opportunistically sold and subsequently repurchased (at significantly lower prices) several bank stocks and a railroad. On the banks, our research shows them much better capitalized than the last cycle. At its most basic level, there were no Dodd-Frank Stress Tests or CCAR in 2008.
There has been much conjecture as to the shape of a recovery, typically employing an alphabet soup of letters such as V, W, U, or L. The economic situation most likely follows a U-shaped path based on a cautious restart and the severe damage already inflicted on service oriented small businesses. However, financial markets do not have to symmetrically follow the economy. In fact, they most often lead the economy. So far, markets have looked more like a V or a sloppy W. Many are skeptical of a V-shaped recovery because it has rarely occurred in the past. On the other hand, neither have pandemics or a simultaneous fiscal and monetary response of this magnitude. This recession was self-inflicted by shutdowns rather than the typical correction of excesses built up in the economy over time. That portends well for recovery as we move towards a full restart.
There may be setbacks but history tells us not to underestimate America’s ability and desire to recover. Keeping that in mind, we remain focused on balancing risk and reward through a difficult time period. Our hearts go out to all those impacted by COVID-19 along with our gratitude to those on the front lines.
Please stay safe.