Last quarter, I started this piece by welcoming you to the new Roaring 20s decade. At the time, we were cautiously optimistic that markets would continue to grind higher for a while longer. However, we warned that downside risk potential was greater than it was throughout 2019 and noted “any signs of economic weakness or new uncertainty might cause a violent reaction to the downside.” What an understatement!
Not since the Crash of 1929 have equities plunged so quickly into a bear market. During this quarter, the S&P 500 Index lost 34% of its value between the all-time high reached on February 19 and the current bottom reached on March 23. The index did recover approximately 15% off that bottom by the end of the quarter. However, it’s important to remember that a passive S&P 500 portfolio worth $100 on February 19 was worth only $66 one month later on March 23. At that point, an investor needs a 52% positive return before their portfolio breaks even at $100 again. This highlights the critical importance of capital preservation and is the reason WBI Investments remains so focused on risk mitigation and avoiding catastrophic losses like we just experienced. And let’s be clear, we are still in the middle of this crisis, so more devastating losses could easily lie ahead.
Looking back in time while the record-breaking bull market continued to grind higher last year, most investors were keeping a close eye on the impact of trade wars, easy monetary policy, weaker corporate earnings, ballooning corporate debt, global economic slowdowns and inverted yield curves. Equities seemed to be “priced for perfection,” so many analysts looked for any indications that a market correction and economic recession might loom on the horizon. At the same time, there were still forecasters out there claiming “this time will be different” and “we will never again experience devastating recessions.” Of course, history did repeat itself and showed markets can still drop by 30% or more in just a few weeks, and devastating recessions are not a thing of the past (more on that later).
However, history books will note the catalyst for this crisis was certainly different this time. We have never faced a global pandemic that forced so many economies to completely shut down or potentially face enormous loss of life. Finally, after many weeks of tragic reports with many more still likely to come, it does appear that infection curves may be flattening due to social distancing efforts. The impact on global health appears to be slowing which is certainly a positive sign. However, the devastating impact on global economies is just starting to reveal itself. Although COVID-19 was the catalyst for this crisis, the negative trends and indicators we were concerned about last year didn’t disappear. Unfortunately, the virus simply accelerated and exacerbated the market selloff and economic slow-down that we were already expecting.
Markets in Review
The market’s 30%+ drop is only its seventh since 1928 and the quickest by more than two weeks. There are only two other instances where the speed of the decline was anywhere near as fast – 1929 and 1987. Furthermore, the S&P 500 lost 12.5% in March in its biggest monthly decline since the 16.9% slide of October 2008.
Due to a late quarter rebound, the year-to-date returns do not tell the whole story. Although the S&P 500 was down -20% year to date, the index lost -34% from its all-time high during the quarter. Similarly, although the Dow Jones Industrial Average was down -23% year to date, the index lost -37% from its all-time high during the quarter.
Value-based investments demonstrated even worse results, on a relative basis, as the Russell 3000 Value Index lost -28% year to date including a -39% peak to trough decline during the quarter. Small and mid-sized capitalization companies also suffered worse than large-capitalization firms as the Russell 2000 dropped -31% year to date with a -42% peak-to-trough decline during the quarter.
U.S. fixed-income assets benefitted from positive performance in January and February but enormous problems with liquidity and forced liquidations caused volatile gyrations even in the “safe haven” U.S. Treasury market during March.
COVID-19 and the Pandemic of Fear
Although we began the year with many potential areas of concern, literally no one knew it would be a fast-moving global pandemic that would cause the next bear market and almost certainly the next recession. On January 11, China reported the first death from a novel coronavirus in Wuhan. Within the next ten days, other countries began confirming cases as well. By February 10, the death toll in China had already surpassed the 2002 SARS epidemic. On February 14, the first death in Europe was reported and infections began to surge in new areas like Iran and South Korea. However, five days later, on February 19, the S&P 500 Index hit its all-time high and U.S. markets were up almost 5% for the year. Our country, or at least the market, was still convinced that this was not a domestic concern. How quickly things change.
By February 29, the U.S. announced its first death and expanded travel restrictions. On March 3, the Federal Reserve met in an emergency session and cut interest rates by 50 basis points (or 0.50%). On March 11, the World Health Organization finally declared that COVID-19 was a pandemic and the U.S. suspended travel from Europe. On March 15, the Federal Reserve cut interest rates by 100 basis points (or 1.00%) only 12 days after its previous cut. By March 23, the S&P 500 Index had dropped 34% from its all-time high reached only weeks before and New York City was identified as the biggest epicenter of the outbreak.
As of April 16, the official number of global cases is 2.2 million with 145 thousand fatalities. In the U.S. alone, we are fast approaching 700 thousand cases, although it does appear that the pace of infections has finally slowed down.
Certainly, this crisis is unique in so many ways. The speed with which it took hold and the fact that it impacted the entire world is mind numbing. The fear of sickness and death spread even faster than the illness itself. In February, we watched China build temporary hospitals in days and saw pictures of empty city streets as they brought their entire economy to a grinding halt. Social distancing became the only way to avoid catastrophic loss of life predictions, so China was forced to shut it all down and have people shelter-in-place. At the time, we realized that the hit to their economy would be massive, but it still seemed to be a relatively distant problem that was possibly already under control. Just a few weeks later, our country and so many others across the globe were forced to do the same thing. Shut down the economic engines, take the key out of the ignition, and bunker down.
What Will Be the Depth and Duration of the Economic Devastation?
Historically dreadful economic data has already started to come out but the worst is yet to come and nobody knows just how long this will last and how much damage will occur. Even acknowledging the enormous amount of monetary and fiscal stimulus that was injected into the market so far, John Williams (President of the New York Federal Reserve Bank) explained, “The coronavirus pandemic has created circumstances we have never experienced before in our lifetimes, and the reality is that the full scale of the economic consequences is still unknown.”[i] He noted further, “To put the current situation in context, we are running more open market operations, for greater sums, than at any time in our history.” So, although the markets have already bounced back quite a bit on the news of drug trials, slowing infection rates, and prospects of re-opening the country again, the real economic impact is just starting to be revealed and it will be many months, if not years before the full impact is truly understood.
Unemployment appears to be spiraling toward 20% as soon as this month with the strong potential for even higher levels. As of April 16, the four-week total of people who have filed for unemployment benefits during the first full month of coronavirus shutdowns is now above 22 million which is approximately one-eighth of the workforce. This total far exceeds that of any previous four-week period on record. If the pace of unemployment claims doesn’t slow down for several more weeks, we could even be heading towards a 30% unemployment rate which would be triple the level from the last Great Recession of 2008-2009.
The NAHB Housing Market Index, a popular measure of the health of the residential real estate market, plunged 58% to 30 in April from 72 in March. This is the biggest decline in the 30-year history of the metric. Similarly, new privately-owned housing units started, referred to as Housing Starts, collapsed down -22.3% on a month over month basis in March which is the worst monthly change since 1984.
Retail sales for March fell 8.7% month over month which is the largest decline on record. The April Empire (NY) Manufacturing activity survey hit an all-time low as it dropped -78.2% (a drop of only -35% was expected). Also, Industrial Production for March declined -5.4% month over month which is the biggest decline in output since February 1946.
We must recognize that most of this record-breaking data is based upon the month of March during which time the economy was not fully shut down for the entire period. April data that we will receive next month will most certainly be unbelievably worse.
The National Bureau of Economic Research (NBER), which officially declares recessions, currently defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. Given that definition, it might be a few months before NBER makes its official declaration, but we are clearly already in a recession both domestically and globally. Various quantitative models confirm that prediction including Bloomberg’s U.S. Recession Model which is already pegged at a 100% certainty of a recession in the next 12 months.[ii] Many economists believe that this will likely be the “worst recession in generations as the U.S. economy grinds to a halt and millions lose their jobs.” Former Federal Reserve Chair Janet Yellen described the crisis as a “huge, unprecedented, devastating hit” and expects to see a 30% decrease in GDP for the second quarter this year.
Ray Dalio, founder of Bridgewater Associates which is the largest hedge fund in the world, thinks it’s going to be even worse. Mr. Dalio gave a speech on April 8 in which he said, “We are heading into a great depression similar to that of the 1930s, which will take years of financial and economic reconfiguration and human ingenuity to recover from.”[iii] He emphasized, “This is not a recession; this is a breakdown. You’re seeing the same thing that happened in the 1930s.”
An old joke unfortunately seems to hit home right now: The pessimist says, “everything’s terrible, it can’t get any worse.” The optimist says, “oh yes it can.”
The very nature of this crisis makes it extremely difficult to read the future for equities. The degree of corporate profit damage depends largely on how long the severe economic disruption lasts. Although there is already talk about slowly re-opening parts of the country that were not as affected by the outbreak, it still seems likely that the current economic and social conditions will continue well into June for much of the country. Even when the economy can start up again, it will likely be many months if not years before it fully returns to normal although there will likely be rapid spikes back up in activity as the engines are turned on as fast as possible.
Neel Kashkari, the Federal Reserve Bank of Minneapolis President, recently described the potential for rolling shutdowns even once we do begin to lighten current restrictions: “We could have these waves of flareups, controls, flareups and controls until we actually get a therapy or a vaccine. I think we should all be focusing on an 18-month strategy for our health care system and our economy.”[iv]
Even though a lot of bad news has already been priced in, stock prices look set to remain highly volatile, with a lot of potential for both upside and downside surprises. New market lows are absolutely possible as well.
The evolution of the pandemic, as well as the extent and duration of government measures to contain it, will largely determine the direction of markets in the coming months, even considering the impact of central banks and fiscal emergency packages. COVID-19 still poses extensive challenges for professional virologists and the scientific community. However, politicians, economists, and investors face even greater questions and challenges. Everyone is still learning about the disease and the economic damage and so misjudgments are inevitable. Mistakes will be made in the markets, the economy, and society. Hopefully, they will be identified quickly and resolved.
Here at WBI, we continue to focus on risk mitigation and the protection of investor capital as we carefully monitor deteriorating economic data and the potential for additional market selloffs. Our strategies performed well as our active management system quickly moved out of equities and into cash and equivalents. However, our portfolio management system is also working to capture as much upside as possible even during these volatile times. We appreciate your continued faith in our approach and wish you and your families both health and peace as we all navigate through these strange times together.
Past performance does not guarantee future results.
The views presented are those of Steven Van Solkema and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.
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Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return.
The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.
The S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors.
The NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ.
The Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe.
The Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index.
The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.
The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.
The Russell 1000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 1000.
The Russell 2000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 2000.
The Barclays U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index.
The Barclays Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers and includes the performance effect of income earned by securities in the index.