March 25, 2020
Our Perspective on this Unsettling Environment
Please read important disclosures and index definitions HERE
March 25, 2020
Please read important disclosures and index definitions HERE
The current environment is testing the nerves of even the most steady and disciplined long-term investors. Over the past month, the S&P 500 index of U.S. stocks has dropped by 32%. Economic activity around the globe has ground to a halt, the number of coronavirus cases is increasing, we are quarantined in our homes and government officials seem to be on their heels. Only the best Hollywood screen writers could have envisioned this scenario. It can be frightening and it begs the question: where do we go from here and what should investors consider doing?
Before we answer these questions, it’s important to remind you of the plan you already have in place. Although few, if any, could have predicted even several months ago that a rapidly spreading virus would shut down major sectors of the economy and cause stocks to drop dramatically, our philosophy when designing a long-term plan and investment portfolio for any client is to assume that the stock market may, on occasion, decline significantly for reasons that are largely impossible to predict in advance.
We aim to build client portfolios with these declines in mind from the very outset of our relationship. We do this in conjunction with a careful understanding our clients’ overall objectives, risk tolerance, time horizon and spending levels. Our intent is to position our clients’ portfolios so that they have a reasonable probability of meeting long-term objectives even in the face of stock market declines.
To prepare for and to reduce the impact of severe stock market declines, B|O|S takes a comprehensive approach. First, with the knowledge that the stock market is inherently risky, most B|O|S clients typically hold high-quality bonds in their portfolios to provide stability. Despite the recent market declines, bonds have generally held up well relative to riskier assets. As of this writing, high-quality bonds are generally flat to modestly negative. Second, as the stock market has risen substantially over the past decade, we have typically “rebalanced” portfolios by selling stocks and buying bonds to keep portfolios close to their “target” allocations and risk levels. Third, as a result of our experience in prior market downturns, particularly the bear market of 2008-2009, we favor high-quality bonds and we generally include little, if any, junk bonds, low credit-quality bonds or highly illiquid assets in client portfolios. In times of stock market stress, these types of assets typically have high correlations with the stock market. That has indeed been the case in the current downturn – for example, junk bonds, as measured by the Bloomberg Barclays High Yield Bond Index, have declined 18% so far this year. Finally, through a sharp focus on each client’s overall financial picture, we advise clients on appropriate levels of spending to help them meet their most important objectives and we look to help clients identify ways to reduce risk in other aspects of their financial lives.
Thus, much of the important planning in a down market comes well before it actually occurs. That said, we want to shift focus to where the stock market may go from here and to what you and we can do to improve your chances of having a positive long-term outcome.
How Far Will the Market Go Down?
The short answer is that we don’t know and no one can know with any level of certainty. The impact of the current coronavirus outbreak on the overall economy is a fluid situation but there are some things we can reference to give us reasonable expectations. These include looking at potential best and worst case scenarios, examining what history tells us about market downturns and analyzing what various market data is telling us.
Best and Worst Case Scenarios for the Stock Market
The best case scenario at this point is that, through discipline and successful quarantine efforts over the next month or so, the spread of the coronavirus levels off and then begins to slow. Moreover, efforts to stabilize the economy through massive liquidity injections, stimulus and relief for unemployed workers and impacted businesses proves effective in the short-term at stabilizing the economy. In this scenario, the stock market may have already faced the worst of its declines and may be close to hitting its bottom. The stock market is usually anticipatory and advances ahead of any economic recovery. To the extent progress is being demonstrated to move beyond the coronavirus scare, the stock market could rally in the near-term.
The worst case scenarios is far worse: the virus continues to spread, takes far longer than anticipated to slow down or resurfaces again in the future. Economic activity stagnates for much longer than anticipated and we enter a deep and long recession. Millions of Americans are unemployed and fear continues for many months to come. Similar to the 2008-2009 market decline, the total stock market decline reaches 60% or more from the recent high. Economic activity is slow to rebound and the stock market takes many years to recover. Of course, the worst case scenario could be even worse than outlined here – there is no way of knowing for sure.
History as a Guide / Putting this Decline in Perspective
If history is any guide, the outcome will likely fall somewhere in between. Considering the 14 bear markets in the U.S. since 1929, the average decline of the S&P 500 was 39%. But this time is very different, right? Yes, this situation is absolutely different but most major market declines are a result of something that seemed very different at the time. The stock market is a very volatile place and that has been forgotten over the past decade as the stock market has risen. While the current 30%+ decline is frightening, we often see very significant declines in the stock market. The chart below, which shows the intra-year market swings in the stock market, demonstrates just how volatile the market can be.
Now, let’s take a closer look at the stock market decline over the past few months. It is definitely severe.
However, the chart below helps put this current decline into a longer-term perspective. The stock market has essentially given up its gains of the past few years. Longer-term investors over the past 30 years have achieved very strong growth even though there have now been three major market declines (2000-2002, 2008-2009, and 2020). Earning attractive long-term returns requires tolerating these types of events every decade or so.
The Importance of Long-Term Discipline
So, wouldn’t it just be better to get out now and get back in when this is resolved? We don’t think so for several reasons. First, as the chart below demonstrates, returns for balanced investors are typically very strong in the years following a crises.
Moreover, it is extremely difficult to time the market. As the chart below demonstrates, stock market recoveries can happen quickly and when least expected. Those investors who miss the best days are likely to reduce their long-term return potential.
Key Market Metrics
Can the stock market go to zero? Will the stock market fall as much as in the Great Depression (over 80%)? These are some of the questions on investors’ minds.
While we don’t know where the bottom of this bear market will be, we do know that the stock market is comprised of companies that will continue to provide important products and services to all of us going forward. Once the coronavirus risk subsides, we will drive our cars, drink lattes, eat out at restaurants, improve our homes, and do many other things. Publicly traded companies will continue to seek to earn a profit and deliver value to their shareholders.
At some point, the stock market should stop going down as investors shift from protecting the downside to looking to capture return opportunities. Although impossible to predict, one could argue that we may be approaching that point. Price-earnings ratios have dropped to much more reasonable levels in the US and they are downright cheap in many other areas of the market (value stocks, foreign stocks, emerging markets, etc.). The current earnings yield on stocks at over 6% (while likely to be revised downward as some companies cut their dividends) is extremely attractive relative the yield on most high quality bonds.
What Can I Do and What Is B|O|S Doing?
What should you do?
In our experience, the best advice we can give is to stay disciplined as hard as it may feel right now, and it is very hard. Use your income, cash balances or bonds to support your living expenses while your stocks recover. Most clients’ stock allocations are well below their target allocations. If you don’t have the stomach to consider buying again, we encourage you to hold on to what you have. And, if you have real concerns or are really not sleeping at night, consider selling a little bit of stock now to avoid the temptation to sell if things get even worse. Be sure to get away from the barrage of bad news for periods of time and, to the extent possible, spend this time you now have at home doing some of the things you enjoy or have not had time to pursue.
What is B|O|S doing?
B|O|S is working hard at this most difficult time to do what we can to help you. This includes, among other things, closely monitoring financial markets and the different investments in client portfolios, looking for opportunities to tax-loss harvest (capturing valuable tax losses to reduce your future tax burden), working with you to determine whether you have sufficient cash and liquidity to ride out this storm, devising customized approaches to rebalance or alter portfolios depending on your needs and preferences, reforecasting long-term financial plans to provide perspective on long-term spending plans and looking for opportunities to reduce debt levels, where appropriate, and refinance mortgages at lower rates.
Hope, Ingenuity and the Human Spirit
We can never know anything with certainty and we do not know how this story will end. However, despite the difficulties of comparing one situation with another, we have found history to be a reasonable guide. At the end of the day, America is a creative, hard-working and resourceful country. We have overcome many extreme challenges. We all have tremendous incentive to get back to a normal life. This gives us hope for a promising future.
Hang in there, stay safe and be with your families at this important time. We are here for you.