Coronavirus Update #6
Updated: Apr 23, 2020
Dear Clients & Friends,
I thought that another COVID-19 update would be welcomed.
First and foremost, I want to remind everyone that, in addition to reducing risk last year, we also reduced risk at the very beginning of March (two weeks ago). We reduced risk again at the end of the day on Wednesday after a market rebound, but before the initial jobless claims report was released on Thursday.
Though our forecast was for a massive spike in initial jobless claims of 1.3 million, the actual number was a jaw-dropping 3.3 million. In addition, we don’t think that this number was accurate. Reports that unemployment offices are unable to keep up with the massive inflow of jobless claims lead us to believe that this number is actually higher than the one that was reported. However, the markets rallied viciously even despite this horrific report.
Many believe that the market has found its bottom because investors seem to have ignored the unemployment figures. We disagree. We believe that, preceding the financial crisis of 2008 and again today, many investors are succumbing to “optimism bias.” Optimism bias is a cognitive bias that leads us to overestimate the likelihood that positive events will happen in our lives, and underestimate the likelihood that a negative event will occur in our future. In the current context, optimism bias can prevent rational evaluation of the severity of COVID-19. No one wants to think about how bad this pandemic could get… so they don’t. Thus, we believe that the recent market strength is a “dead cat bounce.” We believe that the market will fall further, and so we stand by our decision of a few days ago to reduce risk yet again.
There is one very encouraging metric that is worth mentioning: insider trading (the legal kind- stock purchases by corporate executives). Last week, we saw the highest ratio of buys to sells among insiders that I’ve ever seen in my career. This indicates that insiders see tremendous value in their own companies at current levels. On the other hand, could this be yet another indication of optimism bias? Only time will tell.
Several clients have asked why their bonds have declined in value. This is extremely common during the early stages of a significant market decline. We attribute this decline to three things: indiscriminate selling of investments, a misunderstanding of why and how bonds lose money, and the stimulus package that is expected to flood the bond market with more bonds.
Regarding the first reason, many retail investors are fire-selling their investments. Imagine that an uninformed investor owns a “balanced fund,” such as a target date retirement fund, in their 401k. They have likely experienced losses because these funds consist of a “balance” between stocks and bonds. If they sell this fund, they are unknowingly and simultaneously dumping both stocks and bonds at the same time.
Regarding the second reason, the only way for a bond to permanently lose money is for that bond to default. As long as the bond matures, it matures at par, and the full value is returned to the investor. The vast majority of the bonds in your portfolio are high quality. Therefore, we do not expect any material defaults on this side of our clients’ portfolios.
The only investment that has exposure to lower-rated bonds is a position that roughly 20% of our clients own. This position is not publicly traded, and therefore that cannot be fire-sold by panicky investors. This benefit gives its managers the opportunity to purchase well-capitalized bonds at low prices when they are fire-sold from publicly traded mutual funds. This is precisely what was happening in 2016 during the oil crisis, which is why we bought into this fund at that time. The investment returned 45% within the first year. This is why we use less-liquid private funds for this part of our portfolios. We do expect some draw-down in this position, but expect the long-term opportunity to dramatically outweigh short-term volatility. We expect the managers of this fund to cherry pick within the lower-rated credit market in the same way that we expect to cherry pick in the equity market.
Regarding the third reason, the US government will need to raise a great deal of money to fund this stimulus package. They will be doing so primarily by issuing more government bonds and printing more dollars (although they will not actually be “printing” a lot of this money, as they are expected to start using “digital dollars”). Since this creates an over-supply of bonds, the government will need to make bonds more enticing by offering higher yields. The higher yields of new bonds make the lower yields of older bonds less attractive thereby causing the prices to fall slightly. But again, as long as the old bonds don’t default, they will mature at par. (This explanation is not perfectly accurate. It is dramatically oversimplified for the purposes of understanding the correlation between bond yields and bond prices)
As for “printing money,” when we inject more dollars into the system, supply and demand dictates that dollars become less valuable. This causes inflation to rise. When inflation rises, yields on bonds must increase in order to keep pace. And as we saw in the previous example, when yields increase, the value of bonds fall.
The Fed did recently cut rates in an effort to make borrowing more available. This is another form of stimulus and, to some extent, offsets the previous two effects. But all of these factors are in combat with each other, and with so many gears grinding, the bond market became nearly dysfunctional last week due to volatility related to uncertainty.
In short: as long as the majority of our bonds are high quality and we experience low default rates, the recent fall in value should not be of meaningful concern. It’s worth noting that we previously made very good returns in lower-quality bonds, and plan to again in the future. However, we rid our portfolios of nearly all publicly traded lower-quality bonds last year due to our concern over a slowing economy.
The good news:
The good news is that Congress took one week to pass a stimulus package that is far more comprehensive than the 2008 stimulus package, which took 4 months to pass. Congress and the Federal Reserve seem to have gained much more knowledge about what is possible, what is legal, and how to implement modern stimulus packages. Furthermore, Congress has made a historic pledge to do what they can to avoid a depression, which is what the market seemed to be pricing in last week.
Although I do not agree with every part of this stimulus package, it is, generally speaking, a very good package. It is targeted towards middle- and low-income Americans, small businesses, and large businesses that are necessary for the sustenance of our domestic economy. Where large businesses benefit, there are meaningful restrictions regarding what this stimulus money can be used for; this was a major oversight (total blunder) of the 2008 stimulus package.
The bad news:
We are not out of the woods yet, more bad news is forthcoming, and we expect a recession. We’ve been writing about a coming recession for quite some time now. We believe that the terrifying fragility of the investment markets is partly due to an already slowing economic growth rate. At least, therefore, the MORWM family of clientele is better positioned than most for our current conundrum.
About the bailouts:
Many people are morally opposed to bailing out major corporations. On a personal note, I agree with this to some extent. We’ve just experienced the longest economic expansion in US history. Instead of shoring up their balance sheets, many of these corporations irresponsibly distributed enormous executive bonuses and dividends to shareholders, while engaging in huge stock buyback programs that were intended to increase their stock price. However, this debate is better suited for the future regulation of businesses that are “too big to fail.” At this particular moment in time, I believe that the focus needs to be on preventing both massive layoffs and the collapse of companies that could potentially induce a rippling effect throughout the economy. That said, I do hope that American corporate culture learns from this, and that more ethical business practices are adopted.
We have completed the majority of our research related to how we intend to begin cherry picking, and we have better clarity about when that cherry picking will begin. It’s a moving target, so we cannot define exactly when that will be. But I can assure you of this: we will not hit the bottom perfectly - that’s impossible. However, with objective analysis and diligence, we hope to benefit from the old-fashioned, long-proven discipline of buying low and profiting from the recovery - whenever that may be.
In the meantime, as this virus continues to spread, take care of your family. We’ll take care of your portfolio.
Have a wonderful weekend. We hope that everyone is slightly bored because that would indicate that everyone is keeping to themselves!
-The tireless team at MORWM
Matthew Ramer, AIF® Principal, Financial Advisor MOR Wealth Management, LLC 1801 Market Street, Suite 2435 Philadelphia, PA 19103 P: 267.930-8301 | c: 215-694-4784 | f: 267.284.4847 | 601 21st Street, Suite 300 Vero Beach, FL 32960 P: 772-453-2810 firstname.lastname@example.org | www.morwm.com The majority of this content was written and distributed MOR Wealth Management, all rights reserved. Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered through CES Insurance Agency.