SENT on Mon, Mar 9, 2020 at 1:39 am MDT
As I write Sunday night, it looks like tomorrow will be another volatile day in the financial markets in what has been a volatile two-week period. Those stock markets abroad that have already opened for trading are down 3-5%, as are U.S. stock index futures. However, the really big move tonight is in the energy markets, the price of oil falling more than 20% as Russia and Saudi Arabia have decided to abandon their roles as key suppliers cooperating to support the price of that commodity. This in turn is leading to some violent moves in currency markets, and yields on U.S. Treasuries continue to dive lower (i.e. their prices are rising) in a flight to safety and amid ongoing concerns about global economic growth.
Despite the confidence exuded by the talking heads on financial news networks like CNBC and Bloomberg TV, it's always a tenuous business to try to assign big stock market moves (down or up) to one specific root cause. And frankly it's not a particularly productive exercise to try to do so, other than for the benefit of TV ratings. That being said, in my humble opinion, while the coronavirus was certainly the catalyst for, and is still an ongoing contributing factor to, this stock market correction or bear market, there are several other factors at work:
1. U.S. stock market valuations, depending on your preferred metric, ranged from somewhat high to extremely high, and this condition was only getting worse. While the S&P 500 stock index returned more than 30% last year, the earnings generated by those 500 or so companies barely grew and their sales rose an anemic 4%. High stock market valuations themselves aren't necessarily predictive of imminent market drops, but they are predictive of lackluster returns over the intermediate- to long-term.
2. Anecdotally, mom-and-pop investors had shown signs of once again becoming enamored with the stock market and in stock speculation in particular. As just a few indications of this, the following articles were published in the financial press within a few weeks of the top: Forget Dow 30K. It's Already Hit 40K on License Plates; Mania Has Taken Hold in the Equity Market and There is "No Respect" for Risk, Says One Strategist; and More Investors Play the Stock-Options Lottery. Historically, it has rarely been a good sign when retail investors jump on the bull market bandwagon.
3. Investors are losing faith in this Federal Reserve as an independent policy-making entity and in the efficacy of monetary policy in general. The Fed has historically had dual mandates to attempt to control unemployment and inflation in this country, and has at least tried to maintain a semblance of political independence while doing so. In the last couple of decades, however, the Fed has had to concern itself much more with developments in the stock market as these increasingly affect consumer behavior and business sentiment.
However, this "Greenspan Put" has gone too far, and it now seems that whenever the stock market quivers, and especially during this administration, that the Fed reacts forcefully by pumping more liquidity into the system. This happened most recently last year after the stock market fell 20% in the fourth quarter of 2018. The now-ingrained notion among investors that the Fed will always be there willing and able to bail them out if the going gets tough is falling flat. Witness the stock market's reaction to the Fed's emergency rate cut just last week.
4. Rightly or wrongly, Trump is seen as a more stock-market-friendly President than either of the Democratic candidates. In that respect, we're now in a form of negative feedback loop. The worse our stock market performs between now and the election, presumably the greater the chance for a Democratic victory, since voters often vote according to their 401k and brokerage statements. (This is a dynamic that Trump is all too aware of given his recent touting of the MAGA stocks). And the greater the chance for a Democratic victory, the greater the perception that the stock market will perform poorly.
5. The commodity and bond markets were once again "canaries in a coal mine", harbingers of tough times to come in the stock markets. Commodities last gave advance warning of troubles to come in the stock and credit markets five years ago when oil fell from over $100/barrel to below $30/barrel. This time around, the major commodity index had already fallen by as much as 11% during the weeks before the stock market topped out on February 19, a sign of waning economic activity.
While stock indices were marching merrily higher last year, the Treasury bond market inverted as various longer-term rates fell below shorter-term ones. This seemingly irrational development is often, but not always, an advance sign of economic weakness. And now stock markets seem to be taking their cue almost minute by minute from U.S. Treasuries, much like a homeowner wondering naively, but worrying none the less, why the neighbors next door are taking to their bomb shelter.
Troubling signs in the bond markets are now also taking the form of widening credit spreads. In other words, while rates on credit-risk-free Treasury bonds are plummeting, rates on corporate bonds, even high-quality ones, are not and are even starting to go the other way. As I've mentioned in the past, corporate stock buybacks funded by the issuance of low-cost debt has been a major, if not the major, impetus for the stock bull market and especially for the outperformance of the U.S. stock market over foreign ones. If that dynamic is interrupted, either by credit market conditions or through regulation, a major source of demand for equities will be gone.
As a final argument that the coronavirus is beginning to take a backseat to other developments and conditions in the financial markets, consider that the stock market in China, ground zero for the contagion, had a tremendous week last week, and that South Korea's market also fared well despite that country being one of the worst affected.
... and Client Portfolio Positioning
As you might conclude from the discussion above, I've become increasingly skeptical of the U.S. stock market's outright performance, and of its outperformance relative to other asset classes, in recent months. As a result, while striving to remain within the confines of the targeted allocations to cash, bonds, stocks, and commodities in each of your Investment Policy Statements in a disciplined fashion, I've been steadily working to reduce exposure to U.S. stocks and to riskier bonds in many, if not most, of your portfolios. Since each of your portfolios is different and each customized to your own risk tolerance and investment time horizon, it's always difficult to discuss recent portfolio moves in general terms, but the following are steps I've taken along these lines in recent months:
- In mid-December, I replenished the "cash buckets" that some of you have in place to support your periodic portfolio distributions by selling U.S. stock exposure outright.
- In the last few months, in those portfolios that needed this re-balancing, I sold U.S. stock exposure to buy foreign stock exposure and/or commodity exposure. It's often said that in a bear market, correlations tend to one, which means that all risk assets - domestic and foreign stocks, commodities and riskier bonds - all fall together and without discrimination as investors sell what they can rather than what they want to. In this respect, it may take some time for the benefits of these re-balancings to bear fruit, but I'd still argue that U.S. stocks have the most room to fall among these asset classes.
- In the last few months, three of our more risky closed-end bond funds reached my sell targets for them, and for the most part, these proceeds were either re-invested in high-quality bonds or remain in cash equivalents. That 3 of these funds would appreciate together to the point that I was happy to let them go was yet another sign that investors were beginning to throw caution to the wind.
- And I've bought very little additional exposure to risky assets on the way down so far, even though U.S. and foreign stocks and commodities are all in correction territory already.
The net result of these moves, in combination with the market's recent declines, is that as of the end of last week, the vast majority of you are already underweight equity exposure relative to your targets and overweight dry powder in the form of cash or bonds. Hopefully, this knowledge will make these trying times a little easier for you to stomach.
You may also find the following related Articles on Wealth Management Topics that I've previously written reassuring or helpful:
As usual, please feel free to drop me a line if you'd like to discuss trades that have taken place in your accounts, or to chat about how your portfolio is currently positioned.
About the Author
Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.