03/10/2020

We have long said "when the facts change, our strategies will change". Just a couple of weeks ago, the U.S. economy was firing on all cylinders and equities were trading at record highs. Two months into the year the data appeared to confirm the constructive view presented in our Outlook 2020 report.

Then, on February 25th, the mood shifted as concerns over the coronavirus began to spike. Headlines turned to the spread of this potentially deadly disease and the negative impact it would have on economic activity around the world. While the numbers for infected individuals in the U.S. remained relatively low, fear set-in and many concluded that consumer behavior would soon change.

Cancellations for travel, conferences, and trade shows began to ramp up. As anxieties increased, consumers were seen lining up at big box stores to stock-up on basic supplies. In a remarkably short period of time the wide-spread optimism the country enjoyed only days earlier began to unravel.

Not surprisingly, the stock market was quick to respond, and volatility spiked. Over the following couple of weeks, the market would alternately surge and fall by 4% and 5% on any given day. Market movements have been extreme. According to Bespoke Investment Group, daily market action like we have seen over the past two weeks has only occurred a few other times since the S&P 500's inception in 1928. At the time of this writing, U.S. equities are about 19% below the record highs achieved on February 19.

Part of the reason things have moved so fast has to do with the very high expectations that existed when the coronavirus crisis took hold. The market was priced for perfection relative to anticipated 2020 corporate earnings. Even without the emergence of a crisis, it would have been difficult to live up to those elevated expectations over the near-term.

Another factor that appears to have exacerbated the recent volatility has been the prominence of algorithmic-driven strategies; sometime referred to as computer trading. These strategies have become prevalent among hedge funds, and institutional investors. Such strategies react quickly to news flow and can contribute to extreme market movement over condensed periods of time.  

Assuming we stay in correction territory (ie. declines of less than 20%), this will be the seventh correction since March 2009 - when the recovery from the Great Recession began. Corrections during this bull market have lasted an average 78 calendar days and saw an average decline of 15%. From a longer-term perspective (going back to 1990), the average correction has seen a decline of about 18% over an average span of 83 days.

For their part, the Federal Reserve has stepped in with a surprise intermeeting interest rate cut of 50 basis points. While lower rates can generally aid the economy, they do not address the challenges related to supply chain disruptions or changing consumer behavior. Likewise, this dramatic development struck some as concerning in and of itself.

Aside from the legitimate concerns over a serious public health crisis, worries over supply chain disruptions and slower economic growth have logically led to lower earnings expectations. The matter of lower earnings expectations is made considerably worse by the fact that we simply do not know at this juncture how long all of this might last.

As if the coronavirus was not enough to worry about, the market plunged on Monday of this week by over 7% as oil prices collapsed and the yield on the 10-year U.S. treasury bond traded briefly below 0.50%. After Russia rejected a proposal by OPEC nations to cut oil production targets (in an attempt to support oil prices), Saudi Arabia announced that they would aggressively lower oil prices and potentially increase production. From a recent high of nearly $63 last April, WTI crude prices fell below $30 per barrel (intraday) on Monday of this week. An oil price war appears to be developing.

While lower oil prices lead to lower gas prices at the pump, which is generally a good thing for consumers, the markets perceive these developments as decidedly negative. The reason has to do with the high levels of leverage in the energy sector and the price point for oil that is required for many oil producers to remain profitable. At levels below $50 per barrel, or even $40, many of these companies cannot operate profitably and are at risk of defaulting on the debt they carry.

The energy sector represents just under 5% of the S&P 500 and as much as 11% of the high-yield debt market. Clearly, a spike in defaults would negatively impact financial institutions and potentially lead to seizures in the credit markets.

It is important to note that much of what I have covered thus far in this update relates to fear over the bad things that could happen. We simply do not yet know just how much consumer behavior will shift out of fears over the coronavirus; nor its ultimate impact on economic activity and corporate profits. We don't know if lower oil prices will persist, or if higher default rates and extended problems in the credit markets will emerge.

This said, investors hate uncertainty and increasing levels of uncertainty are exactly what we are currently up against. We don't know if the facts have changed just yet; only that our constructive economic thesis is now suddenly in question. Accordingly, the only prudent thing to do is exercise a heightened degree of caution as we make our way through these challenges in the days, weeks, and potentially months ahead. While the negatives we worry about have yet to fully materialize, we must recognize that we are moving dangerously close to these potential hazards.

As a practical matter, our posture has not dramatically changed over the past three weeks. A heightened degree of caution translates into more defensive investment strategy. It means managing risk more aggressively and holding higher levels of cash than would otherwise be desirable. Investors have mostly enjoyed above average total returns in their portfolios over the past ten years and now would be the time to focus on prudently protecting those gains as best we can.

Please note, the observations made here in this Market Update are not intended to represent a short-term market prediction. Even in less volatile times, it is futile to make short-term market predictions with any expectation of accuracy. Given the unique developments over the past few weeks, the difficulties related to short-term predictions is only magnified. Rather, our goal is to correctly assess the risks and potential rewards over the near-term and adjust strategy accordingly. In other words, we are studying the many variables to determine "more likely than not" scenarios that we believe warrant action.

While the facts have not yet changed, we continue to reduce risk across our strategies. This is an extension of our activities over the past year. These activities are designed to improve quality in portfolios and incrementally reduce equity exposure. In this endeavor we must also accept the fact that the yield on cash positions is currently very low. Our goal will be to normalize strategies once the challenges are sorted out.

The bottom-line message of this Market Update is that setbacks are inevitable and occasional obstacles will delay our progress. This is the price we pay for building, managing and enjoying wealth over long spans of time. Admittedly, the process is sometimes grueling, and emotions can be tested. However, we believe our economy is resilient and we will eventually triumph over the troubles that come our way.

Your team at Clearwater Capital remains disciplined and realistic. We have confidence this will serve us well as we navigate an unknowable future.   Please do not hesitate to reach out to us should you have any questions or concerns.

Best,

John