03/17/2020


The COVID-19 national crisis is evolving faster than any crisis I have experienced in my 38 years on Wall Street. This said, I wanted to take a moment to address the many legitimate questions that arise during periods of excessive uncertainty and market volatility. A lot of bad news is coming at us very rapidly and a few well-reasoned responses to these inquiries could be helpful.

How is the COVID-19 pandemic evolving?According to the latest statistics, there are over 188,000 confirmed cases of the coronavirus worldwide, up dramatically from just a week ago. While the pace at which the disease is spreading is alarming, there are reasons to believe the numbers will improve somewhat in the weeks ahead. Rapidly expanding testing protocols and social distancing measures will likely limit the spread of the virus. Some countries, most notably South Korea, appear to be succeeding in halting the growth of the disease. In the last week, the number of cases in South Korea rose just 14% and the crude mortality rate so far is just 0.9%. As the world moves quickly to aggressive containment practices, we are hopeful the infection rates will turn down in the days ahead.

How will COVID-19 impact economic activity?This question points to one of the greater unknowns in this crisis. Never have we experienced such a breathtaking array of changes in society and lifestyles. Almost overnight we have seen the cancellation of major organized sports and entertainment events, dramatic declines in airline travel and hotel bookings, a complete halt in the cruise line industry, severe declines in visits to restaurants and bars, the wholesale cancellation of industry conferences, and the closure of many schools and colleges. We simply have no precedent to judge the impact to economic activity. It is reasonable to assume a decline in spending across the most impacted sectors of the economy could easily yield an annualized decline in real GDP of between 5% and 10% in the second quarter. Looking beyond what will be a very difficult quarter, the key will be the eventual normalization of everyday life. The pace at which the economy is likely to recover depends, to a significant extent, on the effectiveness government policy measures such as closed boards and social distancing practices.

What is the government doing to address the crisis?Government remedies largely involve monetary and fiscal policies designed to stabilize credit markets, provide liquidity to a stressed system, and promote stimulus related plans targeted to counteract an economic slowdown. The Federal Reserve has cut the federal funds rate by a full 1.00% to a range of 0-0.25% and will resume quantitative easing activities. The Fed is pledging to boost its holdings of Treasuries by $500 billion and mortgage-backed securities by $200 billion over coming months. On the fiscal side, the House has passed a package that includes paid emergency leave and free COVID-19 testing. Additional fiscal initiatives, perhaps containing some protection for small businesses, enhanced unemployment benefits and a payroll tax cut is likely to be implemented soon. We anticipate these programs will be large-scale in nature and help restore a degree of optimism within the system.

Is there more pain coming for the equity markets?No one can answer this question with any authority as this crisis is evolving much too rapidly. Extreme levels of fear are widespread in the markets and large swings in stock prices have been occurring daily. As with all periods of intense stress and challenge, we will eventually begin to see progress in our fight with COVID-19, however we are still days (if not weeks) away from this turning point. Stocks will likely begin to recover long before the pandemic is on the wane and we must remember that bull markets are not built on a foundation of good news, but on diminishing bad news. This said, there is simply no reliable guidance as to when and where this will happen.

Will volatility give way to a stabilization in equity prices?Eventually, yes. History shows that large market moves tend to cluster together. In other words, sizable swings are generally followed by a series of aftershocks - similar to what is experienced following earthquakes. This "volatility clustering" is largely the result of behavioral reactions as investors attempt to identify a bottom. Unfortunately, the greater the initial shock, the stronger and more numerous aftershocks are likely to be. This said, stabilization will emerge, but likely only after a continuing series of aftershocks.

When will the markets bottom?As I have recently written, establishing a market bottom is a process rather than an event. Following the degree of damage in our capital markets we have seen over the past four weeks, it is reasonable to expect that large declines in equity prices will be followed by a series of rallies and a retests of the lows (described as "aftershocks" above). Over the past 50 years, when the S&P 500 has fallen 20%, the time historically taken to reach an absolute bottom can range from one month (1987) to 18 months (2000-2002) with an average of about 6 months.

Does this bear market represent a buying opportunity?In a word, "yes", but it is never that easy. This particular question leads to ancillary questions involving when, what and how. The opportunity will be at its best when fear is at a peak. While it will be impossible to identify the exact turning point, it is likely to occur just as the pattern of bad news begins to recede. We believe an incremental approach to positioning for a recovery is the most prudent given the many unknowns that persist.

How long could it take for the stock market to breakeven? One of the few observations I can make with total certainty is that the U.S. equity market has fully recovered from every historical market panic. Forecasting precisely how long it might take to breakeven is another matter. Some markets get back to even in a matter of only months (1982) while other recoveries can take several years. After the 2008 crisis, it took until early 2012, or about three years, to fully recover.

What action is Clearwater Capital taking in this crisis? 

Please consider the following:

  • First and foremost, we are not panicking. Please do not perceive this as inappropriate bravado on our part. We experience the same emotions and frustrations that are universal at times like this. In other words, we have the same doubts, fears, and frustrations you have.

  • Our profession requires us to maintain perspective and exercise discipline in good times, and bad. Over the past year we have taken several steps to improve quality and reduce equity exposures across our strategies. These steps allowed us to become incrementally more defensive prior to the COVID-19 outbreak. Even so, we still have exposure and this has been a painful time. Given the unprecedented pace of market declines, it has become relatively impossible to confidently execute additional defensive measures without the risk of doing so after the damage has been done.

  • Currently, we are operating with the view the COVID-19 crisis is transitory in nature, and the negative effects to our lives and the economy will be temporary. Given the extraordinary levels of uncertainty, we believe the best course of action is to avoid large adjustments to strategy - especially following the big declines we have already experienced. For investors with appropriately conceived investment horizons, the best action during periods of total uncertainty is often no action. An ill-timed maneuver can be greater than doing nothing.

  • While we acknowledge things could get worse before they get better, we do believe this crisis will pass and the recovery to our economy (and our portfolios) will be meaningful. Ultimately long-term investors should be imagining what the world will look like in 2021 (and beyond) once this crisis has long passed. There will be opportunities to adjust strategies in anticipation of this recovery, however we believe investors should move slowly over the near-term.

  • Lastly, risk tolerance is a highly personal phenomenon. For most investors with an investment horizon stretching 3, 5, or more years, volatility is the price we pay for long-term returns. Other investors, who were previously tolerant to the ups and downs of investing, may find the current environment unbearable. Individual investors who feel this way are encouraged to call us to discuss strategies to adjust their investment objective to a lower risk profile.

In conclusion, it is not possible to know how the next few weeks will play out. No one knows if the markets stabilize here, or if the sell-off breaks to lower lows. We remind our readers that the current COVID-19 crisis is not the "end of days" scenario it may feel like and we have many dedicated health care professionals and experts working the problem. We also have every indication that the government will provide as much of a backstop as may be necessary to lessen economic pressures that will emerge very soon. Our base case is to maintain our strategies for now as we patiently await a favorable shift in news flow and for the panic to subside.


Best,

John

John E. Chapman

Chief Executive Officer

Chief Investment Strategist

Clearwater Capital Partners