03/23/2020

The nation is beginning to understand that the coronavirus crisis and ensuing shutdown is going to last longer than originally hoped for. This is beginning to look more like a marathon, rather than the sprint we had hoped for only a few days ago. We have pledged to provide you with regular updates as it relates to the crisis. We have also promised to be candid with you, whether the news is good or bad.

Our thinking is currently focused on the four primary challenges we now face: global health, the economy, capital markets, and personal well-being. This morning I want to share information with you on the economy and the markets. After spending most of the weekend pouring over the latest data, the only conclusion I can offer is the economy is experiencing a significant and historic contraction. In the coming weeks, investors will need to brace for some of the weakest economic data points they have ever seen. Unfortunately, market volatility will likely persist as market participants struggle to correctly "price-in" all that is happening. For now, fear and guessing are about all we have to work with.  

Only a week ago, estimates of how much the U.S. economy might shrink suggested a drop in second quarter GDP of 5% to 10%. Now, estimates range from a drop of 12% to 24%.   There have been 291 calendar quarters since 1950 and the U.S. economy has only contracted in 41 of those quarters (14%). Big declines (5% or more) are incredibly rare. Since 1950, there have only been 6 prior quarters (2%) where GDP declined by 5% or more. A decline of more than 20%? Well, that's never happened in the post WWII period. In fact, the next closest quarter in terms of negative growth was 10% in 1958 (Bespoke).

Just about all discretionary economic activity in the U.S. has come to a stop, and only essential needs are being met. Last week, both the New York and Philadelphia Fed reports on general business conditions experienced their largest drops on record. Weekly unemployment claims surged higher by 70,000 to 281,000. That was the largest weekly increase in the seasonally adjusted number since November of 2012. Since the beginning of weekly claims data in 1967, there have only been 13 total times that jobless claims have risen by 70,000 or more in a single week.

Unfortunately, this is just the beginning for higher unemployment numbers. We must now brace ourselves for tens of thousands of new filings in the next few days, with more likely to come. For example, it is estimated that one in twelve workers in this country work in restaurants. With the entertainment and dining industry shut down, the preliminary layoff estimates we are seeing so far suggest the potential for over a million jobless claims is on the horizon.

As for the capital markets, we are operating at extreme levels of stress and volatility. This was the deepest decline for the S&P 500 from a record high since early 2009. The 30 days it took to fall 30% also ranks as the fastest ever; faster than both the 1929 and 1987 market crashes. Never have equity prices collapsed over such a short period of time and just about every short-term trend in the equity market is now broken. Markets are simply unable to trade on fundamental data because such data does not yet exist.

The collapse is entirely driven by uncertainty and markets are acting as if we are going to encounter the worst-case scenario from COVID-19. Erik K. Clemons, Wharton Business School professor, has analyzed four possible scenarios of the pandemic's evolution going forward. In a March 16 white paper, Clemons studies the virus's ability to mutate and its lethality. He argues three of the four possible outcomes are "delightfully, reassuringly, boringly familiar".

The feared worst-case outcome assumes a rapidly mutating virus with high lethality rates over an extended period. Clemons believes this is the least likely scenario referring to it as "something out of a science fiction novel" and concludes the market reaction is more extreme than any of the likely outcomes would justify. In other words, the markets are excessively reacting to uncertainty rather than expectations. Once data begins to flow and assuming this data does not reflect the feared worst-case scenario, things will begin to turn around.

There is one important and encouraging observation found in the historical record of market crashes. Historically speaking, once a bottom is reached, the rallies that followed have been "swift and violent". From the bottom (once it is reached) the rebounds have been remarkable over the following one month, three months, six months, and one-year periods. S&P 500 performance over these periods have averaged +14.2%, +33.5%, +31.6%, and +54.4% respectively (Bespoke).

All of what I have described above is unprecedented and we are setting many records we would rather have never seen. All economic activity in the U.S. has locked down faster than anything we have ever seen or could have imagined. Perhaps though, when looking back at this crisis the silver lining to it all will be found in the speed at which everything happened.

Once everything is shutdown, there is nowhere to go but up. Just as rapidly as our economy unraveled, it is entirely possible Americans will race back to normalcy once that becomes possible. None of us wants to shelter in place and after a few weeks of this we are going to be highly motivated to reclaim our way of life. No business wanted to close, and no business will want to be the last to re-open.

As the medical story of the coronavirus outbreak plays out, we must do everything possible to limit the damage connected to an economic shutdown and market volatility. We understand that portfolio values are distressed, however we caution investors with long planning horizons who are tempted to sell now and ask questions later. While throwing in the towel might provide a sense of control (and some relief to the stress), timing the markets rarely produces favorable outcomes. The risk of making permanent the current damage is real and is found in missing the "swift and violent" rallies that will eventually materialize.

The chart below is from Bank of America and appeared this morning on CNBC.COM. It shows how costly it can be to miss only the 10 best market days in each decade going back to 1930. As I observed above, these "swift and violent" rallies following market bottoms tend to cluster at the beginning of the recoveries. Bank of America urges investors to "avoid panic selling," pointing out that "the best days generally follow the worst days for stocks."

This month the S&P 500 index has seen its four worst point drops in history, as well as its five largest point gains. Eventually, we will have a big rally day that will mark the bottom of this crash and a recovery will be underway. Confidence in the recovery, however, will not likely materialize until the markets move significantly higher. Investors who sold will be scrambling to get back in and will likely have missed a number of these "best" market days.

At some point, the dialog will begin to shift from the rising number of new infections to a growing number of recoveries. We will hear stories about businesses planning to reopen and employees going back to work. The American spirit is resilient. Schools, stores, and office buildings will again open their doors. Places of worship and sporting arenas will come to life. Going out for dinner and a movie will again be a thing. Will all of it be different in some ways? Yes, but as I have been saying, this is where we will be at our best - this will be where we will figure it out. So, if your mood dips in the days ahead, come back to this paragraph and be reminded that life as we once knew it will eventually come roaring back.

John    

John E. Chapman