Life is not about how fast you run or how high you climb, but how well you bounce.
- Willie Nelson
Humorist and former Texas gubernatorial candidate, Kinky Friedman labels Willie Nelson the Hillbilly Dalai Lama. Willie’s down-home wit, good nature and compassion have earned him this moniker. However, it is sometimes forgotten that his current Zen-like demeanor and generally positive outlook are products of bad decisions and more difficult times. In retrospect, we often find the difficult times forge stronger people.
Today’s Covid-19 pandemic certainly falls under the difficult times category and how we respond will impact our results. As investors, we must remain calm, clear of mind, and search for reality through the fog of battle.
Whiskey River Take My Mind...
The First Quarter of 2020 will go down as the beginning of one of the more trying times in modern history. As we entered into 2020, elevated valuations gave us pause as they reached levels not seen since the end of the tech-bubble. We surmised, without positive movement in earnings, investors would likely face an uptick in volatility. When an imbalance emerges, markets usually correct, but typically you need a catalyst to start the process. In this case, it was the novel coronavirus, later named Covid-19.
Through the middle of February, even as the world became increasingly aware of the growing epidemic in China, most markets continued to post strong returns. As the first community-spread cases emerged in the U.S., however, the S&P 500 began one of the most rapid declines in history. After reaching a market peak on February 19th, it quickly retreated 33.8% by March 23rd. The crash was indiscriminate, but stocks most exposed to immediate disruption declined the greatest (Travel & Leisure, Banks, and Energy).
Adding insult to injury, the first week in March ended with the Russian-Saudi Arabian oil price war. In a sector already struggling with over-supply, energy stocks accelerated their decline to eventually become the worst performing sector of the U.S. market, falling nearly 56%. The market rallied at the end of the month, but the quarter closed as the worst first quarter on record with the S&P 500 declining 19.6%.
International stocks generated returns generally in line with the S&P 500 in their local currencies. However, in this environment of uncertainty, the dollar remains a safe haven. This characteristic caused it to strengthen, adding headwinds for U.S. based investors. For instance, European ex-UK stocks were down 20.9% for the quarter, but after accounting for currency translation, they returned -22.6%.
Wake Me When It’s Over...
With the sharp decline in prices, we ended the quarter with a forward P/E ratio of 15.4x earnings. However, the market is quicker to move than analysts and corporate leaders who are both certain to continue to slice earnings expectations. As the economic impact of the virus remains uncertain, so are the short and long-term impact on corporate results. As more information becomes available, valuations are likely to increase. Even as the market stabilizes, we run the risk of deflated prices and yet a market which looks expensive.
Whereas at the start of the year, analysts expected First Quarter earnings to grow by over 4%, latest expectations are pointing to a decline of more than 10% with a flat to slightly positive increase in revenues. As the majority of the country and much of the world remain in some form of a lockdown, the Second Quarter is likely to see a more significant decline in earnings. Initial estimates suggest a decline in earnings of over 20% and revenues to dip nearly 4%.
My Future Tightly Clutched within Those Healing Hands of Time...
As always, investors are looking to what comes next. Expectations of a V (quicker) or U (slower) shaped recovery hinges on the speed of getting the economy back open. Even as this process remains cloudy, we know that markets reliably serve as leading indicators and will likely rebound ahead of an economic recovery. For investors traversing this challenge, the most important task is to avoid owning stocks that fail, causing a permanent loss of capital.
Diversification and a focus on fundamentals is the most effective approach to mitigating the risks. Still, qualitative assessments can add value when the numbers seem unreliable. For instance, we are likely to see an increase in retail bankruptcies as a result of social distancing restrictions. These bankruptcies are likely to flow through other areas of the economy including banking and real estate. While analysts are still crunching the numbers, investors can make prudent moves based on those qualitative assessments.
Factor analysis can also provide meaningful insight to investors. As an example, stocks which have high exposure to the value factor have significantly trailed their counterparts in the growth camp; this has held true for much of the past decade. During the First Quarter, this disparity continued as large value underperformed large growth by over 12%. On a relative valuation basis, value stocks are as cheap as they have been since the tech-bubble. What we are missing is a catalyst for value to close this gap. Two of the larger sectors, financials and energy, are both facing mounting headwinds which make the current environment unattractive for investors.
While headlines have focused on larger U.S. companies, smaller companies have struggled the most in this environment. Small cap stocks returned -30.6% through the end of the quarter, making size the largest detractor from performance. During economic dislocations, larger companies are seen as a safer place to invest. The risk-off shift made companies with more concentrated product and service models or debt- fueled growth significantly less attractive and many small companies fit this bill.
As analytics help investors make decisions, sentiment also plays a major role in market performance. When sentiment reaches extremes, markets typically tend to react in a contrarian fashion. When extreme fear enters the market, investors tend to oversell equities presenting opportunities for savvy investors. On March 18th, Ned Davis Research’s Daily Trading Sentiment Index reached a level of extreme pessimism. In fact, it reached the third lowest level since 1995. A few days later, the market reached its recent lows only to be followed by a 20% rally.
As most investors today seek to add diversification through holding internationally domiciled stocks, it is important to remember how the global stock market looks. We use the MSCI All-Country World Index (ACWI) as a proxy for what is reasonably available to investors on a global stage. Currently, the U.S. accounts for about 57% of the stocks, while the developed markets (mostly Europe and Japan) make up 31%, and emerging markets account for the rest of the 12%. Emerging markets main constituents are China, Taiwan, South Korea, India, and Brazil.
While currency translation was a headwind for the First Quarter, the dollar is trading at its highest level in 15 years against a trade-weighted basket of currencies. Although there are many factors which impact currency movements, it would be reasonable to expect a reversion to the mean as economic activity normalizes. As this happens, the dollar could be a strong tailwind for U.S. investor’s international holdings. Additionally, as valuations remain a concern for U.S. stocks, relative valuations indicate over the coming market cycle emerging market stocks should outperform U.S. stocks.
As we mentioned last quarter, diversification can help offset risk. Alternative asset classes have helped investors thus far this year. These investments are not designed to outperform equity markets during
major bull runs, but do offer the potential to profit during falling markets.
The Last Thing I Needed First Thing This Morning...
There is an old joke that asks, “What happens when you play a country song backwards?” You get your wife, your trailer, your dog, and your job back. While Willie has made a living out of writing about finding the bottom in life, bottoms in markets are a little tougher to identify.
On March 23rd, the market reached an adjusted close of 2,237. We may look back on that day as the bottom, but we have a long way to go to validate this assumption. It is often said that bottoming is a process. This process has typically involved a major decline, a strong speculative rally, a retest of the bottom and then a sustained increase with breadth.
Benjamin Graham, the father of value investing, reminds us Mr. Market tends to overreact as people extrapolate extremes to false conclusions leading to oversold conditions. Whereas there may be short pauses on the way down, the bottom forming process is caused by finding true demand at a certain level. After fear subsides, sellers find it hard to let go of their positions at unreasonably low prices. It sets what technicians call support levels, and one of these levels will ultimately prove as the bottom. Seemingly much of this action happens outside of fundamentals.
Like the initial sell-off, the first rally is quick but wanes over time. Importantly, fundamentals begin to catch up and the initial concerns which set all of this in motion comes back into play. As analysts adjust earnings, stocks trading at prices lower than a short-time before are trading at valuations now higher than those previous levels; the rally runs out of steam. While this has yet to occur, current valuation levels should raise concerns.
Oh, They Tell Me of an Uncloudy Day...
Many people have lost loved ones, jobs, and the economic outlook is uncertain; our hearts go out to all those who are facing these challenges. While we all face difficult and uncertain futures, we at BBVA hold as our duty to be reliable stewards of our client’s assets. Still, these times are not easy on anyone, and we recognize many are facing difficulties beyond the markets. So, perhaps the best way to end this quarter is to remember the comforting words of Abraham Lincoln on the cusp of an even greater national challenge:
“It is said an Eastern monarch once charged his wise men to invent him a sentence, to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words: ‘And this, too, shall pass away.’ How much it expresses! How chastening in the hour of pride! -- how consoling in the depths of affliction! ‘And this, too, shall pass away.’ And yet let us hope it is not quite true. Let us hope, rather, that by the best cultivation of the physical world, beneath and around us; and the intellectual and moral world within us, we shall secure an individual, social, and political prosperity and happiness, whose course shall be onward and upward, and which, while the earth endures, shall not pass away.”
Details you need to make a smart decision
BBVA is the trade name for BBVA USA, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).