Baldwin Investment Management

Pandemic Blues…

They’ll wait it out. Photographer: Brian Bahr/Getty Images North America

It has been the fastest “bear market” ever recorded taking the fewest number of days (less than 30) for world markets to decline 20%.

Chart 1

The turnabout from mid-February when stock markets around the globe were setting new highs to the end of March when the world was shuddering has been staggering. What set it off? Who is behind the selling? The “match” which lit the fire was COVID–19. Adding ‘fuel to the fire” was the breakup of OPEC+. The onset of a pandemic opened a “Pandora’s Box” of uncertainty. Since markets hate uncertainty, perceived risk rose and prices fell. Piling on at a most unfortunate time was the dissolution of OPEC+ with Russia and Saudi Arabia not agreeing to oil production limits and instead dramatically increasing the production of oil at a time when the world needed less supply due to a reduction in energy demand as a result of COVID–19. Oil prices cratered, bringing back unpleasant memories of 2014 when OPEC pulled the same trick. Low petroleum prices are great for consumers, but terrible for oil industry earnings and cash flow. As to whom has been selling, the following chart paints an interesting picture.

Chart 2

Passive exchange traded funds (ETFs), investment vehicles of choice for many individual investors and their portfolio managers, have seen strong inflows of money during Q1 2020. So in fact, it has been these investors who have helped to stabilize the markets. Rather it has been institutional money managers (think pension fund managers) who have contributed massively to the selloff and the resultant volatility with their short-term trading strategies, as evidenced by the high volumes and outflows from specific vehicles favored by these managers. Since the financial crisis, markets today are heavily influenced by computer-driven investors whose machines react to technical and algorithmic data. Momentum, derivatives activity and market liquidity can drive trading. Stocks are merely pieces of paper which move in a market. In this realm of machine-driven investing, how much a stock moves and how suddenly it moves are factors as important as any other when deciding whether to buy or sell that security. These traders are managing their “risk” rather than managing their reward. As risk rises when share prices fall, these traders sell into the market to reduce exposure – but are amplifying the very downturns they hope to avoid by selling. The downward cascade in equity prices was not a function of fundamental analysis of corporate earnings and cash flow. It was a function of programmatic trading with little regard for fundamentals – thus encouraging to us, as it seems a little mindless – ignoring balance sheets, management quality, industry futures, cash flows, earnings potential and dividend prospects. Unlike the machines, when buying shares of stock in a company we look out over quite a few years of cash flows, not a quarter or two, just as any owner of any business would. We discount those multiple year cash flows back to a present value and make our investment decision. We are not just interested in next quarter’s results.

It seems obvious that the U.S. and probably the world will go into a recession. For Q2 2020 and perhaps Q3, it could be a steep recession. Unemployment will rise markedly. Earnings will go down fairly sharply in Q2 and perhaps Q3. But there is support for the equity markets. Interest rates have plummeted. In the U.S., the Fed funds rate (the key rate for the Federal Reserve and primary influencer for all other rates) is now in a range of 0 – 0.25%. Overseas rates are as low or even negative. It is a good time to be a borrower. These low interest rates have forced up the prices of bonds and made stocks more attractive than they were at year-end and even more so today after the steep selloff. Today the S&P 500 yields a good bit more than the 10-year Treasury (in fact, the gap between the two is the largest since the 1950’s). Further, the Fed has said it will do whatever it takes to support market functions. Other central banks around the world have made similar commitments. Also, fiscal policy is beginning to be enacted. Central governments are promising to spend hundreds of billions if not trillions of dollars or Euros to support economies. There is urgency. Finally, energy is cheap. Low oil prices are a disaster for oil companies – but for most of the rest of the world cheap energy is a boon. The reduction of a major expense for most households and companies will help support the world’s economies at a critical time.
Should an investor stay the course after such a downfall? With particular focus on the American stock market, let’s look at some historical facts. Since 1929, in the 24 months following a bear market, S&P 500 total returns have averaged 20%. Excluding the Great Depression, the average gain has been 27%.

Chart 3

Since 1931, an equity investor who missed the 10 best days of each decade realized a 91% return. Staying fully invested meant earning 14,962%. In the 2010’s, missing the 10 best days meant gaining only 95% instead of 190% when consistently invested. It is just hard to time the market – usually best to stay invested. Following is another series of interesting charts looking at the impact of economic shocks. This series also looks at markets outside the U.S. and different causes for the troubled times – including pandemics, terrorist attacks, financial crises and nuclear accidents. Despite the troubles, the markets turned up.

Chart 4

Solutions to the problems which presently are nagging investors (i.e., COVID–19 and cratered oil prices) are being worked on feverishly. Vaccines for COVID–19 are being researched and will be developed. Conversations amongst OPEC members and petroleum organizations outside OPEC are taking place because everyone is losing a lot of money at the current price of crude oil. We believe these issues will disappear in the relatively near future. With solutions on the horizon, markets will rally and perhaps strongly, because uncertainties/risk will be reduced and securities are cheap. Already China, the first to combat COVID-19, is reporting no new cases and its economy is “gearing up” after two months on “lockdown”, demonstrating that the pandemic is not a “forever thing”. Similarly, South Korea is reporting a decline in cases – having successfully bent the infection curve with widespread testing and social distancing. OPEC is meeting in April and the Texas Railroad Commission (the ultimate oil & gas regulator in Texas, the biggest producer of oil & gas in the U.S.) has been invited to attend and speak. People are thinking hard and negotiating behind the scenes to lift the price of oil. Problems will get solved and we think that after being quarantined for a couple of months, most people will be eager to re-engage with their lives.

Some prognosticators predict that markets will return to their February highs by year end 2020, (if the aforementioned challenges get resolved in the relatively near future). We are not so bold. But we think the markets around the world will be heartened. They will rally hard and in 2021 new market heights could be scaled.

Predictions for 2020

  1. No Recession is forecast for the U.S. Economy. – No – COVID-19 & a collapse in oil prices have “put paid” to a recession.
  2. Inflation in the U.S. will rise, but stay under 2%. No – Very little chance that prices will rise in such an economic environment
  3. Interest rates will stay low. Yes – To safeguard world economy
  4. Oil prices will remain rangebound & there will be more mergers and acquisitions. No & Yes – Oil prices have cratered due to the dissolution of OPEC+ and there will be mergers & acquisitions due to low oil prices
  5. Carbon emissions will not fail. Yes – Hydrocarbons are cheap & the environment will take a “backseat” to the economy.
  6. International equities may have a day in the sun. No – Investors will probably run for safety, which means the U.S.
  7. A tale of two halfs, perhaps. Yes – Hopefully the 2nd half of 2020 will be much better post COVID-19
  8. Objects in motion tend to stay in motion. No & Yes – Obviously the momentum broke, but we believe it will return in the second half
  9. There will be no big policy changes coming out of Washington D.C. Yes – “All Hands On Deck” to fight COVID-19
  10. Corporate America will continue to reward shareholders. Yes & No – Strong companies will continue to reward their stockholders, the weak will not

A Final Thought

The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.

The reported numbers enclosed are derived from sources believed to be reliable. However, we cannot guarantee their accuracy. Past performance does not guarantee future results.

We recommend that you compare our statement with the statement that you receive from your custodian.

A list of our Proxy voting procedures is available upon request.
A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinmgt.com/disclosure