The U.S. equity market just completed its worst-performing first quarter in history. That is no small feat, considering all the things our country has been through in the last 100 years. More than world wars, economic depression, terrorism, oil shocks, Spanish flu, credit meltdowns, or poor monetary actions, it was the novel coronavirus that brought the global markets to a new series of dubious records. Volatility, price swings, and velocity moved with such force and speed as to defy belief. To go from a record high to a 15% correction in only seven trading days — then into a bear market eight sessions later — is something that, on average, would take nine months to accomplish.
There have been other viral outbreaks during which the market reacted negatively. Deadly flu epidemics in 1957-58, SARS in 2002, and Swine flu in 2009 all saw three- to six-month declines ranging from 12% –22%. After a year, though, markets had moved higher again. Strangely enough, the great Spanish flu pandemic, infecting over a quarter of the entire world population, did not move the market significantly lower. From January 1918 to December 1920, the Dow Jones Industrial Average was only -3.26% during the greatest medical disaster in human history, although it did rise and fall 50% during that time.
So, why is a -35% response to a medical event that has yet to rank in the top ten most deadly? The market hates uncertainty, and this pandemic has brought along its share of it. Initial uncertainty about virus containment gave way to uncertainty about a global pandemic, mortality rates, medical availability, and treatment in the face of no vaccine. This led to the inevitable worldwide financial uncertainties, making it very difficult to determine future earnings and, therefore, values on financial assets. In the midst of this, the default position for some, whether driven by fear or uncertainty, was simply to sell. Still, there were additional factors that forced the market down as quickly as it did.
But, amid record-setting market volatility, not all of the market drop can be attributed to virus fears. The extreme amount of derivatives trading used by computer-based funds and broker-dealers amplified downside moves. Additionally, a 50% reduction in overall market liquidity made forced liquidations even more painful.
Embedded in the equity market and institutional asset management over the past decade is the element of derivative trading strategies — including systematic, market neutral, algorithmic, or computerized, along with volatility and gamma neutral spread trading. It all sounds very complex and statistical — and it is. With an estimated $2 trillion managed this way, it’s not unreasonable to say that this dynamic played a significant role in the market declines. This is why we have so many trading days with wild swings, as big money attempts to adjust their positions mechanically. We know that almost $1 trillion unwound during March, but we still view this type of market distortion as short-term in nature. Cash sitting on the sidelines will eventually need reinvesting, which is positive, but the damage has been done for now.
Adding to this are fewer market makers that exist to provide liquidity. The exchanges appoint market makers and specialist firms to provide liquidity when there is none. They are the ones that take the other side of a trade when no one else will. This is their mandate, as given by the exchanges. Unfortunately, for a number of reasons, there are half as many market makers and specialist firms today as there were three years ago. This means only half as much liquidity was available at a time when the market needed it most.
Unrelated to COVID-19, the breakdown of OPEC caused global oil prices to fall significantly as a full-scale production war between Saudi Arabia and Russia began. This, coupled with dramatic decreases in demand for fuel due to stay-at-home orders, caused a downward spiral in oil prices, which fell from $61 per barrel at year-end to near $20. The effects of a dramatic drop in the price of oil have far-ranging impacts on oil producers, drillers, refiners, and the businesses that cater to this industry as well as the communities that support domestic oil production. On the plus side, consumers will have much lower gas prices and more disposable income when they return to work. The negative effect is a longer lasting reduction in domestic oil production. This will not affect global oil prices nearly as much as it will reshape U.S. unemployment and the labor market.
It appears now that damage inflicted from the coronavirus will be greater economically than medically. The mortality rate is below 3% and dropping, as more testing is available (by comparison, the Ebola virus was 50%), with China and South Korea reporting virtually no new cases. Despite global economies coming to a standstill, China and South Korea are about six to eight weeks ahead of the U.S./Europe infection curve and beginning to resume production. Federal Reserve response has been swift and solid, and appears to be soothing the credit market malfunctions that occurred during March. Government response with healthcare support and economic stimulus has been significant — and significantly bi-partisan.
The U.S. economy will no doubt slow in the first quarter and contract sharply in the second quarter. We may possibly meet the textbook definition of a recession (two consecutive quarters of negative growth). The key point is that the economic slowdown is due to a global health issue — not a policy mistake. Errors in either fiscal or monetary policy usually cause most domestic recessions. Not this time. The Fed and global central banks have been taking strong steps in providing credit and liquidity to the markets. The U.S. government has provided some safety netting for millions of people and businesses. Altogether, this should serve the economy very well over the next 12-18 months.
What Has AAFMAA Wealth Management & Trust Been Doing?
During a time of market stress, AAFMAA Wealth Management & Trust (AWM&T) constantly re-evaluates existing positions with an eye toward economic recovery. In other words, when markets recover, as they always have in the past, where do we want to be positioned? We have used this unfortunate event to make portfolio adjustments that could be beneficial for the long term.
First, from a macro point of view, we believe growth stocks will continue to outperform stocks with traditional value characteristics. For multi-asset portfolios using mutual funds and ETFs, we sold a significant portion of domestic value funds and bought domestic growth. We believe investors will continue to place a premium on earnings growth, margins, and innovation in the coming years, just as they have for the past 11 years.
Second, with interest rates low — and presumably staying around these levels for some time — financial companies will struggle to grow their earnings. Information technology companies, in one form or another (software, hardware, analytics, for example), will continue to have expanding margins and profitability. With valuations on these great growth companies lower than they have been in years, we took the opportunity to sell out of most financial securities and emphasize information technology. In only a few short weeks, this readjustment has increased that portion of the portfolio by over 800 basis points.
Third, we have remained calm in the face of chaos by adhering to our investment discipline of rebalancing. On two different occasions in March, many portfolios sold fixed-income holdings and bought equity securities in order to bring equity levels back to their target allocation. This methodology has the effect of investing in equities at lower prices throughout a declining market. It sounds so simple to buy low and sell high, but investors do not do it nearly often enough. Our rebalancing discipline helps us to achieve that objective.
AWM&T sees opportunity in not only the equity markets, but in fixed income as well. With dislocation, lack of liquidity, and forced liquidations occurring in the corporate bond market, AWM&T was able to take advantage of this opportunity. We sold short term Treasury bond funds with yields near historic lows and bought investment grade, intermediate term corporate funds, allowing us to increase yield and take advantage of the undervaluation in this sector of the bond market. While interest rate risk is increased somewhat, we see that risk as muted against the backdrop of sustained low interest rates and credit mispricing.
We recently rebalanced our fixed income portfolio allocation, allowing us to buy high-yield bonds at depressed values. Our clients may recall that we drastically reduced high-yield exposure a year ago, in anticipation of another credit panic. This move has helped preserve principal in our fixed income area, despite the severe drop in the high-yield and corporate markets, and allowed us to take advantage of credit disruption.
What Lies Ahead?
No doubt, uncertainty still rules the market, although each day provides a little more progress. Do expect, however, the headline “de jour” to drive the short-term momentum. We anticipate continued market volatility in the months ahead, although probably not to the extreme level we experienced on March 18. The March 23 market low was probably the bottom, although that opinion is useless if one is a long-term investor. For the long term, it is safe to say that we are much closer to the bottom than to the top, making it an advantageous time to invest in great companies at bargain levels. Past markets have shown that prices usually move in advance of announced positive news. Don’t be surprised to eventually see higher prices, at some point, despite continued negative news.
From a human standpoint, we sincerely desire this sickness — both physical and financial — to be over soon, and believe that the worst will be behind us in the coming months. America’s ability to bounce back from this should not be in question. We’ll see, in between our determination and steadfastness, acts of generosity, kindness, and compassion. Faith may abound and gratitude flourish in ways that we have not yet imagined. We will help the world to regain its collective footing and continue forward in our success, innovation, and philanthropy.
As we watch and wait hopefully for those better days, two factors will ensure our financial success: time and patience. Those elements have been the keys to long-term investing, which history has shown to be rewarding. As for AWM&T, count on us to continue implementing our investment discipline and providing experienced guidance and analysis to Member portfolios.
Total Returns Q1 2020
S&P 500 (19.60)%
MSCI ACWI IMI (22.44)%
Russell 1000 Value (26.73)%
Russell 2000 (30.62)%
Barclays Int. G/C Bond Index + 2.40%
AWM&T Is Here to Help You
Our goal is to help our Members achieve and maintain financial security, especially during times of uncertainty. Our monthly webinar series covers a new military or veteran-related personal finance topic each month, and our Relationship Managers stand by, ready to assist you with your questions and investment strategies. Contact us today to discuss how you can best position yourself during this time of market volatility. We look forward to serving you.