The Way Forward

John P. Swift, CFA, CPA
Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com

In October 1987 I was a young stock market analyst working for a large Wall Street firm when panic struck the investment markets. Many reasons were offered as to the cause of the market panic at the time, and since, that centered on heightened hostilities in the Persian Gulf, fear of higher interest rates, a bull market without a significant correction for over 5 years at that point, and the introduction of computerized trading. The stock market dropped 4.6% on Friday, October 16th, and that was just a precursor to the 22.6% drop on Monday, October 19, 1987, “Black Monday”. My direct report was a Senior Analyst with 13 years of experience. It was the first time I saw a grown man cry.

Fortunately for us the firm was stocked with more senior market analysts and portfolio managers who were around for the 1973-74 oil embargo years which ultimately created a new financial term for an economy with simultaneous high prices and depressed economic activity, “stagflation”. It was these more senior market professionals that encouraged us to remain committed to taking the long view, and that our client’s strategic asset allocation was the most important determinant of long-term success. They encouraged us to rebalance back to their strategic weight in stocks and bonds and that this ensures that they would always be buying low and selling high.

That early experience, in hindsight, was critical in my development as an analyst and portfolio manager. It informs my decisions about markets and provides the discipline to always “be fearful when others are greedy and greedy when others are fearful”, as Warren Buffet has famously offered. Against that backdrop, I’ll talk about the outlook for the market and how that informs the way forward.

Consumer Confidence Will Take a Big Hit

We should anticipate very shortly a pretty substantial drop in consumer confidence. [The Conference Board Consumer Confidence Index will be released on March 31. In February, it increased slightly.] I don’t care how good the labor market has been. People are naturally going to fear the worst, given the extreme measures governments are taking. They’ll focus on the latest bad news and ignore areas of progress.

The problem is the pandemic of fear is spreading much faster than the actual virus. China had 80,796 cases as of yesterday, with a population of 1.4 billion. South Korea had 7,869 cases, with a population of 51 million. They’re making progress, apparently, in China and South Korea in containing the virus, and even in the epicenter of Hubei province they’re talking about slowly resuming transportation. I don’t know what purpose it serves when German Chancellor Angela Merkel scares the living daylights out of people by warning that 70% of Germany’s population could contract coronavirus. It didn’t even spread to 70% of the Chinese. In fact, it has spread to just 0.005% of the Chinese population. It’s not what we should expect from the leader of a G-7 nation. People aren’t focusing on the fact that 80% who get infected are likely to suffer only mild symptoms, and that may be understated; that the most vulnerable are older people. Italy has everyone spooked. However, Italy is the oldest nation among developed nations, and we know that older people are more susceptible to the virus. We need to be careful as analysts to not extrapolate from the Italian experience as they represent a population that is not representative of our own.

Prospects for Global Recession

We’ll see a short recession on a global basis. Japan and Germany will undoubtedly fall into recessions. Italy will have a very severe recession, with its national lockdown. Is the U.S. economy resilient enough to decouple? Probably not. The fear factor is spreading faster than economists like myself can gauge. My guess is that the virus will dissipate significantly by the middle of the year, based on the experience of China and South Korea and previous virus outbreaks. The recession will end by then, and the investment markets will naturally improve prior to that.

There will be recovery and resumption of the bull market. I think it will be like 1987 all over again, the only difference being that the pace of change has increased with the advent of better monetary and fiscal tools, and increased speed of information and integration in prices versus 33 years ago.

S&P 500-October 1987-July 1989

Source: Yahoo Finance

What Can Policy Makers Do?

To avoid a worst-case scenario, President Donald Trump and Powell could work out “helicopter money” (in 2008 the Fed Chairman Bernard Bernanke quipped that the most direct way of spurring economic demand would be to drop cash from helicopters). Today’s “helicopter money” is a tax cut financed with bonds purchased by the Fed. The good news is that banks are in better shape than they were going into The bad news is that half of nonfinancial investment-grade corporate bonds are triple-B rated and on the edge of turning into junk. If an institutional investor such as a large pension fund is required to own investment-grade bonds only, there could be more pressure on credit spreads.

None of these policies can create a recovery. To do that, we really must get past this pandemic of fear. The Fed will be looking for more-unconventional policies, which will undoubtedly lead them to lowering interest rates to zero and, once we get there, revive quantitative-easing purchases of bonds. Eric Rosengren, the head of the Fed in Boston, threw out the idea that Congress may need to amend the Federal Reserve Act to let the Fed buy other assets, possibly corporate bonds. Restarting purchases of Treasury bonds won’t make a difference since the bond yield is already close to zero. Fiscal stimulus measures like tax cuts will help to soften the blow and can easily be financed at near zero yields currently. If those yields rise, then QE can help keep a lid on them.

President Trump has been beating on Powell to lower rates. I wouldn’t be surprised to see a Rose Garden news conference where Trump and Powell announce helicopter money—a tax cut financed by the Treasury, with the Fed agreeing to buy those bonds. I’d give it a 30% to 40% likelihood. The Federal Reserve said this past week that it would inject more than $1.5 trillion into short-term funding markets to prevent ominous trading conditions from creating a sharper economic contraction.

What’s Going on in the Oil Markets?

On top of everything, the Saudis and Russians are fighting about oil production, which caused prices to collapse. That alone is reminiscent of 2015, when we had a growth recession in the global economy and earnings, and it added to downside risks for the energy sector. My thinking is they won’t be able to take the pain of having oil prices this low for long. On the supply side, there will be cutbacks: U.S. shale producers will be forced to cut production, or the Saudis and Russians will come up with a deal because prices this low are a calamity for both.

Should Investors be Buying Now?

The bull-bear ratio, which comes out every week, has taken a deep dive. The faster bearishness goes up, the better for the outlook. The bull-bear ratio is 1.58. It had been 2.04 the week before and over three at the beginning of the year. A lot of it is people moving from bulls to the correction camp. Bears only edged up from 20.4% to 22.9%. In 2008, the percentage of bears was over 50%. A lot of people are still net bullish.

What We are Looking to Buy When Rebalancing Portfolios If you have cash, this is the time to buy quality names, some of the Blue-Chip dividend-yielding stocks. The market is trashing everything including utilities, consumer staples, and quality companies that pay dividends and have always paid dividends in recessions. In an environment where interest rates are close to zero and may stay there for some time, dividend stocks are quite attractive. People sell companies they like in panic environments because it’s harder to raise cash with illiquid names. There could be another downdraft in oil—so no rush to jump into energy stocks. The best opportunities are in blue-chip companies with a long history of paying dividends, and as always, even if you don’t have cash, a process of rebalancing back to your strategic stock/bond asset allocation will naturally be buying cheap stocks and selling relatively more expensive bonds now that interest rates are at all-time lows.

As you know, our investment process focuses on firms that have high and sustainable free cash flow return on equity relative to their cost of capital which leads us to invest in Blue Chip stocks that are leaders in the industries with strong balance sheets. There is a list of S&P 500 stocks called the Dividend Aristocrats that have paid and increased their base dividend every year for at least 25 consecutive years. This means that these firms not only maintained but increased their dividend payouts during the recessionary periods of 2008-2009, 2001-2002, and 1990-1991. Our Core Equity Portfolio has a number of positions that appear on this list, and it’s these steady and growing blue-chip dividend payers that are the focus of our new purchases when we go to rebalance portfolios back to their strategic weights.

I wish you and your families good health, and I’m always available if you would like to talk. I was out here in the AZ desert on Spring break when these containment efforts were put in place and the kiddos’ school was closed. We closed our offices and are now using collaborative software tools to meet as a team via a video link-up every other day. As a result, I’m out here in the desert, but available over the phone, email, text or Zoom video link.

Warm regards,
John P. Swift, CFA, CPA