Given the sharpness of recent market declines, we felt it important to give all of you an additional mid-month update you on our current outlook and to update you on our strategies and portfolio progress. We are still of the mindset that this could be the beginning phases of a recession. We had iterated this just two months ago in our newsletter “Secure Act Passes, Cautious Stance Remains, Financial Planning Crucial”, pointing to concerns seen in the treasury markets. Additionally, the same letter stressed recessions are normal. The violent move in the markets we’ve recently experienced is not normal but not necessarily unique. Volatility does pick up like this from time to time. The most recent historical instances of this were in 2008, 2010 and 2011. Beyond that, markets have been relatively stable but did see spikes in both volatility and drops in equity prices. As recently as the fourth quarter of 2018, markets fell nearly 20% over a three-month period. The “three-month” period is the major difference than we have experience so far in the current environment. The US stock markets have now fallen about 20% in less than one month since the record close back on February 19th. That is an impressive decline and also makes it extremely difficult to analyze valuations of companies.
Our portfolios were positioned going into February in the most conservative allocation for each risk level. For reference sake, we will use a moderate risk account as an example. Over market cycles, a moderate account can have pure equity exposure in the form of public stocks and public REITs (Real Estate Investment Trusts) ranging between 45% and 70%. At the end of January, moderate accounts were actually below 45%. After markets had taken a 15% dive, this skewed moderate accounts to nearly 40% equity/stock exposure or less. Because of this, we performed a mid-month balance, allowing accounts to get back up to 45%. Now that the markets have declined 20%, we will again balance accounts, which will place a moderate risk level closer to 50% equity exposure with still plenty of room to continue gaining exposure. If markets decline further, we will continue increase this amount. We want to stress, we firmly believe this recession, if we’re in the midst of one, will be a soft recession. This means we believe the actual impact to businesses and the general economy will be minor and short lived. As far as stock prices or “the markets”, we can never predict what those will do, but it is very possible to experience further declines in the months ahead. Our focus is on the valuations of specific stocks of the companies we buy.
Currently, we are witnessing some stock valuation multiples below 2008 lows. We feel it’s necessary to repeat that. We are witnessing valuations in some stocks that are below 2008 lows. If we had a time machine and could go back in time to the specific point that certain stocks were trading at the lowest multiples ever during 2008’s financial crisis, would you have any interest in investing? Would you buy stocks? We believe most of us would knowing what evolved over the following decade. But remember at the time, equity markets were collapsing. Banks were shuttering. Lehman Brothers and Bear Stearns had fallen. Treasury yields were diving to historic lows for that period in time. Access to capital was near impossible. It was undoubtedly the worst recession, later called the “Great Recession,” to hit America as well as the rest of the world since 1929, the “Great Depression.” In order to invest at those generational low multiples, you would have to be investing in the midst of sheer panic. We are seeing some multiples even lower, today.
COVID-19 will undoubtedly have an impact on certain businesses through 2020. However, we believe this to be an extremely short-term issue. As an example, South Korea was one of the first countries most impacted by the virus after China. Within South Korea, active cases have stabilized just under 7,500 cases. This process to stability took less than one month. People may argue more stringent containment measures were used, however that is not our focus. Our focus is not the scope of the outbreak but instead the panic ensuing. Let’s look at a recent example of an outbreak so many have already forgotten. In our previous letter to clients, we paralleled statistics with the most recent flu season, so we will not reiterate that comparison. Let’s instead look at the 2009 H1N1 pandemic. It is estimated to have infected 60.8 million Americans, hospitalizing nearly 275,000 of them, and leading to 12,469 deaths. This was all in the US alone. South Korea’s rates look well below 1%. Italy and Iran seem to be outliers with much higher rates.
Ignoring the market decline, we want to discuss these statistics to put the current outbreak itself into perspective relative to past outbreaks while trying to remain rational. We understand there are massive limitations to the current data released, but it is the best information we have available at the moment. Even if this data were grossly underestimated, we still believe this to be a short-term issue. Everything from active case to mortality rates are completely at the whim of the quality of data, which is continuing to come from substantially small sample sets. We believe these short-term concerns are bringing massive long-term opportunities. It’s easy to conceptualize the massive impact on travel related companies during this panic. But, assuming the company has enough financial flexibility, would you argue their businesses should return to normal in, say, three years? Will people still not travel and cancel plans due to COVID-19 in five years? And if so, can we conceptualize the business at least returning to normal earnings at that point?
In the majority of cases for companies impacted in this way, you are again paying a massive discount to 2008 valuation low multiples. We had previously discussed Carnival Cruise Lines (CCL) as a specific example. If we look in terms of the CCL’s revenues alone, you would have paid 1.71x forward revenue estimates in January of 2009, the lowest multiple in the history of the company, until now. CCL is now trading at 1.29x revenue estimates. So, if we step back and make generalizations, this means CCL’s revenues could drop by a third, and you would be paying for the business the same multiple of revenue you paid in January of 2009, a generational opportunity. We believe that a drop like that in revenue is definitely possible; it may even be more severe. However, we are arguing for where the revenues will be in five years. Will revenues recover? And how long would it take? We would argue the cruise industry is no more in jeopardy than it is from the flu that occurs year after year. We continue to see the impact being a short-term panic of irrational proportions not confirmed by data.
Other areas of the market have also seen some unexpected volatility completely unrelated, such as the Energy space. To avoid an excessively long update, oil markets are essentially seeing price wars from foreign countries. Oil has dropped 50% since January. Fortunately, we have been underexposed in portfolios to that part of the market. However, we’ve now seen valuations get to irrational levels that may warrant us to begin adding exposure to this sector in the near future. We believe it could be an extremely difficult time in the energy space for the next 18 months, however there are several companies that have solid balance sheets to weather a long-term storm, which is highly likely. If continued price declines occur, we may have to begin adding certain securities to portfolios.
If portfolios would have been fully invested in equities, we would definitely be feeling more pain. However, we have been trying to articulate the anticipation for an event like this. The time is here. We must begin selling and reducing fixed income/bond holdings in favor of value-oriented stocks. We believe this could be a gradual process over a period of time, which we had initially speculated to be 18 to 24 months. That was before the markets declined nearly 20% in two weeks. We continue to watch bond markets for further confirmation of entering the markets faster, but we will be more patient for those clients at the lower end of the risk levels. We continue to believe this recession, if we are indeed in one, will more mirror the recession in 1990. In that instance, the markets had fallen sharply over six months and swiftly recovered to all-time highs. These highs were seen well in advance of any pronounced “ending” to that recession that could be seen in advance. Waiting for the storm to calm, you would have lost out on the opportunity to invest at the most opportune time.
Again, we must stress, we are doing this with extreme care based on risk level. Our higher growth and aggressive accounts must take advantage of a 20% decline, before receiving any definitive confirmation within bond indicators that the markets should start rising again. If markets continue to further decline, our aggressive clients will need to get to the high-end of equity exposure and ride out any further volatility that comes in the months ahead. For our mid and low-end risk level clients, we will plan to get to at least half of intended equity exposure by the time any confirmation arises that markets may have bottomed. We will most likely wait for confirmation from the bond markets before moving the lower risk client portfolios to their full equity exposure. This was articulated in last month’s letter as to what the process looks like.
We asked for continued patience from all our clients just in January, waiting for more opportune times to invest in equities. We are now asking for the confidence that the time to begin more aggressively allocating to equities is here and that we have begun that process. Given how fast the markets are moving, timelines remain difficult. Typically, in terms of the yield curve, it takes two to three years from trough to peak in yield spreads. It is our opinion this began in August of 2019, therefore we would expect to be fully exposed to equities sometime between August 2021 or 2022 at the absolute latest. However, if markets continue to move in the manner they have, we would anticipate the allocation timeline to be significantly shorter with our higher risk clients seeing a full equity allocation by year end if not even sooner. We will keep you posted. Just remember: This too shall pass, and to be successful investors, we must “buy low and sell high”, even when it doesn’t “feel” right. We will continue to keep a level head in these times of irrational behavior.
Some closing thoughts from the Rudyard Kipling poem “IF”:
|“If you can keep your head when all about you
Are losing theirs and blaming it on you;
If you can trust yourself when all men doubt you,
But make allowance for their doubting too;
If you can wait and not be tired by waiting,
Or, being lied about, don’t deal in lies,
Or, being hated, don’t give way to hating,
And yet don’t look too good, nor talk too wise;…….
And – which is more – you’ll be a Man my son!”
We are here to serve you and if you have any questions or concerns, please don’t hesitate to call us at any time.
Your TEAM at F.I.G. Financial Advisory Services, Inc.