Beginning of a Recovery…or a Rally in a Bear Market?

In a little over a month’s time global stock indexes have declined dramatically – at one point declining 35% – in reaction to COVID-19 and its negative impact on economic growth both here and abroad. Declines of 35% or more are almost always associated with economic contractions or what is more commonly known as a recession – and this one is no exception. The COVID-19 crisis is unlike anything the modern world has ever experienced and has stopped economic growth in its tracks. It has set off a ‘”bear” market in all kinds of financial securities, but most obviously in stocks. The important question for citizens and investors is, “How long will it take to quantify who is infected, who is not, and who is immune?” Those answers will get us closer to turning economies back “on” and mitigate further downside risk. Though many speculate about this, no one knows these answers with certainty. In terms of financial markets we can use some metrics to make well-informed judgement calls to put the odds in our favor.

As you are aware our Active Risk Management process has significantly reduced your downside during this difficult period. This process has allowed us to be flexible about having less stock exposure, avoid unhealthy sectors (such as oil, airlines and cruise lines), and the discipline to allow stop loss orders to mitigate catastrophic loss. In the end, we not only have less stock exposure than normal, but different exposure. For the most part, the companies you own sell essential services or products, such as consumer staple companies (think food, beverage and personal care products) or healthcare companies (many of which have or are developing products that will be part of the COVID-19 solution). It is for these reasons that your stocks are holding up much better than stock market indexes. However, at what point should we add more stock exposure and companies that will benefit from a recovery?

Though this bear market is unlike any that have come before it, investors would be wise to review the history of bear markets for clues as to when this one will come to an end, as well as data points that make this one different. We know the average bear market tied to recessions usually creates a 35-55% decline in stock indexes. We recently experienced the 35% decline, but could there be further downside? Typically bear markets end when price-to-earnings (P/E) ratios get very compressed on previous year’s earnings. On average, a 13x P/E ratio coincides with a bear market and we have not yet reached those levels. There is a psychology among most investors at the end of bear markets which is devoid of the “buy the dip” mentality and we have definitely not reached that stage yet. Lastly, stock market recoveries begin in earnest based on the perception that the economy will start growing again in the not too distant future. Although government stimulus will be helpful, we think that the visibility of future economic growth is still too cloudy to be convinced that all is well with global stock markets. These data points – among others – suggest to our team that remaining somewhat conservative at this point makes good investment sense.

We have little doubt that the COVID-19 crisis will come to an end and a significant recovery in financial markets will ensue – we just need more data to build a good case for its timing. Mass testing may get us further down this path. In the meantime, our team is making a list of great companies that we think will lead the eventual and significant recovery. Remember that during the first year of bull market recoveries global stock indexes often advance 25-30%! We look forward to this in the, hopefully, not too distant future. Our list of “recovery stocks” reflects a world somewhat changed by COVID-19 – we are avoiding industries that we feel may have difficulty recovering and focusing on those that may thrive in the new post COVID-19 crisis. In our opinion the world will be somewhat “reshaped” once this crisis passes and your investment portfolio should reflect those changes.

The past few weeks have been a “wake up call” to those investors who own stock/bond index funds or exchange traded funds. These products may do fine in a rising bull market but fare very poorly in bear markets – and their performance in these recent weeks has been no exception. The average stock fund has plummeted since they must own all stocks – including those shares that have declined the worst, such as airlines, restaurants, cruise ships, oil and the like. Bond funds have also had very disappointing declines given their exposure to risky bonds and a lack of liquidity causing prices to plummet. It is for these reasons we are reminded that our investment style focused on individual stocks and bonds allows us to avoid certain sectors, remain focused on the highest quality bonds, and have access to tools such as stop loss orders. If you have friends or family that can benefit from our work, please let us know.

All of us on the team hope you and your family and loved ones are staying safe and healthy. It is important that we all appreciate this precious time we have and before we know it the world will be spinning quickly again – hopefully, in the very near future.

Please let us know if you have any questions about your portfolio, wealth planning or have experienced any changes in your financial circumstances.

Your Team at Main Street Research