As you read this, I hope you and your family are safe and well.
A lot has changed since our last quarterly commentary. We are in unprecedented times, and this COVID-19 pandemic has affected all aspects of our lives. Given these unique circumstances, let us first address some important issues we want you to be aware of.
Our team is healthy, safe, and committed to serving our clients through these difficult times. Century Wealth Management is fully operational. Our office is open but is being staffed one person at a time. Those who are not in the office are working from home. We have a business continuity plan, which prepared us well to deal with the state-wide stay-at-home order. We are all looking forward to getting back into the office and working together. Until then, we can handle everything remotely.
State of the Markets
For investors, the first quarter of 2020 was a roller coaster ride. A slow and steady upward trajectory as the U.S. and global stock markets reached all-time highs in mid-February, followed by remarkable, volatile ups and downs as fears about the spread of the novel coronavirus began to take hold.
By March 23, the U.S. stock market (Russell 3000) suffered a steep decline of almost 35%. Since that low point, the U.S. stock market has bounced back and has recovered more than 28% from the bottom. The quarter closed with a 20.9% loss and is down 12.1% YTD as of April 17.
Correlations tend to be high during stock market panics, so the decline and recovery numbers outside the U.S. are similar. International developed markets (MSCI World ex USA IMI) were down 24% for the quarter and are down 20.5% YTD. Emerging markets (MSCI Emerging Markets IMI) were down 24.4% for the quarter and 19.4% YTD. Publicly traded real estate (S&P Global REIT) experienced a significant decline of 29.2% for the quarter and 24.6% YTD. The U.S. bond market (Bloomberg Barclays U.S. Aggregate Bond Index) performed well with a positive return of 3.2% for the quarter and 4.7% YTD.
The total returns for major asset classes are below. (We normally only reference index performance as of quarter end, but given the significant day-to-day volatility and strong recovery, we thought it would be helpful to see year-to-date numbers as well.)
What is Driving Market Returns
Health is the number one priority. Unfortunately, the process for protecting health and containing the virus is having a significant impact on the economy. What the ultimate impact will be is unknown, but all markets – stocks, bonds, real estate, etc. – are reacting in real-time to how the economy is likely to be impacted by this pandemic. As we go through this journey, we can group events into multiple chapters that pointed markets in one direction or another.
Chapter 1: Pricing in Worst Case Scenario
When the risk of this virus spreading rose, and before there were unified strategic responses, the markets seemed to be pricing in a worst-case scenario. In this chapter, stocks declined significantly.
While initially bonds performed well as a broad flight to quality, halfway through this chapter, there was a separation between U.S. Treasuries and the rest of the bond market. Corporate bonds, municipal bonds, and almost anything with credit risk went from positive to negative performance as liquidity dried up. (More commentary on this later.)
Chapter 2: Significant Response
From a health perspective, federal, state, and local governments will get both criticism and praise for their work. There will forever be disagreement on how fast, slow, stern, or relaxed social distancing and stay-at-home rules could or should have been implemented. There is no way to know how an alternative scenario could have played out, so we will have to live with the actions and the results.
That said, from a fiscal and monetary perspective, the Federal Reserve’s and Federal Government’s response has been fast and broad. The Federal Reserve has very quickly put in place multiple programs designed to keep our monetary and financial systems flowing smoothly. On March 28, the Federal Government passed a $2 trillion stimulus bill that provides significant support – including $1,200 checks for individuals, increases in unemployment benefits, forgivable loans to small and medium businesses, and reasonable support for larger companies. (Our summary of the CARES Act stimulus bill can be found here and here.)
This combination of health care and economic response likely takes the worst-case scenario off the table. This may be why stock markets have recovered so significantly and quickly.
Chapter 3: What Comes Next
We may have eliminated the risk of a worst-case scenario for our health and the economy, but we don’t know what will happen next regarding case count, mortality rate, unemployment, business closures, corporate earnings, etc. The markets have responded positively to good news and negatively to bad news. In the near-term, we are likely to see both, so it would not surprise us to see more ups and downs in the markets while we slog through this period of uncertainty.
Chapter 4: The Long-Term
We are already seeing unprecedented unemployment numbers, which are likely to get worse. The economic contraction in 2020 will be significant. We may also see a second wave of COVID-19 in the future.
The good news about bad news is that it is very likely to be temporary. There will hopefully be successful vaccines, testing, and treatments. We’ve beaten influenzas in the past. There will be a point in the future when this is behind us.
The same will apply to the economy. We all have incentives to get things back up and running – to work, to earn, to spend, to save. There may be significant disruption along the way for both individuals and businesses, but we know historically that we can dig ourselves out of any hole.
No one knows if a full recovery will take six months, one year, or three years. But the speed of government’s fiscal and monetary support, and their proclaimed willingness to do more, does provide a significant safety net, which may actually work like a trampoline.
Performance in Times of Stress
In periods of uncertainty and volatility, we get to see the best and worst features of public markets.
The best features are liquidity, efficiency, and regulation. This allows long-term investors to buy what they want – whether individual securities, mutual funds, or ETFs – easily, cheaply, and safely. Of course, the process of selling meets the same qualifications.
Public markets continually set the fair price of those investments. The frequently used definition of fair price is “a price agreed upon by a willing buyer and seller, assuming both parties are knowledgeable and enter the transaction freely.” On a normal day, in a stable economic environment, opportunist buyers and sellers will find a price on which they agree to be fair, and that price will determine the value of your holdings. This is another good feature of public markets.
But in times of uncertainty, when transactions are between forced sellers and hesitant buyers, pricing can be distorted. Small, forced transactions still define the price of securities, which then determine the value of your holdings. In times of stress, this can be the worst feature of public markets.
An example of price distortion can be found in the bond market over the last several weeks.
In an ideal environment, bond prices and performance should be based solely on yield and credit risk. The solvency of investment grade bonds should be extremely high, making actual credit risk extremely low. While these easily measured fundamentals drive long-term performance, in the short-term, prices can be significantly impacted by liquidity.
Bonds don’t always trade with the same liquidity or transparency as stocks. So, when forced sellers need to exit positions in times of uncertainty, buyers can set prices to their advantage.
The chart below illustrates this short-term disruption in the bond market showing the YTD returns of ETFs that represent core sectors of the bond market (GOVT, LQD, MUB) and the total bond market (AGG).
After the initial flight to safety that drove yields down and prices up in February, almost all bonds, with the exception of U.S. Treasuries, (the largest holding in the bond index), reverted from gains to losses in March. Once the Federal Reserve initiated programs to support liquidity in the bond market, things turned around quickly.
These temporary declines may have had a significant impact on bond returns for investors in the first quarter. And while not all funds are back in positive territory, they have recovered significantly since the end of March and closed gaps in performance in April.
The stock market has its own version of flight to safety. In uncertain economic environments, some investors are drawn to larger, more stable companies like those in the S&P 500. Pair this with price distortion that comes from forced sellers, and you see a large dispersion between performance of large cap and small cap stocks.
Unlike the bond market, which rebounded quickly, it may take some time before small cap holdings fully recover. That said, it is often coming out of bear markets when these funds deliver their best returns.
The charts below compare three indices, which each represent segments of the U.S. stock market based on market capitalization – S&P 500 for large cap companies, Russell 2000 for smaller companies, and Russell Microcap for the smallest of the small companies.
The charts show both trajectories of each index over the two years leading into the great recession and five years of recovery from the market bottom.
This does not represent actual past performance (which is also no guarantee of future results). Instead, it is meant to illustrate the trend that poor performance is often followed by significant rebounds.
Actionable Items Related to the CARES Act
A quick reminder of a few items from the stimulus bill that may impact your personal finances:
- Tax return filing is deferred till July 15, 2020. This also applies to any taxes owed for 2019, and Q1 and Q2 estimated payments for 2020.
- Any required minimum distributions (RMDs) are waived for 2020, although IRAs can still be used to fund Qualified Charitable Distributions up to $100,000 for those above 70 ½.
- IRAs and employer-sponsored retirement plans can be used as temporary resources during this crisis if needed.
Please proactively consider your personal situation to see what changes can and should be made to get the best overall outcome. Please reach out if you have any questions.