The Tug-of-War Between the Bulls and the Bears Continues

Editor's Note: The following section was written on April 30, 2020.

After one of the sharpest drops into a bear market (indicated by a decline of 20% in major market indexes) due to economic fears around the COVID-19 containment measures, April saw one of the strongest months on record for stocks in the last 45 years. The tension between truly terrible economic data—over 12% of the U.S. workforce is now covered by unemployment benefits, the economy shrunk in the first quarter at an annual rate of almost 5%, with worse results to come in the second quarter, and corporate earnings are extremely strained—and the strength of equity markets have left investors puzzled.

It Might Be Hard to See, But What’s Happening in the Markets Has a Rational Basis

The headlines around the market’s strength don’t tell the full story, however. Despite appearances, the market is being somewhat rational because sectors, like health care, have been hurt the least, while sectors like energy, which has been hammed by declines in demand, have declined the most. What is more interesting is that the winners have won big. Five mega cap tech names now make up 20% of the S&P 500 index—we haven’t seen concentration like that in more than 60 years.

The success of these companies’ business models is what is powering the S&P 500’s recovery while leaving international, value and Small-Cap stocks lagging. While these laggards caught up a bit last week, they have a long way to go to catch the performance of the mega-cap tech companies. That doesn’t mean it won’t eventually happen. Over time, Small-Cap and Value companies have outperformed Large-Cap and Growth, specifically because these types of companies are riskier and investors demand a higher premium to hold them.

International and U.S. stocks have traded leadership positions over time; while U.S. stocks have dominated since the great financial crisis of 2008-2009, that’s not necessarily what will happen in the future. Since no one can reliably predict which sector, geography, or factor will have the highest performance at a given time, diversification is still the wise approach.

So, while the market has had recent winners and losers, the question of how there can be winners at all still puzzles some investors, given current events. The answer is that investors seem to be looking through the next six to nine months, toward more normalized earnings, thereby discounting the short term decline in corporate earnings and cash flow. The basis for this appears to rest on the idea that the economy will re-open, and life will get back to normal.

Three Reasons for Optimism

Despite the dominance of negative headlines, there are several good reasons for this line of thinking. First, we have made major progress against the virus. Containment has worked to flatten the curve, which has kept the hospital system from becoming overwhelmed. Deaths have been declining in COVID-19 hot zones (like Italy and New York). Research related to potential treatments and a vaccine is progressing.

Second, the Federal government is filling the hole left by the slowdown in consumer and business investment with massive stimulus packages. So while the economy is contracting at an unprecedented rate, the government is back-filling the loss of activity with loan programs, grants and unemployment. While this might not be enough to keep the economy from cratering, it will help keep many businesses and households solvent so that when the economy rebounds, they can get back to business.

Finally, the world is starting to reopen. China appears to have resumed economic activity without sparking a major uptick in infection rates, as has South Korea, which never imposed a full shutdown. U.S. states are starting to reopen; Georgia has reopened all shops and restaurants; Texas is allowing businesses to reopen at 25% capacity, and Minnesota is allowing manufacturing to resume. The world, America included, is getting back to business.

So while there are some reasons to be optimistic against the backdrop of gloomy economic data, the volatility of the last 8 weeks is very likely to continue as investor sentiment about the market swings between the bear case and the bull case. Understanding your risk tolerance and liquidity needs is the surest way to make the right decisions during levels of high volatility. Never try to time the market, it just doesn’t work. If you own stocks, own them for the long term, which means having other sources of liquidity in your portfolio, so you don’t have to sell when markets are depressed.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Bulls vs. Bears: The Fight Behind Ongoing Market Volatility

Editor's Note: The following section was written on April 22, 2020.

As earning season continues, the impact the COVID-19 containment efforts are having on the economy is coming more into focus, and the view is less than stellar. And yet, the market is holding well above its lows from March 23. One thing that’s different about this sell-off compared to others is the polarization I hear between market optimists (bulls) and pessimists (bears).

This extreme polarization is the source of the volatility we are seeing in the markets, but the truth rarely lies at the extremes. However, understanding both sides can help build a well-rounded view of the market situation. As such, I thought it was worthwhile to layout both the bull and the bear arguments, as I understand them.

The Bull Argument

The bull case starts with the assumption that the containment efforts around COVID-19 will start to soften sooner rather than later and economic activity will begin to rebound. While most bulls acknowledge the recovery is going to take a while (e.g., the hopes of a V-type bounce is largely out of the question), earnings will eventually bounce back—no matter how bad the data is over the next six months.

Further, once the recovery gets going, it’s going to be supercharged by low interest rates and government spending—not to mention deferred demand from consumers- and businesses-from the last few months. So, the bulls look beyond the next six months, and believe the world is likely to be back to normal (or better) in a year or so.

The Bear Argument

The bear case starts with doubts that the containment measures will soften, noting that even if they do, infections will just spike again and put us back in the same situation we found ourselves in early March. Bears are also more pessimistic about finding a vaccine; it could be a decade as opposed to 12–18 months. And even after the economy reopens, consumers are likely to save more and spend less (e.g., Depression Era syndrome), and businesses will think twice before making capital expenditures and hiring, resulting in falling demand.

While bulls see low interest rates far into the future, bears see all the government debt that’s piling up and must be repaid. There are three ways to repay government debt: higher taxes, higher growth or higher inflation. Given that higher growth is hard (if not impossible) to achieve, we are looking at higher taxes (bad for stocks) or higher inflation, which will cause interest rates to go up and provide a headwind for equity prices. Oh, and then there are the rumors surrounding North Korea’s reclusive dictator who may or may not be dead. A transition of power in North Korea might not be good for markets, as a new leader is likely to rattle the saber a bit—maybe test some nukes or fire some midrange missiles.

The Verdict

A good friend and great investor once told me, bears have better facts, but bulls make more money. I think there is a lot of truth in that. The bull story seems a bit too optimistic, and the bear story seems to correspond with the data a bit better. That said, being long on stocks for the long term is generally the right decision, and trying to time the market isn’t. So, whether you’re a bear or a bull (or hopefully, you’re neither), a long-term approach to investing may be the soundest decision.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

How to Reconcile Bad News With Good Market Returns

Editor's Note: The following section was written on April 15, 2020.

It’s a confusing time for investors. The headlines tell a very negative story. So far, first-quarter earnings have been disheartening, unemployment claims are increasing, and pundits are predicting that the second quarter will bring the deepest recession since the Great Depression. While COVID-19 deaths may be peaking, the coronavirus will be an ongoing concern, complicating restarting the economy. And yet, the market has made up about two-thirds of its losses.

The rally is ostensibly on the back of improvements in infection rates and suggestions that the economy will start opening relatively soon (meaning weeks instead of months). But one thing we know about viral outbreaks is that they are fairly predictable. Even in early March, epidemiological models predicted that COVID-19 would peak in April.

While we have greater clarity now, we had reasonably accurate models during the peak of the sell-off; the most reasonable (and well-capitalized) market participants probably just shrugged off the potential short-term impact of COVID-19 containment efforts, believing that equity markets tend to reward investors over the long term. Despite this, the markets moved. Why?

Understanding Market Valuation

One way to understand market valuation is the Dividend Discount Model (DDM). The DDM tells us that the price of the market should be equal to:

• Total dividends and share buybacks (e.g., the net cash that investors can expect to receive),
• Divided by the risk-free rate (e.g., the 10-year treasury rate) plus the risk premium (e.g., how much more investors require in return to hold stocks over 10-year treasuries), less the long-term growth rate in earnings.

Which Factor Is Driving Market Performance?

Once you understand this model, you can begin to see that news that impacts any of these factors can also impact the markets. The question is, which of these factors is moving the market now? We can probably rule out growth and dividends and buybacks.

Dividends and buybacks are closely related to earnings. When earnings are down, the market tends to look through bad quarters to come up with a more “normalized” value, so while the next six months could be ugly, the market is thinking in normalized terms, which probably haven’t changed much, even with the introduction of COVID-19. It turns out that real earnings growth (after inflation) is relatively constant over time at about 3%, which is about the same as GDP growth.

COVID-19 is unlikely to slow real earnings growth over the long run, even if it hurts 2020 results. With a vaccine 12 to 18 months out, the world will certainly face new challenges, but we don’t expect COVID-19 to alter the trajectory of the last 100 years. So, the growth factor probably isn’t behind the recent market movement. That leaves the risk-free rate and the required risk premium for our current market movers.

The risk-free rate—the 10-year treasury—has dropped considerably as inflation expectations have declined and the Fed has engaged in additional quantitative easing measures. Lower risk-free rates are supportive of equity prices; therefore, the longer rates are low, the more attractive equities look relative to bonds.

Now, the big market-mover: equity risk premium, defined as how much incremental return investors require from an equity investment in exchange for the additional risk taken on versus a safer asset. It turns out that equity risk premium is the most volatile factor in the valuation equation. With COVID-19, investors are demanding a higher premium for holding stock than safe bonds. We can’t say exactly why (especially if you believe that stocks will be higher in the future), but we can certainly see it in the data in Figure 3 below. The takeaway from this is that high-risk premiums generally correlate with strong returns over three to five years.

What’s the Bottom Line?

When the market is ignoring the fact that equities are almost always higher in the long run because of relatively consistent growth, you should take the opportunity to buy if it makes sense within your financial plan. One final note, while risk premium is predictive of returns over the longer term, it's not predictive of short-term returns; they could be terrible, or they could be great. If you decide to buy equities when the risk premium is high, you need to make sure that you have enough liquidity to meet your needs so you won’t be forced to sell equities if the short-term returns turn out to be terrible.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Market Rally Continues Despite Terrible Headlines

Editor's Note: The following section was written on April 8, 2020.

We express our sympathy to the family, friends and loved ones impacted by COVID-19 as deaths begin to peak in the U.S. New York announced its highest daily death count on April 8, reporting that 779 people had died. Despite this horrific news, investors found a reason for optimism: Hope that infections might be peaking and may begin to decline—meaning the economy can start to reopen and we can all get back to normal—and the market rally off its recent low continued. In the chart below you can see the reported deaths in New York (orange line) to the Institute for Health Metrics and Evaluation (IMHE) model of infections put out by the University of Washington. The IHME model (or one very similar) will likely be used by policy makers when determining when to re-open the economy. The slight dip in the reported deaths below the mean estimate sparked the rally Monday that continued into Wednesday.

And while the data trends are certainly good news, talk will turn to the possible resurgence of the virus once we are past the peak. Every time a few cases are identified, concern will spike that we might have the beginning of the next exponential pocket, questions about renewed social distancing will abound, and fear will roil the markets. This is the pattern that characterized the Spanish Flu of 1918, where the initial spike was followed up by a lesser, but still deadly, outbreak a few months later.

It’s Not All Downhill From Here

With evidence of the curve flattening and the recent market rally, it is tempting to think that both the economic and pandemic crises have passed; however, we think such optimism is foolhardy. Fortunately, it now appears that fewer people will die from the virus than previously estimated due to effective countermeasures like social distancing; however, the economic impact is just hitting the world, and recovery will not be “V” shaped. A recent Bloomberg survey shows that, on average, economists estimate U.S. GDP will contract by about 30% in Q2 2020, on an annualized basis, and may not return to February 2020 growth rates until after 2021. Goldman Sachs predicts that 2020 earnings for the S&P 500 will decline 30% or more. As we look ahead, the economic data isn’t pretty: government deficits running into the trillions combined with Federal bond-buying that will add trillions more will create economic headwinds for years to come. Behavioral changes implemented to contain the virus will hinder economic recovery by limiting travel, entertainment spending, and a host of other normal consumption patterns businesses rely on until a vaccine becomes widely available.

It’s a confusing moment for market participants:

• The virus is peaking, but will it return?
• The market is rallying, but will real economic activity support it?

We don’t know the answer to these questions, and neither do other market participants. As such, the market is likely to lurch between optimism and pessimism on what will often be statistically insignificant data points—the result will be continued volatility. We don’t know what direction the market will move in the near term, no one does, but our data suggests that the market will continue to move up and down a lot. In a market like this one, which we expect will continue, the best approach is usually to stay the course. Significant positive market days tend to cluster around significant negative days, so being out of the market means you’re likely to miss those positive days, which may be detrimental to your returns for decades to come.

Headlines Get Worse Before They Get Better

Editor's Note: The following section was written on April 3, 2020.

Market volatility continued this week, as the U.S. likely approaches peak infection and death rates resulting from COVID-19 and the economic impact of the efforts to contain the virus began transforming from projections to realities.

Starting with the virus itself; infections topped 1 million globally, while deaths in the U.S. rose to over 6,000; epidemiological models project deaths to peak on the east coast in mid-April and for the central U.S. in late April, so expect headlines to get worse before they start getting better. On the economic front, 6.6 million individuals in the U.S. filed for unemployment this week. That’s nearly 10x more than the highest weekly job loss the economy has ever seen, barring last week. We expect more job losses in the weeks to come, as nearly every economic indicator and corporate profits turn the brightest shades of red. Be ready for the headlines over the next few weeks as they will test the resolve of even the most seasoned investor.

Even though the news will be difficult, it doesn’t mean the markets will decline. While volatility tends to beget volatility, it doesn’t tell investors anything about the direction of the market. It's impossible to say whether it takes collective market participants 2 days, 2 months, or 2 years to see through the turmoil of the next few weeks. What we do know is that markets tend to reward investors over the long-term, and unless you are in a position such that you are forced to sell stocks—which you shouldn’t be if you have a solid financial plan—holding through volatility has historically been a much more successful strategy than attempting to time the up and downs.

Fortunately, there are things you can do. As markets gyrate, there are opportunities to tax loss harvest portfolios to offset gains for future years, buy quality companies at discounts and take advantage of potential miss pricings in the bond markets. Our investment team is working to turn the current volatility to our clients long-term advantage, and while it may not show immediately, our portfolios will be better positioned for the long term because of the decisions we have made and will make over the next few weeks.

In the Eye of the Storm

Editor's Note: The following section was written on April 1, 2020.

Yesterday brought the end to the first quarter of 2020. January seems so far away as the COVID-19 virus impacted every aspect of our lives, reduced our freedom of movement, and created anxiety around both our portfolios and the health of ourselves and loved ones. As the situation has emerged, it’s been important for our clients to know that we are fully functional and continue to be here for them to offer advice during this difficult time.

The current crisis is different than past crises in that this is a distinctly human one—models suggest that over 100,000 Americans may die of the virus in the coming months. That said, it is different than other crises because, unlike the 2008–2009 Financial crisis, no one knew when it would end. The current situation will hopefully abate by late summer through social distancing and other measures and come to conclusion 12 to 18 months from now with a wide-spread vaccine. The question then will be how fast the economy comes back online—and we believe that government stimulus packages, ultra-low interest rates and deferred demand will help accelerate the recovery, but it may take longer than many expect.

Things Will Get Worse Before They Get Better

While the markets have rallied off their lows, no one knows what markets will do in the short term—we are now in the “eye of the storm.” The crisis that was predicted is starting to come to fruition. On the human side, cases are spiking and models suggest that as the virus peaks in mid-April, more than 2,000 Americans could be dying each day from COVID-19. We all knew that shutting down the economy would have consequences, and last week we got our first look at the data, including over 3 million lost jobs.

That is likely only the beginning. Analysts think that the fall of economic activity will be the worst since the end of World War II. In the coming days, corporations will report tanking profits, more jobs will be lost, businesses will close, and families will declare bankruptcy. Even with the $2 trillion government relief package, and likely more on the way, impacts will be felt.

Five years from now, we will certainly be surprised if equity markets are not substantially higher than they are today—how we get there is unknown The headlines over the next few weeks may test even the most stoic investor’s resolve to stay the course, but crisis after crisis has demonstrated that staying the course and not giving in to the desire to sell will yield the best long-term returns.

Understanding "Volatility"

The anticipation of what is coming has elevated volatility to levels not seen since the great recession. Most readers know that volatility is a measure of risk, and while there are many different measures of volatility, historical volatility is measured by the standard deviation of returns of a given asset. If we take the S&;P 500, for instance, the average daily price move (either up or down) since February of 1927 is 0.075%. Between the March 1 and March 30, the average daily price move (either up or down) was 5.06%—that’s more than 670x the normal daily average move.

Volatility was low at the beginning of the year, and you can sense this intuitively by looking at the daily returns up to late February. As the uncertainty of the virus started to take hold, volatility soared. There are lessons to take from this visualization of volatility:

• Volatility moves in regimes. When volatility is low, it tends to stay low, and when it’s high, it tends to stay high (at least for some period of time).
• Don’t try to predict returns day-to-day. There isn’t a pattern in the direction. It’s as close to random as you can get, so don’t try to time the market.

The headlines are about to get worse, and the high levels of volatility are here to stay, for at least a while, so pains of the first quarter are likely to spill over into the second quarter. Those that stay the course are likely to come out the other side with their financial and life plans intact. Stay safe.

Managing Portfolios During Market Volatility

Editor's Note: The following section was written on March 27, 2020.

The past week has been full of unprecedented events impacting every aspect of our lives, families, governments, society, wallets, and especially, our daily routines. Infection rates in Europe and the United States are spiking (along with mortalities) and one-third of the earth’s population is under some form of lockdown or shelter in place. The federal government is on the brink of passing the largest relief spending bill in history ($2 Trillion) to keep business and families from going bankrupt in the short term and the Federal Reserve has committed to buy unlimited amounts of bonds. So far millions of people have lost their jobs with millions more at risk and global markets have produced large losses for investors. While these headlines are certainly depressing, even worse headlines are likely to come before we get through the worst of the COVID-19 crisis which, from an infection perspective, might be 30 days away.

Despite these headlines of doom and gloom, it was generally a very good week for stocks and bonds. Combined, this serves as a powerful reminder not to try to time the market, especially one this volatile. The worst may not be over for equity markets, we may retest the lows, or we may not. No one knows the short-term path of markets (if anyone tells you they do, don’t trust them!), which is why a solid financial plan that ensures you aren’t forced to sell equities during a downturn is the best approach for most investors. That said, we have not sat idle, over the last week we have been actively positioning the portfolios to take advantage of recent events. Over the last two weeks, when appropriate, we have been engaged in:

Portfolio Rebalancing

Portfolio Rebalancing is the practice of selling portfolio assets that went up to buy assets that went down to return your portfolio to a target allocation, this is often done automatically when your portfolio reaches a pre-determined threshold. When markets are highly volatile, we wait to rebalance portfolios so that we don’t buy more stocks in a continually falling market. Last week we determined that it made sense to re-balance, so we started selling some bonds and buying stocks across portfolios. The benefit is that by buying stocks low while getting you back your target allocation positions you maximize your return when the market rebounds without taking on more risk.

Investing in Real Estate

We added real estate to most portfolios in the form of an Exchange-Traded Fund (ETF) that buys Real Estate Investment Trusts (REITs) because we believe real estate adds protection, yield and increased return opportunity to the portfolio. We believe long term-leases provide some protection if the crisis continues because the yield is very attractive in the current ultra-low interest rate environment and, after the stimulus package, we expect real estate prices to go up as inflation expectations rise.

Tax Loss Harvesting

In addition to buying equities at low prices, as mentioned above, market declines also create an opportunity to harvest your losses for a tax gain. Tax Loss Harvesting is a tax-efficient tactic where we sell one investment at a loss and replace it with another very similar investment. We can take the loss and use it to offset future gains, reducing future tax bills.

Repositioning Equity Holdings

While you may not see 1000s of trades occurring in your account, they are happening inside of the ETF and Mutual Funds that you hold. For example, the momentum strategy funds have been actively selling losers directly impacted by the virus and replacing those companies with higher-quality names that are likely to hold up better as volatility persists. Similarly, the value funds have been buying high-quality companies, with characteristics of good business models that are cheaper due to the recent sell-off with the hope of enhancing future returns.

These are difficult and strange times for everyone. Fortunately, at Wealth Enhancement Group, we have the right technology, people and processes in place so that despite our offices being closed, your team and I can continue to provide the same planning, guidance, and advice that we always have. If you have additional questions please reach out to myself or the team.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.

Markets Respond to CARES Act

Editor's Note: The following section was written on March 25, 2020 at 7:00 p.m.

On the back of Tuesday's record-breaking rally, it was the Dow Jones Industrial Average's best day since 1933; the markets moved higher again today. The rally was most likely fueled by reports that a $2 trillion “emergency relief” bill is moving through the senate after Democrats and Republicans reached an agreement late Tuesday. Senate Majority Leader Mitch McConnell discussed the bill, named the Coronavirus Aid, Relief and Economic Security Act (CARES) on the senate floor today – he characterized the spending measures as both economic stimulus and economic relief.

The CARES Act as Stimulus

Generally, stimulus bills are passed when the economy needs a jolt. We saw this with the structural imbalance in the economy during the 2008-2009 financial crisis when Congress passed measures to bail out banks, and following the normal, cyclical slowdown during the recession of the early ’90s. Currently, the economy only needs a "jolt" because measures put in place to address the spread of the virus, including widespread closures, essentially “de-stimulated” the economy.

The CARES Act as Relief

If the CARES Act provides economic stimulus because it gives the economy a needed "jolt," it is also a relief to the extent that it provides a stop-gap measure for the economic pain to come. This relief is about keeping good individuals, families and companies liquid (e.g., they have enough cash to pay their bills) so they can remain solvent (e.g. not bankrupt) during the next several months and emerge on the other side of this pandemic ready to actively participate in the broader economy.

Late in the trading day, however, word started to leak from the Senate that the agreement reached in the wee hours of Tuesday night, might not hold amidst renewed partisan bickering. As a result, the market gave back some of its impressive gains, but most indexes finished in positive territory.