Virus Hysteria

Virus hysteria

Dear Clients and Friends,

As we are all aware this last 3 weeks has been bad for the stock market. The market has dropped just under 20% from the peak as of yesterday’s close. Many of you are nervous and that is understandable. Over the last few weeks, a virus scare has become a hysteria. In my 22 years as a financial advisor I have never seen a hysteria quite like this one. In a small way it reminds me of a more extreme version of Y2K scare … stockpiling dry goods, worry about the unknown, and massive media hype playing into the worst parts of our fears. One thing I have learned through experience is every market drop is different … yet every market drop is the same. We now look at Y2K with a historical view, but the panic people felt at the time was real. My office is here to talk to you if you have concerns, questions or just want to status reports. Please don’t hesitate to call.

As part of my due diligence process, I find the smartest, best people and listen to what they have to say. Let me share an analysis from one of them.

Stephen Auth, Chief Investment Officer of Federated Investors wrote:

Given the novelty of this virus, we have no perfect template to answer some very key questions that ultimately will affect the outlook for the global economy and financial markets. How far will the virus spread? How long will it last? How many people in each country will be infected and worse, die, as it progresses country by country? No one knows, and most scientists, lacking the data, are unwilling to project potential outcomes. So we need a framework for understanding the data as it comes in and for projecting the trend and, importantly, the change in the trend. Here are the key stats we are following:

Virus progression in China: Slowing. China arguably is the key country to watch since the virus started there. Importantly, it is a “worst-case scenario” for how the epidemic will unfold because the flu got a more-than-usual head start in establishing itself, in part because the government blacked out news flow about it for weeks and because China’s health-care system is less advanced than in the developed world. So it’s good news infection rates in China already have begun to slow to just 3% per week, far below the explosive growth witnessed early on and is now occurring (off very low initial numbers) in the U.S. and Europe. If the weekly new infection rates in China continue to decline, that would portend positively for the path of the virus in the developed world. But if it reaccelerates, that would imply the virus is likely to enter a dangerous second growth phase even after the first phase fades. We’ll see.

Virus progression in Korea, Japan, and Italy: Still expanding. These are the next countries to watch. The virus landed there sooner than the U.S. and should peak sooner as well. If that occurs in these three countries within the next two to three weeks, consistent with what we’ve seen in China, markets will breathe a sigh of relief even if the expansion in the U.S. and Europe continues. But if the virus continues to expand in these early-stage countries, markets will begin to discount the possibility of a longer-term disruption in commerce and ultimately earnings.

Virus progression in the U.S.: Still expanding in the very early phase. For the next two to three weeks, we expect a daily drumbeat of new and ever-growing numbers of cases and cities with infections. Like China, once better and more available testing kits/protocols are deployed in the field, an alarming “sudden” jump in detectable cases is probably on the horizon. Ultimately, we doubt the U.S. markets will fully stabilize until U.S. infection rates begin to decline.

Virus progression in the presently hot, humid climates of the Southern Hemisphere: Low. We view the progress of the virus in hotter countries where it already has been introduced as accidental experiments that will help the markets answer a central question: like most others before it, will this flu epidemic be bailed out by the warmer weather only a few weeks away in developed Northern Hemisphere countries? Or is this new Covid-19 virus a monster than can better survive warm weather? With only 83 of a total of 97,886 worldwide cases of the virus reported occurring through yesterday in Southern Hemisphere countries, our base case is the former but we acknowledge the risk of the latter. If infection rates in the warmer countries above remain low, markets will take this as good news.

He went further to write:

Our view is the underlying health risks are potentially serious but likely overstated. Nonetheless, there remains a risk the economic impact is exaggerated by the individual reaction of the millions of market-economy participants operating within a collective, fear-driven crowd psychology (see insert at bottom). We are more worried about demand destruction than supply-side disruption, but are watching both.

Supply-side disruption measures: Limited so far. Supply disruptions can be dangerous because as shortages of key products and services needed for the global economy to operate smoothly develop, the overall economy can start to sputter and eventually stall. If iPhone components become unavailable, iPhone production inevitably will slow. With less iPhones in retail stores, iPhone sales inevitably will slow as well. Etc., etc., etc. China is the epicenter of this argument, largely because it is a crucial global supply chain source and because in its attempt to arrest the spread of Covid-19, it literally ordered key production centers to shut down temporarily. The good news is factories there are starting to come back on line, and so far, few other production centers have shut down. This makes sense. Most modern factories are highly automated, and if necessary, could be operated by workers in protective gear if there was a buck to be made. We are watching for both anecdotal reports of further supply disruptions, along with published weekly economic series such as rail and truck volumes. So far we classify this risk as “limited.”

Demand-side disruption: Limited but growing Demand disruption is the key risk ahead. As the public panics over the flu, and/or governments and corporations take preventive measures, we likely will experience additional demand disruption already hitting airlines, cruise ships, casinos, hotels and other components of the travel and leisure industries. Key potential weak spots include restaurant traffic in large cities, mass transit ridership and mall traffic. At the moment, most of these indicators are holding up, but we expect them to begin worsening in coming days. How long this will last will depend a little on the public’s perception of the risks of being out and about, even if everyone is taking normal precautions to limit the virus spread. Our view is that within a few weeks, the public in general will begin to assess the risk of the virus spreading more realistically, and with it, commerce in the retail side of the economy will begin to stabilize and even re-accelerate. Key indicators we are following include weekly series such as hotel occupancy and movie ticket sales.

Liquidity events: None so far. A third area we are monitoring closely are liquidity events that grow out of either supply or demand disruption. In 2008-09, this actually was the core of the crisis, as the temporary downturn in real estate markets, of which the banking system held levered positions, produced a temporary impairment of bank capital ratios. Because banks largely are funded overnight through demand deposits and/or the commercial paper market, this exposed them to a systematic withdrawal of cash at the same time, spawning a massive chain reaction of called loans and defaults that shut down borrowers, cut off credit and tanked the economy. This time around, the banking system is healthy. But in some ways, we do have a temporary systematic force at work: the potential for retail businesses suffering from a sudden drop in sales and cash flows. Another weak spot could be oil producers suffering from temporarily depressed spot prices and volumes. Many of the former are small businesses that both power the economy and, along with some of the latter, are highly levered. So we are watching for signs of stress that could suggest they are in danger of going under through, again, anecdotal bottom-up evidence from our stock and high-yield teams, along with such indicators as the National Federation of Independent Business small business confidence index and Challenger Gray’s measure of layoffs due to bankruptcies. Our base case is that given the systemic nature of the problem, corporate landlords and bank lenders are likely to extend terms until the storm passes rather than throw all their loan and rental customers under the bus at the same time. We’ll see. If bankruptcies begin to rise, it would be a sign that a liquidity crisis is emerging. And that in turn could lead to the next area we are watching.

Negative feedback loops: None so far Given the size of the publicly traded corporate credit markets and their increased importance in funding companies around the world, a freeze-up here could create a liquidity crisis that leads eventually to bankruptcies, rising unemployment, lower demand, lower earnings and still higher credit spreads, creating a reflexive feedback loop in the capital markets that takes on a life of its own. This is why we expect the Fed to remain focused on liquidity infusions (more below). In a related vein, we are watching the stock market itself, both for signs of compelling valuation and for potential negative wealth effects if the decline becomes long lived. And we are watching the potential for political feedback loops. That is, if the virus is quickly contained and the economy resumes its upswing, President Trump’s approval ratings should rise and the prospect of four more years of his pro-growth policies likely would buoy markets. On the other extreme, if things get so bad that voters become disillusioned with capitalism as an economic model, Bernie Sanders could rise in the polls and begin to take the delegate count lead again in the Democratic primaries. Joe Biden, now the Democratic front-runner, is probably viewed by the markets as market neutral.

Employment declines: Low so far. The fourth area we are watching is employment, the heartbeat of the economy. If businesses disrupted by the forces noted above begin to take more drastic countermeasures, such as laying off workers, our base case of a likely short economic disruption could extend to something worse, potentially a recession. The first sign of this happening will be employment. This will show up in key indicator series, especially weekly jobless claims data and, monthly, ADP’s tally of payroll growth among small companies (under 50 employees), the government’s count of non-farm jobs in the retail and leisure & hospitality industries, and Challenger Gray’s survey of layoff announcements. So far, so good.

The chess game of policy reaction

A third broad area of the present crisis is public policy reaction to mollify the impact of the pandemic on the global economy. Here, most of the talking heads have been, frankly, less than helpful. They conflate random various public policy tools, codifying them all as simply “stimulus measures.” Specifically, we are watching for following potentially helpful policy reactions:

Liquidity provision measures. Already underway, these key measures are vital. If we are right about the likely path here, the major near-term risk to the economy is that a short-term liquidity crisis, particularly among small businesses, morphs into store closures, bankruptcies and rising unemployment. So the monetary authorities in particular need to flood the system with liquidity to help these little businesses survive. This is why we liked the Fed’s sudden 50 basis-point cut, which some characterized as using its “stimulus bullets” too early. This cut should not be viewed as a stimulus bullet, but a liquidity bullet designed to avoid the need for a stimulus bullet. We think the Fed should further bolster liquidity through Quantitative Easing (QE) injections, in particular through direct purchases in the credit markets. This is where the real crunch seems to be occurring and could be the Achilles Heel in the capital markets. Other measures we are watching for include similar central bank action around the world (Hong Kong, Australia, Malaysia and the Fed so far this week), and regulatory relief by the appropriate overseers to encourage larger lenders and landlords to extend terms for borrowers being squeezed by the exogenous and systemic force of nature represented by the virus. (Very different from cutting off a sole borrower whose product/service is simply failing in an otherwise healthy economic environment.)

Short-term fiscal measures that can help with liquidity problems. On the fiscal side, governments have the ability to provide short-term cash to smaller businesses in the form of tax holidays, such as Social Security tax payments. We expect the Trump administration to utilize these in the weeks ahead and if we see them, we will mark this in the progress column.

Larger-scale fiscal measures to jump-start the economy if it heads into recession. Frankly, none are needed so far, as we are not in a recession. But should one come, the government certainly has the ability to legislate for large-scale tax or spending measures to spur the economy. We hope we don’t get to this stage but are comforted knowing that over the long term, such measures are available and likely would be employed.

Investment template: No time to panic

Against all this uncertainty, we are watching for opportunities under the assumption our base case (a short but sharp economic pullback followed by a dramatic back-half recovery) is correct. But we are pacing our investments to allow for a change in course should the areas we are monitoring turn more negative. We already have averaged in 2 points further to equities in our PRISM® stock-bond portfolio model on the first big downdrafts of last week (putting us at 70% of our maximum overweight in stocks), and have plans to add a third point if markets decline a full 20% from their highs. (In the past, 20% downdrafts have proven excellent long-term entry points—even during the 2008-09 crisis.)

At the portfolio level, we are similarly using big market down days to upgrade our portfolios, adding ever-higher quality long-term growth stories at significantly reduced prices. Again, we are advising moving deliberately and confidently into equity positions rather than trying to call a precise bottom amid the current volatility. We are entering the “Be Not Afraid” moment. Follow with us the progress of the crisis for sure, and adjust your strategy accordingly. But above all, remain confident and careful. This is no time for panic.

Everyone take care, please try not to worry. Also, don’t forget to buy 6 years’ worth of toilet paper just in case.

Regards,
Matt

_____________________________
Matthew R. Lang
Financial Advisor

236 North Washington
Monument, CO 80132
Phone: (719) 481-0887
matt@langinvestmentservices.com | www.langinvestmentservices.com

Independent Advice. Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser. Fixed insurance products and services are offered through CES Insurance Agency.

Stock market ebb and flow

The worries on the market ebb and flow like the tides.

Last autumn, the worries were in full force: are we nearing a recession, is inflation coming, is this the big market correction, will the trade war escalate, will we have a lasting government shutdown, and many more.  Consequently, the market had a big drop in Q4 of last year, bottoming on Dec 24 with a drop of about 20% in 3 months.  Ouch.

Then something remarkable happened.  The worries all seemed to go away.  And just like that, the market has bounced back entirely and is right now butting up against the all-time high levels.

So what happened?  Nothing. The worries which existed in Q4 still exist.  In actuality these worries plus a myriad of other worries are always present.  The worries represent the balance of risk, which is essential in a functioning market.

I remember when I was a 25 year old advisor in 1999 at the peak of the tech bubble (we didn’t know it was a bubble then however) hardly anyone was worried, including myself.  “This is the new, connected world….a new economy,” was what everyone was saying.  And my least favorite expression of all, which I still hear on the financial news is, “we are in a goldilocks economy.”  I know what the talking heads are trying to say; the economy is neither too hot or too cold…just right; but personally I think they should find an example that doesn’t have bears in it.  More to my point, in 1999 the worries were gone, but the underlying risks were as high as ever.  The second chapter of the Goldilocks should have been published in 2000 with the bears chasing down a terrified Goldilocks and getting even.

The current worry list has some of the same entries as Q4 last year, minus a few that are resolved and plus a few new ones.  I’m happy the worries are there.  I’m happy the market risk is balanced.  I’ll be worried when everyone else is not.  I’m not worried about rain while its raining, I’m worried about rain while its sunny.

We’ve enjoyed a 2019 rally (bouncing off the 2018 swoon) and the market is probably due for a breather in the short term.  However, I think this will continue to be a good year in the market overall.  Instead of looking at the worries, I look at the reality.  We have a great economy, everyone who wants a job has one, low inflation, low interest rates, people are spending money, business is expanding, capital expenditures are up, and people are generally happy.

Spring is in the air.  In Colorado we are having our first 70 degree days this week.  Enjoy this time of year…..and leave the worrying about your money to me!

 

Matthew Lang is a financial advisor located at 236 N Washington St, Monument, CO 80132. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 719-481-0887 or at matt@langinvestmentservices.com.

Stock crash

Is this the beginning of the end?

With the recent two-day drop in the stock market, there is increasing fear that this is it—the big one that will take us back to the depths of 2008. Although that level of concern is certainly understandable, a closer look at the real economic and market situation around the world suggests that the volatility we are now seeing (and may well continue to see) is perfectly normal. Over time, this kind of turbulence is why stocks can yield the returns they do.

Still, how do we know whether this decline is normal and whether we’re headed for another 2008? Is there a way to tell?

Is this decline normal?

Let’s start with the easy question first. As of this writing (October 12, 2018), the S&P 500 is down about 7 percent from its peak. Since 1980, declines during a calendar year have ranged between 2 percent and 49 percent, with the average decline at just more than 14 percent. So, the market could drop another 7 percent (i.e., as much as we have already seen), and we’d still be at the average decline for a typical year.

Another way to answer this question is to see how often a decline of any given size occurs. Markets experience a 10-percent decline every year, on average. Even if things get worse—we are not there yet—this is about the fifth drop we’ve seen in the past five years. In that sense, we are once again right in line with the averages.

Are we headed for another 2008?

These facts are all well and good. Even if things are normal now, however, we need to think about how much worse this situation could get. There are no guarantees, of course. But if we look at past bear markets (defined as declines of 20 percent or more), we can make a few observations.

First, of 10 such events since 1929, 80 percent have occurred during a recession. The U.S. economy, despite some slowing trends, continues to grow; we are not in a recession. A growing economy tends to support market values and limit declines.

Second, 40 percent of past bear markets have come during times of rapidly rising commodity prices (e.g., the 1973 oil embargo). Rising prices tend to choke off economic activity and slam profit margins. Now, we have moderate commodity prices overall, which support economic growth and help profit margins, at least here in the U.S. These moderate prices, generally speaking, are not a problem.

Third, during 40 percent of past bear markets, the Federal Reserve has aggressively raised interest rates. While rates have been rising, they are still very low by historical standards. In fact, they are at the lower end of the range that prevailed from 2008 to 2011, after the crisis. They are also likely to stay low by historical standards for some time. As such, we certainly do not have the conditions that fuel a bear market. Despite the recent increases, low rates continue to benefit the economy, which has supported the market so far and will continue to do so.

Finally, half of the bear markets were born when market values were extreme. Current valuations are high by historical standards but low by the standards of the past five years. As we are seeing, an adjustment to lower valuations is painful. But it also means the risk of a further drop dissipates, which takes us back to the fact that periodic drawdowns are not only necessary but healthy.

Almost all bear markets have more than one of these traits; right now, we have (at most) one and really more like one-half of one. This doesn’t mean that we won’t see further declines. It does suggest that they are less likely—and would probably be short lived.

We can also look at recent history to evaluate how much trouble we might see if the situation were to worsen. Earlier this year, for example, markets pulled back by 10 percent, only to rebound and reach new highs. In early 2016, markets were also down more than 10 percent, only to bounce back to new highs. And we can go back further, to even worse pullbacks. In 2011, when Greece almost declared bankruptcy and broke up the European Union, we saw markets drop 19 percent. In 1998, during the Asian financial crisis, we also saw a pullback of 19 percent. Despite the headlines, our current economic situation is much more like early 2018 and 2016, and it is nowhere near as bad as either 1998 or 2011. Even with those declines, the annual return for each year wasn’t disastrous. In 2011, the market ended flat; in 1998, it gained 27 percent.

What is the outlook for the rest of 2018?

Markets are up for 2018 so far, even after the recent pullback, and the economic fundamentals are good. While further volatility is possible, based on history, it does not seem likely that we will see a further massive and sustained decline that takes us back to 2008. Worst case, if the Chinese trade confrontation situation gets as bad as the Asian financial crisis or the Greek crisis, we could see additional damage. But we likely won’t see anything worse than what occurred during those pullbacks.

With a growing economy, with strong employment and spending growth, and with moderate oil prices and interest rates, the U.S. is well positioned to ride out any storms—more so, in fact, than we were in 2011. Current conditions look much more like 2016 than 2011. As the island of stability in the world, we are also very attractive to foreign investors, as we can see by the strength of the dollar.

Look beyond the headlines

By understanding the history and economic context of today’s turmoil, it is clear that markets may get worse in the short term. Still, the foundations remain solid, which should lessen the effect and duration of any further damage. Yes, the headlines are very scary, but things aren’t that bad. So, we will be postponing the beginning of the end . . . again.

Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict.

 All indices are unmanaged and investors cannot actually invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results.

Matthew Lang is a financial advisor located at 236 N Washington St, Monument, CO 80132. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 719-481-0887 or at matt@langinvestmentservices.com.

© 2018 Commonwealth Financial Network®