Q1 2020 Portfolio Commentary & Update: Fireside Chat

April 8, 2020

Back in the early 1930s, when the nation was facing unprecedented financial troubles, a comforting and calming voice reached out through radios in living rooms across the nation. Franklin D. Roosevelt’s informal, personal and brutally honest fireside chats were meant to level with the American people on what the government was doing to address the economic and humanitarian crisis the nation was facing. He used plain language and concrete examples of how his programs would attempt to bring commerce and confidence back to pre-depression levels.

After listening to a few crackly recordings of these fireside chats, I’ll attempt to channel my inner-FDR in the below update. These are challenging times for us all. I don’t want to downplay the health crisis we face. Dollar signs mean nothing without first ensuring the health and safety of those we care for and love.

My friends,

We are likely in the early innings of a virus-induced recession. Of course, we will only know in hindsight after Q2 GDP is printed later this year. Analysts are expecting GDP to contract in Q1 2020. Q2 GDP may see a drop of more than 30%. This would amount to the largest quarterly drop in history, including during the Civil War and the Great Depression.

I think there are a few key reasons why the U.S. may see a recession (two consecutive quarters of GDP contraction) rather than a depression (severe economic downturns that last several years). 

To start with, going into this crisis the U.S. economy seemed to be on strong footing. Companies were reporting record profit margins and growth prospects appeared solid. What flipped on a dime is that whole swaths of the economy have been taken offline due to stay at home orders.

Basically, the government is paying people to stay at home to stop the spread of the virus. The Federal Reserve has announced a mind-boggling amount of stimulus, $1.6 trillion thus far in 1 month. To put this in perspective, this is more than was deployed during all of 2008/2009! They are offering this stimulus through a plethora of programs in order to essentially put the economy into a medically induced coma until we can return to “normal.” More to follow on, quote – normal.

The CARES Act (or Coronavirus Aid, Relief and Economic Security Act) recently passed by Congress, is providing direct relief checks to individuals and families (depending upon 2018 income levels) and is creating a lifeline for businesses to borrow to retain staff and pay for ongoing employment expenses. CARES, along with the Fed’s stimulus programs and liquidity injections, comes at a cost (the Federal debt is set to grow to 93% of GDP this year), but the alternative of doing nothing would have possibly meant financial melt-down. It seems that the goal is to give workers and corporations the means to pick up where they left off after the pandemic has passed.

So now that it is apparent that the Fed and U.S. government are throwing everything, including the kitchen sink, at the market, what comes next? This is where the crystal ball gets hazy. There is no playbook to reference for this type of sudden downturn in the economy. Yes, we have had slowdowns, but not shutdowns.

Despite the wide range of possible future outcomes, in my opinion, we can rule out the two extremes: Financial meltdown on the downside (already discussed) and going right back to peak market levels from January 22 on the upside – when the first U.S. COVID-19 case was reported.

For the market to revisit recent highs in the near-term (say by the end of 2020), I believe it would take the confluence of the following: The wide adoption of a rapid-result COVID-19 test, a meaningful drop in new COVID-19 cases, a very promising vaccine, and the assumption that everything will go right back to B.C. way of life (Before COVID-19 in this case).

I think the first 3 have a reasonable chance of occurring, but life after COVID-19 may look meaningfully different for some time to come. People likely will think twice before packing restaurants and sports stadiums. Companies likely will hold more cash for contingency plans and may bring production of goods back to the U.S. All this means risk appetites for both firms and investors may dwindle. By extension, this means that stock valuations must come down. Paying 30-40x next years’ earnings for a stock now seems extreme, given that over the next two quarters we likely will see earnings evaporate from record highs to negative readings.

That leaves us with a broad range of possible outcomes in markets. We will be the first to admit that recent times are uncertain and that confidence in the next few months are in short supply. Heck, I don’t even know if I’ll be able to leave the house in a month!

However, as we take that concept of time, that fourth dimension, and allow it to represent not the next few months, but the next few years, then things start to seem much more palatable… Will we find a vaccine for the virus over the next 2 years? Almost certainly. Every scientist on earth worth her lab coat has been laser-focused on this goal. We will crack the code.

Since BSW, as a matter of course, invests in stocks for the long term, we are looking past these crazy, stress-inducing times and seeing a world where things may be different, but where good companies can profit, workers can thrive and society comes out stronger and more united.

You may ask, what has BSW been doing since all this started?

BSW has been communicating openly and candidly with clients – no sugarcoating. In our opinion, this is no time for false hopes. In this spirit, we would not be surprised if the stock market retested the recent lows. We are not out of the woods yet. There likely will be ramifications that come out of the pandemic that will continue to weigh on the market. While there are still active COVID-19 cases, the risks of a round two infection cycle stemming from social reengagement is just too high.

Throughout this downturn, BSW has been actively rebalancing portfolios as client growth allocations have drifted below our rebalance trigger points. We have sold fixed income opportunistically to fund purchases of global stocks. If the market keeps going lower and our triggers hit again, we will buy more stocks. To reiterate, we already know that the next quarter will be miserable, but the market is a forward-looking mechanism. We are buying stocks today that we feel have a reasonable chance of being much higher in 2-3 years, not 2-3 months. Let’s also not forget that historically, the market turns higher well before the coast is clear.

BSW has also been in steady communication with our managers. These are the folks on the front lines who are talking with company CEOs, dealing with tenants in our direct real estate holdings and navigating new legislation and its effects on fixed income markets. It’s during these times of stress that we are particularly glad that our up-front due diligence process is so people-centric. While our stable of seasoned managers cannot control what is confronting them, it seems that none are panicking, and all have plans in place to protect capital and take advantage of the dislocation in certain asset classes.

Going forward, our plan is simple. BSW will remain diversified, will rebalance portfolios as conditions warrant and will continue to look for opportunities. We did the hard work together when we built your macro asset allocation plan (the high-level allocation between stocks, bonds, and other assets) at either the start of our relationship or more recently when your life situation may have changed. This asset allocation attempts to consider the likes of a downturn within its modeling and still result in a high probability of success. This is important to remember.

Over the next few months, BSW also intends to tax loss harvest. This involves selling stocks at a loss to capture these losses for tax purposes. The losses can be used by clients to offset certain taxable gains, can be carried forward into future tax years and ultimately result in higher after-tax returns. Importantly, during this process, we remain in the market by simultaneously purchasing proxy positions that give us exposure to desired areas of the market.

Lastly, if the current market downturn results in a meaningful change in the future expected returns for certain asset classes, we will re-underwrite your plan and may suggest some changes. For example, at the recent stock market high, our expectation for global stock returns for the next 7-10 years was 6% per annum. The starting point matters. Purchasing stocks at high valuations result in lower future returns. Alternatively, back in March of 2009, expected future returns on stocks got as high as 9.5%. Three and a half percent doesn’t seem like a big difference, but over several years is very needle moving.

In summary,

We are in uncharted territory in terms of both the economic downturn and the level of government response.

It may be a while before we get back to some semblance of “normal” life again.

As long as COVID-19 case numbers remain above 0, we are not out of the woods.

We believe the next quarter will be rough, but we need to look past this to what a recovery might look like.

On the other side of COVID-19, investors might not take as much risk, companies might act differently, and we need to be realistic about a new, new normal.

BSW is taking decisive actions throughout this disruption.

We are in this together. We can get through this together.

As FDR said to close out his fireside chat on October 22, 1933, “Our troubles will not be over tomorrow, but we are on our way and we are headed in the right direction.”

We look forward to the day when we can see you in the office again! Until then, we are always available by phone or video chat.

Stay Safe and Healthy.