1Q20 Investment Update

Quarterly Investment Update

4/4/20

To cap off the worst quarter in the stock market since the 2007-2009 Financial Crisis, the S&P 500 finished down ~25% from its peak in mid-February, bringing down the performance for the year to -22.5%. Below is the YTD chart for the S&P 500, showing the 4% runup in equity prices until mid-February, when it dropped ~36% from its peak before retracing a bit to make the quarter look somewhat better than it was.

A lot of hope had been pushing the market higher in the last week of March. Congress had passed a $2 trillion economic relief bill, the Federal Reserve announced it would back credit and municipal bond markets as well as the Treasury market (which it has been doing basically since ’08). Many have also been talking of a “V-shaped” recovery in which, as soon as this is over and people can go back out, the economy will rebound and quickly get back to where it was before. However, this logic relies on some shaky (at best) assumptions of consumer behavior and business prospects. Firstly, this would require what they call “pent up consumption demand,” i.e. people will go out and spend on all the goods and services they were waiting to buy during this lockdown. With consumption accounting for 2/3 of the US Gross Domestic Product, a pop in consumption could, potentially, lead us quickly out of this recession.

There is one problem, though. People won’t make up for lost consumption right away—it will take time to build up consumption habits from before this all started. Couples who went out to dinner once a week aren’t going to go out 7 days a week to make up for lost time. You can’t get 3 haircuts in a row that you missed, or go on multiple trips in a row that you missed out on. Heck, most people—who haven’t lost their jobs—won’t have any more vacation time left!

Even further, as of Friday April 3, jobless claims doubled in just a week to 6.6 million Americans applying for jobless claims (the consensus estimate was just 3.2 million), as now 10 million people total have applied. The unemployment rate, estimated to tick up from 3.5% to 3.8% actually jumped to 4.4%. Estimates now say that number could go as high as 30%, with 10% currently being a low estimate. The chart below shows the past seven employment cycles and the number of months it takes from maximum employment to maximum unemployment, dating back to 1970.

The average amount of time between these two points is 7 months. We’re two weeks in. And when this is finally all over and people can start to go back to work, odds are that companies won’t hire everyone back right away, because there isn’t the demand needed to support that many employees. Then, when those people do get their jobs back, people have more important things to worry about than eating out or going on vacation. They will need to pay down debt. They will need to cover the essentials. Wall Street Banks are now preparing for 15 million people to default on their mortgages, making up 30% of residential mortgages, which would be far greater than what we saw during the housing bubble and crash of ’08-’09. According to the chart below, 53% of Americans also have ZERO emergency savings, meaning as more people lose their job, more defaults will occur and more debt will be taken on to cover immediate-term expenses. Thus, a “V-shaped” recovery, if this continues into the summer, is incredibly unlikely.

Looking Ahead

As we move into 2Q20, it is important to know where we are in regards to the market, and where we could be headed both as the United States and globally. Below is a Quad map for the G20 countries, which shows where we are now (at end of 1Q20), and where we are most likely going, based on the data we have, for the rest of the year. Basically, the entire world is heading into Quad 4, and a global recession of the extent we haven’t seen since the Global Financial Crisis. Growth and inflation are both slowing around the world, as everyone begins to shudder from the coronavirus pandemic.

In regards to the US specifically, below is the estimate for both real GDP growth (%) and inflation growth (%) for the second quarter and beyond. At the moment, the data shows us entering a deep Quad 4 recession in this second quarter, followed by a slightly smaller contraction in Q3 and an even slighter contraction of GDP in Q4. However, just because

GDP growth is negative isn’t all bad for the market. Typically, the market begins to front run an economic recovery as things get “less bad.” That is why, as growth begins to slow at a slower rate in Q2 as inflation accelerates, we will hit Quad 2 (growth and inflation accelerating) which is good for risky assets. This is where, as the market begins to settle down and the VIX comes below 31, we look to buy. We don’t, at this time, know when that moment will come, because the market can begin pricing in Quad 2 in Q3 as early as a couple months; or, it could be the end of Q2. As buyers stop chasing these bear market bounces, and fewer people believe in the underlying economy, that is where our moment to go all in will be. For the moment, though, we will let other people lose their money chasing a bear market.

Bear markets

I have run on longer than I had originally planned, so thank you for sticking with me. I’ll save some of the other stuff for a later update next week, but there is one more point I want to address in further detail. Bear markets don’t end just as abruptly as they began. As much as we would all love them too, that just isn’t how history goes. As the chart below shows, bear markets last anywhere from 3-61 months, with the average coming in at about 20 months.

However, recessionary bear markets are a whole different beast. They last, typically, about 21 months with an average decline in the S&P 500 of -42%, with it only once lasting less than 4 months (1990). 1990 only saw a drop in real GDP of -1.4%. We are currently one month in with a max drawdown of -27%, and looking at a decline in real GDP closer to that of the Great Depression than 1990.

Of course, history does not tell us exactly what will happen today. Heck, we’re in completely unprecedented times. Anything could happen. History does not repeat itself, but it often rhymes. So, with that, we’ll preserve our capital for the time being and let history tell us whether we were right or wrong. With a ~50% lead on the S&P 500 since 2017, I’m willing to take that chance.

-CB