Stocks discounting a better outlook

The recovery in the stock market from the March 23 low has surprised many people. How can the market go up when everything looks so bad right now? The reason is the market is a “discount” mechanism, meaning it will look forward as best it can and reflect in today’s current price what it believes is the outlook for corporate profits say 6, 12, 24 months out. When the market hit its March 23 low (down 38% from the February high), it most likely pretty fully “discounted” the current recession. Conversely, the market’s rise since March 23 most likely reflects investor consensus that the economy and earnings should start to improve later this year and in 2021. Morningstar data shows that since 1982, the top three performing sectors in the one year following the end of a bear market are tech stock funds up 69%, emerging market up 62%, and U.S. small cap stocks up 56%. This compares with all U.S. stocks (aggregate) up 41% on average in the one year following the end of a bear market.

Client education really helps

One thing we have been doing actively over the past few weeks is reaching out to clients to get a read on their state of mind with respect to not only their health and well-being but also about concerns surrounding their investment portfolios and financial plans. It has been heartening that we have actually had very few who have expressed a high level of anxiety about their investment portfolios. They have questions and concerns of course, but we are not seeing a “panic” mentality to reduce equity exposure. This is a good thing because we feel we have educated our clients in understanding that a)  market timing does not work and b) they should not be overly concerned about their investment portfolios as long as they remain true to the investment strategy and asset allocation developed from their financial plan.

Poker champ's view on diversification

This weekend’s Barron’s magazine ran an interesting article about Annie Duke, a world champion poker player. Annie now provides consulting and coaching services to managers in the financial services industry. Her insights into risk management under uncertainty can be extremely valuable. I found it really interesting when asked what she did with her money in this most recent financial crisis, her response was “nothing, on purpose…..I kept my 65% equity, 35% fixed income allocation.” She went on to explain that, as with winning in poker, one has to understand where and when one can “outthink” other people. She understands that if you don’t believe you have special expertise or can outthink the other guy, in this case the market, you are much better off playing a “hand” you know will work. In this case, Annie is making a reasoned “bet” that her 65-35 portfolio has the highest “payoff” probability over time, rather than trying to time the market which we know has a very low payoff probability.

Benefits of diversification

Yesterday I posted on how market timing can materially reduce long-term investment returns. An excellent way to eliminate the negative impacts of emotionally-based market timing is through holding a portfolio that is diversified across several asset classes. Case in point: a recent study by Morningstar looked at the last 20 years ending March 31, 2020 and showed that a diversified (60% equity, 40% bond) portfolio achieved a total cumulative return of 176% compared with the stock market (S&P500) return of 155%. Diversification worked by resulting in lower portfolio drawdowns during market declines and allowing for faster capital recovery in market uptrends. Moreover, the study shows that in highly volatile markets like the last 20 years, diversification is important in both preserving capital and delivering higher absolute and risk-adjusted return.

Bob Toomey, CFA/CFP
VP, Research

Market timing can hurt investment returns

Volatile stock market conditions like we have experienced lately can cause anxiety and induce people to sell their stocks and wait for “a better time to invest”, in other words, “time” the market. History shows there can be a big cost in attempting to time the market. A recent Morningstar study shows that during the 20 years ending December 31, 2019, if one remained fully invested in stocks, the average annual return was 6.1%. If one missed the 10 best days of the market, the return dropped to 2.2%. If one missed the best 20 days of market, the return was actually negative, -0.13%. The point? Emotionally-driven market timing usually fails and can have a material adverse impact on the success of one’s investments and financial plan.

Bob Toomey, CFA/CFP

VP, Research

Commentary on our recent strategy changes

As you know, this past Monday, we executed our strategic decision to concentrate more of your assets in what we call “stalwarts”, or companies with the strongest competitive and financial positions and which we believe are best positioned to weather the current uncertainties and thrive upon a return to normalcy. We did this for a couple of reasons: 1) increase portfolio concentration in higher quality equities; and 2) be better positioned in stocks of the highest quality as a protective measure if the COVID-19 outbreak and economic downturn are more prolonged than we expect. Based on what we have seen so far, the strategy appears to be working as we expected. During the three-day rally in the stock market earlier this week, your equity positions fully participated in the rally based on comparative indexes we looked at. This is encouraging and it appears we are on the right track.

Looking forward, while none of us can forecast the market in the near term, we believe it’s probable that the stock market may remain volatile for a while and we would not be at all surprised to see a retest of the market lows in the coming weeks. History shows that sometimes these retests can take the market below the previous low. That said, it is encouraging that the Federal Reserve, the CDC, Congress, the President, and federal and state governments are all moving swiftly and taking concerted actions to address the C-19 issues. It is within this context of an economic slowdown and expected volatile markets that we made the changes on Monday which we believe should provide the highest probability of both capital preservation and a successful outcome when we come out on the other side of this unprecedented event.

As always, if you have questions or concerns, please do not hesitate to contact us.

S.R. Schill & Associates

Summary of Our Deliberations

On Monday March 23, 2020, we held the second segment of our Q2 investment strategy meeting. Our deliberations focused primarily on determining the best manner in which to implement our previously stated goal of positioning your portfolios in assets we believe offer the strongest staying power and financial strength through the recession we believe we are now in while also offering strong recovery potential when things improve. What this means essentially is we have taken actions to better concentrate your investments in ETFs containing the highest quality stocks (we refer to them as the “stalwarts”) that we believe have the strongest market positions, financial strength and sustainable cash flows.

To provide a little more detail on our changes to your portfolios, within equities, we significantly boosted your concentration to large cap stocks primarily within the technology and health care sectors of the economy while reducing exposure to smaller cap stocks which are inherently less financially secure. This change provides increased concentration within your portfolios in “stalwart” companies like Microsoft, Apple, Amazon, Walmart, Costco, Merck and Johnson & Johnson. You will see in your accounts additions of several new ETFs that give us this exposure including the XLK (technology ETF), IHE (U.S. pharmaceuticals ETF), and RTH (U.S. retailers ETF). To determine the best ETFs to implement this strategy, we thoroughly analyzed the balance sheets and cash flow strength of the top five companies in these ETFs to be sure we were investing in companies with above average cash flow relative to debt. I would also note that as part of our strategy process, we took the opportunity to streamline or reduce the number of individual ETF holdings within the models. This allows us to better concentrate your investments in the areas we believe will serve us all best in the upcoming economic and market environment.

With respect to your holdings within fixed income, we decided to concentrate for now solely on U.S. Treasury notes and bonds, which are considered the strongest bonds in terms of credit quality. We eliminated holdings within mortgage-backed bonds, preferred stocks and high yield debt as we want at this time to concentrate holdings in the highest quality credits. We are now overweight a normal allocation in the long and intermediate maturity sectors within bonds, and at a normal weight in short term bonds. In terms of portfolio macro allocation, our actions reduced net equity exposure slightly, while increasing fixed income exposure. Exposure to REITs and small cap stocks was also reduced.

Some final thoughts…. This has been an unprecedented and turbulent time for all of us. We have seen unprecedented volatility and the fastest decline by far into bear market territory in history. Making forward-looking estimates of the economy and corporate profits right now is probably more difficult than any of us on the committee have ever seen in our careers. That is why we believe investing more of your assets in blue chip “stalwarts” offers some risk protection because of their strong business position and cash flows, and with the extent of the downturn uncertain, we want to be in the strongest companies financially. We did set an investment trigger, as we do at every meeting, that would cause us to re-evaluate and most likely increase our equity exposure if there was a new, positive development with respect to a medical treatment  or vaccine for COVID-19, or an indication that new cases were peaking or coming down which would result in improved economic activity. We wish everyone the best of health and stability in the forthcoming days. 

S.R. Schill & Associates.