By Paracle
The events of the last few months have unfolded quickly, and for all of us life changed dramatically in a very short period of time. Even now, we don’t yet know when things will return to any semblance of normal. But even though we are not finished with this crisis by any means, it is still possible to take a step back to try address a few common questions that we have heard. Hopefully our answers will help you gain perspective and make the right decisions for your money.
What Changes Can I Make To My Investment Allocation To Either Take Advantage Of The Sell-Off Or To Protect Myself From Future Declines?
As you can likely tell from the wording of this question, we’ve received a wide range of questions regarding investment allocation. Some individuals have asked what more can be done to take advantage of discounts that have been very extreme in some areas of the market (e.g., U.S. small value companies dropped by as much as 44%). Others on the opposite side of the spectrum have asked whether they need to adjust their risk level because the steepness of this decline was so uncomfortable. The broad range of these sorts of questions demonstrates the variety of differences existing for each individual. Different personalities, ages, portfolio sizes, spending levels, etc., all interact and affect how each individual thinks about managing their wealth as they seek a balance between a desire for growth in up markets and protection when things go haywire. As always, the best answers for these questions involve revisiting your own unique long-term forecast and 10-year cash flow plan. Reevaluating your plan will help determine whether you can afford to take more or less risk in your portfolio. We encourage you to reach out to us at any time if you would like more context for this scenario.
Why Has The Market Bounced Up When The News Is Still So Bad And Uncertainty Remains?
Markets are forward-looking, and oftentimes recoveries begin well before the worst of the data points are seen. At this point, the fact that significant price recovery has occurred demonstrates that investors collectively believe that the actions taken by our government will help provide consumers and businesses with spending resources that would have been otherwise lost, and that the economy will recover from its temporary shutdown relatively quickly. It is important to observe that investor expectations are not always right! Markets could certainly still reverse course and decline again, which could be especially likely if there are signs of a resurgence during next winter’s flu season. Time will tell.
You have no doubt seen the statistics regarding how much higher unemployment is right now than it was even during the Great Depression of 1929 or the Great Recession of 2008. The numbers are indeed scary, and some wonder why this data point alone does not justify a further drop in the markets. The important distinction here is that the events of 1929 or 2008 were driven by extreme excesses in the financial system. Once these weaknesses became evident, the resulting market collapses led to drastic declines of 50%-70%. In the current environment, there were not comparable sector-driven excesses that made the whole market unstable. Instead, the increase in unemployment was driven simply by the fact that the government told companies, big and small, that they had to take a forced temporary hiatus. To the extent that the government-provided stimulus helps keep consumers afloat in the short run and the economic hiatus actually does turn out to be temporary, then businesses should be able to rehire employees that they laid off or furloughed, and things should slowly be able to get back to normal. Some weaker businesses will certainly fail in this environment, but it is most likely the ones that would have failed in the next recession anyway. COVID-19 was simply an unexpected and incredibly fast catalyst. And there is no question that specific sectors, such as travel and airlines, may take longer than average to recover.
The other thing that should be observed is that China already went through a shutdown and there are clear signs that their economy is emerging from it acceptably. So, investors could look at that as a model for why we could have some optimism about our own economic situation.
Note: Some question the integrity of this data. Even if we take the official government-provided data with a grain of skepticism, there is still data coming from multinational global companies (e.g., Mercedes-Benz) that supports the legitimacy of the recovery.
Finally, much of the bounce-back has come as states have started to cautiously reopen. Aside from the contentious issue of whether each state is making perfectly responsible choices or not, this pressure to reopen confirms that there is widespread recognition of the fact that it’s important to balance the continued solvency of economies with health safety concerns. Physical and economic health are connected and this cannot be seen as an either/or scenario, but rather as: how do we strike balance between both? The markets have responded positively to this line of thinking.
Do I Need To Be Worried About Bond Defaults In My Portfolio?
There were a few days in late March when bond markets appeared to be on the verge of panic, reminiscent of 2008/2009. In fact, bonds lost more in one day than ever before. This situation occurred simply because there were so many investors who were rushing the exits to go to cash out of fear that corporate and municipal defaults could rise as the economic decline plays out. As with any sell-off, many proverbial babies were thrown out with the bathwater. Quick action by the Fed helped to provide needed liquidity, which averted pressure and stabilized the bond markets. However, there is little question that some bonds issued by weaker companies could fail. Do you need to be concerned?
We utilize bond strategies managed by Baird Funds in most client portfolios. We met face-to-face with Baird’s managers in early February, before there was any hint that financial markets would become overwhelmed with the coronavirus. At that time we talked mostly about the fact that the bond markets were showing signs of being at the tail end of the economic cycle, where bonds of lower credit quality were trading at high prices, and they felt like the commensurate yields were not rewarding enough to own any of these bonds (Baird never buys true high-yield bonds, but they do sometimes own some lower investment-grade bonds that they expect to receive credit upgrades). They were focused on safety in the portfolio because they could foresee an accident waiting to happen if the economy turned.
The insight here is that thoughtful managers were already taking protective steps since the investment markets were showing signs of being near the end of the economic cycle, irrespective of the fact that the coronavirus is what eventually triggered a pullback. One never can predict what a recessionary catalyst will be, but good managers can read the signs of an overheated market and not get caught up in the irrational optimism that seems to affect investors at times when the market has been doing well.
We also utilize strategies managed by Vanguard. These low-cost strategies represent the bond markets at large and therefore have less emphasis on individual security selection, but they are very well-diversified in high-quality bonds and therefore should have very little exposure to default risk.
Apart from these observations, here are a few other reference points to help explain why we do not think that you need to be worried about solvency in well-selected bonds:
- Municipal finances coming into this crisis were in much better shape than prior crises, such as 2008.
- The Federal Reserve has the ability to support both the corporate and municipal markets.
- Significant aid from the Federal government has already been allocated, and there is likely more to come.
- The majority of exposure in the strategies we use is investment grade, which has historically had low default rates (see table below).
- High-quality bonds are currently undervalued relative to U.S. Treasuries and may attract investors into the space.
- The strategies that we use contain a significant number of holdings and therefore have smaller position sizes in each bond holding. They are also diversified by issuer and sector and so are not reliant on any one company or municipality.
Should We Load Up On Zoom Or Other Tech Companies?
There is certainly a very narrow band of known winners in this several-month period while people are stuck at home, including cloud computing, online retail, streaming video, interactive video, online signature services, and other companies that are benefitting from the fact that so many people are working at home and families are stuck at home. Also benefiting specifically from the virus are teledocs and pharmaceutical companies that are connected to potential vaccines and antivirals. Much of what is going on is speculative, though. No one truly knows how long stay-at-home orders will last or which companies will benefit most from finding a treatment or cure. To build an entire investment strategy around these things while the world is in such a state of flux would be incredibly risky (Zoom’s recent data security issues are a case in point of the potential risks of getting too concentrated in any one company). Additionally, chasing some of these things right now is probably not a good idea since many of the companies have already been bid up by others who see the same trends. Those who happened to own these businesses at the beginning of this mess were certainly fortunate, and you do own exposure to companies within these sectors as a part of your portfolio.
When individuals have asked which companies might make sense as investments to take advantage of COVID-19, we emphasize that trying to pick winners in an economy with such uncertain outcomes is exceedingly dangerous. With uncertainty in mind, we have been reminding people that now is a time when you want more diversification rather than less. Rather than try to hit a home run by picking an individual company that may or may not produce a high return from this point forward, we advise spreading investments broadly, which essentially represents a bet on eventual broader recovery. This is a far more assured approach.
This is not to say that someone couldn’t risk some chips on a few good bets that could pay off handsomely; we just wouldn’t bet a meaningful portion of your portfolio on it given the potential to adversely affect your financial security.
Should We Buy Companies Or Industries That Have Been Most Heavily Sold Off (e.g., Energy, Airlines)?
Just as some individuals are wanting to capitalize on the positive trends of this downturn, others are looking for deeply discounted companies that have been negatively affected, including those in the airlines and energy industries. Again, there is nothing wrong with a few targeted bets if you are the betting type. However, investing in any individual company or sector is far riskier than a more diversified approach. Moreover, there were some fairly extreme discounts even in diversified investment approaches, so why take a risky bet when there are far less risky ones available? We have much greater confidence that these highly diversified categories will recover value as the economy turns than we do that specific sectors will recover well enough to provide a return within a reasonable time frame. Similar to the comments above regarding technology and healthcare, you do own companies that have not fared well in this environment that should stand to benefit from a recovery in the economy (see table below that includes industries and sectors that have been affected).
Also keep in mind that we include value-oriented strategies in the portfolio, where managers are actively and systematically seeking companies that are at favorable valuation points. These strategies have identified many opportunities in this environment that should benefit going forward.
With All The Government-Provided Stimulus, Should I Worry About Inflation?
As we think about this question, keep in mind that the rationale for massive government stimulus packages is to try to provide money to help replace wages or profits that consumers and businesses have lost. It is important to note that no one expects the collective stimulus measures to actually exceed the economic output that has been lost, which means that it should not add to inflationary pressures. In fact, on the contrary, there is actually greater concern that the economy could still potentially be in deflationary mode. Even despite all the stimulus packages, this is especially a worry if the shutdowns last more than a few months or if the shutdowns go into effect again in the fall or winter due to a resurgence of the virus (that is why Congress continues to assess whether even more stimulus is needed).
If the economy kicks back into high gear down the road, then inflation could certainly happen in the future, but most economists see it as something that would occur a few years from now, and not in the near term. Remember, too, if inflation were to take off, the Fed has plenty of options at its disposal. It could sell bonds that are in its inventory and/or raise rates. It would probably do both (honestly, we sincerely hope that this turns out to be necessary insofar as it would lead to more normal yields in the bond markets, which is good for you in retirement).
Finally, it is important to note that stocks have historically provided protection in inflationary environments. Holding stocks is far preferable to holding commodities such as gold, since stocks earn a steady income in many environments, whereas commodities typically provide returns over time that are only at the rate of inflation (or even lower due to inefficiencies in the ability of the average individual to buy exposure to commodities).
Do I Need To Worry About Solvency Of The U.S. Government And A Potential Decline In The U.S. Dollar If The U.S. Loses Its “Safe Haven” Status?
Keep in mind that governments around the world are all doing the same things to keep their economies afloat in the short run. As long as all governments are in the same boat in this regard, there will likely be a lower chance that people will worry that any one country (like the U.S.) has suddenly become riskier than others due to overspending. So we don’t think that is of great concern. (This is not intended to minimize any longer-term concerns regarding the level of our spending or our national debt. There is no arguing that aiming for lower levels of spending, on average, would make our country’s financial situation stronger.)
The dollar has risen during this crisis, as evidence that the U.S. is still perceived as a safe haven for investors. Once the crisis is over, it would not be surprising to see a reversal of this trend, so don’t panic if you do see the dollar moving in the opposite direction at some point in the future. Having foreign investments as diversifiers in the portfolio helps to provide some protection when this happens.
Your Questions Matter
We understand that these are deeply unsettling times, but you don’t need to figure everything out on your own. If you have concerns about anything we discussed above or if you have questions we have not addressed, please don’t hesitate to reach out to us at info@paracle.com or 206.466.6200.
About Paracle
Paracle Personal Financial Management is an independent financial planning firm founded in 2004 with an honest desire to help people optimize their finances by providing unbiased financial planning and investment advice that puts their clients first. Paracle specializes in delivering expert, comprehensive wealth management services to busy families. Their expertise integrates financial planning with investment management to ensure their clients experience confidence in every aspect of their plan so they can focus on what matters most. To learn more about Paracle, connect with them on LinkedIn.
