Please find below a special update we received from our TOPS (The Optimized Portfolio System) Team.
Warmest Regards, and Stay Safe,
Rob
1st Quarter 2020 Market Commentary
“The COVID-19 Coronavirus Pandemic Causes an Historically Swift and Deep Market Decline”
As February unfolded, COVID-19 Coronavirus became the number one focus of markets globally and the repercussions are touching nearly every aspect of our lives. The forced shutdown of most stores, businesses, travel and gathering places brought the global economy to a standstill. Understandably, investors feared the development of a deep recession or a depression. The result was one of the deepest and (and quickest) stock market selloffs ever seen.
After the very strong positive 2019 returns from all sectors of the markets from stocks to bonds to REITS to natural resources, the reversal in the markets has been staggering. The only positive Q1 returns are from U.S. Treasury Bonds, which are perceived as the safest fixed income investment, and mortgage backed securities. The global selloff in all other asset classes utilized in TOPS portfolios resulted in negative first quarter portfolio returns ranging from -7.7% to -24.8%. The more conservative TOPS portfolios (lower equity allocations) experienced the smaller losses. Although trailing twelve-month returns are now negative, all TOPS portfolio returns for the trailing five-year and ten-year timeframes remain in positive territory.
The TOPS Process
The TOPS investment process is designed to weather market concerns like we are experiencing with COVID-19. The TOPS Portfolios have a high level of diversification, with exposure to many major asset classes. Diversification is a tool we use to help reduce expected risk in the portfolios. Likewise, the TOPS portfolios provide a full array of risk levels, with multiple TOPS portfolios outperforming the popular S&P 500 benchmark during the first quarter sell off.
Possibly more important than the discussion of short-term performance, however, is a reminder regarding the time horizon of the TOPS strategies. TOPS is designed primarily as a long-term strategic investment process, with investment periods typically ranging 3 to 10 years, or longer. Likewise, these models have been created looking back at many historical disruptions to the economy and markets. The expectation remains, Coronavirus will be contained, at which point we would expect economic activity to gradually return to normal levels. Therefore, over the normal TOPS time horizon, it is possible the overall impact of Coronavirus could be nominal. While markets are expected to move up and down, short-term market movements typically do not impact long term strategies and goals.
Our team continues to monitor the situation and will adjust portfolio allocations if the economic effect of the virus impacts our long-term relative risk / return expectations for major global markets. As a reminder, however, TOPS utilizes index-based ETFs primarily invested by market capitalization. This means the underlying holdings in TOPS automatically adjust over time and companies which fail are routinely removed from the indexes. Further, the nature of TOPS is that investors have more exposure to companies which are growing by market cap over time. For example, within the TOPS large cap growth holding (ticker: SPYG), Amazon represents 6.82% of the exposure within the allocation to SPYG, compared to 0.14% for Boeing.
With over 75 years of combined portfolio management experience, this is not the first market challenge we have encountered. To the contrary, this is what we expect to happen. Markets will ebb and flow, and we talk often of market cycles. Likewise, market corrections (even those from concerns over global contagion) are common, with historical references. Thank you for your continued trust in us, as we professionally manage through the short-term storms the market often presents.
First Quarter Market Review
Domestic stock market indexes were positive year to date into February, when the S&P 500, the Dow Jones Industrials and S&P Midcap reached new all-time highs. Major media attention for the first several weeks of the quarter was focused on the Trump Impeachment proceedings and the probability Senator Bernie Sanders would be the Democratic presidential nominee. While that caused some market volatility, it was nothing compared to the investor panic that ensued as the extent of the coronavirus pandemic became clear.
No sector of the equity market was spared in Q1, although US large cap stocks continued to outperform. Still, the S&P 500 had its worst quarter since the Great Recession at -19.6% as S&P Growth (-14.5%) resumed its leadership over S&P Value (-25.3%). S&P Midcap (-29.7%) and Smallcap (-32.6%) were hit harder. International stocks were down substantially with FTSE Developed ex-US -23.8% and FTSE Emerging Markets -24.2%. Neither Natural Resources (-30.9%) nor US REITS (-24.3%) provided a hiding place.
As is often the case in times of market turmoil, fixed income returns were significantly ahead of equity market returns as bonds performed their role as stabilizers during the early stages of the stock market decline. For the quarter, the US 10-year Treasury (10UST) yield reached a new all-time low under 0.5% as the Federal Reserve took dramatic steps to support the financial system. The 10UST finished the quarter at 0.70%, down from 1.92% at the end of 2019. The Barclay’s US Aggregate Bond index returned +3.1% in Q1. The Bloomberg Barclays US Treasury 3-10 Year Index was the best performer of the TOPS portfolio indexes at +7.1%. Shorter treasuries also had positive returns and TIPS were barely negative. The currency hedged international bond index returned +0.2% and US investment grade corporates reported modestly negative returns. Even the weakest fixed income areas represented by Solactive US High Yield Corporates (-11.9%) and JP Morgan Government Bond Emerging Markets (-14.9%) were not hit as hard as the equity indexes.
Important Topics Going Forward
Economists differ on if this will be a V shaped recovery, U shaped recovery or if it could lead into prolonged recession. Much will depend on things that are unknowable. Three topics we believe may impact our portfolio strategies in coming months include:
The True Extent of the Disease and Length of Lockdowns Remains in Question
The Extent of Future Government Measures will have an Impact on the Recovery
Actions by Companies and the Impact on Employment will be Important
The True Extent of the Disease and Length of Lockdowns Remains in Question
By the time you read this, many Americans will have been infected with COVID-19. We will begin by stating the obvious: we are all more concerned about the impact on lives than about the impact on the financial markets. We are not epidemiologists, so we cannot forecast the breadth or length of the pandemic. The stress on the economy may worsen and turn the expected severe contraction (a short period of negative GDP growth) into an official recession (at least 6 months of negative GDP). In our estimation, however, the measures taken by governments, businesses and individuals around the world are likely to produce a recovery eventually.
Jeffrey Kleintop. Chief Global Investment Strategist at Charles Schwab & Co., recently noted, “it is unlikely to end until people feel comfortable leaving their homes again.” The government actions of shelter-in-place and social distancing mandates have basically shut down large parts of the economy. Until restrictions are lifted meaningfully, there is no way for anyone to know for sure that a bottom is at hand. This recession, however, is the result of an unforeseen event, not the normal end of a slow build-up of excesses. Kleintop further notes, “This may mean the recession and bear market could be deeper, but also that the duration may be shorter.” There is evidence that parts of the world are already in recovery. China and South Korea are recovering from their peak in COVID-19 cases and related business shutdowns. If this recovery follows historical trends of 2002 and 2009, emerging markets would be expected to lead the recovery. Oil prices and the strong US Dollar may be impediments this time around though.
The Extent of Future Government Measures will have an Impact on the Recovery
The US government has taken extensive action over the past few weeks. As a positive, the speed at which the government reacted financially is unprecedented. The actions taken over a matter of days took 6-9 months in the 2008-2009 Financial Crisis. Notably, the President quickly signed the recent $2+ Trillion CARES Act, the Fed Funds rate was slashed to 0.0 to 0.25% in two emergency rate cuts and Quantitative Easing (QE is bond buying by the Fed) has been reinstated.
The CARES Act includes:
Direct payments to U.S. taxpayers
An expansion in jobless aid,
Suspension of student loan payments
Direct assistance to companies
As the quarter ended, discussions continued regarding additional steps by the U.S. government (and governments abroad). The size, breadth, depth and timing of these additional measures will be a deciding factor on the path of recovery. At this point, comments from both sides of the aisle and across the Fed and Treasury appear to be supportive of additional measures as needed.
Actions by Companies and the Impact on Employment Will Be Important
Actions by companies and the impact on employment will be very important for the economy and markets. Many analysts have slashed their outlooks for S&P 500 revenues and earnings. The March 28 Wall Street Journal reported: “More than half of U.S. states have imposed lockdown measures restricting gathering and social contact, disrupting the lives of more than 100 million people and suspending the operations of thousands of businesses.” On the other hand, the rapidly drafted executive orders also exempt millions of jobs and services deemed too essential to shut down.
But what will the economy look like after the pandemic has peaked and the restrictions are lifted? Will economic growth rebound strongly back to normal or recover slowly and remain relatively depressed? The actions companies take, and the subsequent impact on earnings, will help to answer these questions. As Dr. Ed Yardeni, a leading economist who consults with the TOPS team, recently noted, “Keep in mind that while industry analysts tend to be too optimistic during good times, they tend to be too pessimist during bad times.” We are hopeful business leaders will get this right. We feel valuations have priced in a lot of bad news at this point, leaving room for positive surprises.
Closing Thoughts
Like other dark periods in world history, those who perished from COVID-19 will always be part of our memory of this historic period. From a financial standpoint, this period is also likely to provide many lessons worth remembering. A fellow investment manager of ours made the comment that he had marked his calendar to write a follow up to this bear market 5 years from now. With the benefit of hindsight, and the fear of the virus behind us, it will be an interesting time to reflect upon. At this point, we are encouraged to look ahead to brighter times.
We have been talking for longer than we can remember about valuations being elevated on stocks, especially in the U.S. For our readers getting tired of continuing to read about elevated valuations, we can report valuations are no longer elevated. As Vanguard has reported recently, “The recent reduction in equity prices, and related drop in valuations, should raise longer term expected returns.” In other words, we are holding at lower prices, which makes it more likely to sell higher.
The timing of the recovery is unknowable, so in the interim, we can expect there will be commentators who will attempt to scare investors into actions that harm their financial health. Moves up and down will be swift, and some of the investors who try to time the bottom will be hurt. For example, investors who sold out of stocks prior to the late March bull rally, missed the best week in the markets since 1933. We would counsel you to ignore the noise and stick to your long-term investment plan. That is what the TOPS portfolio team plans to do.
There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses.
TOPS® Portfolio Management Team
Michael McClary – Chief Investment Officer
Robert Leggett, CFA – Sr. Portfolio Advisor
Tyler Denholm, CFA – Vice President, Investment Management & Research
Adam Schenck, CFA – Sr. Portfolio Advisor
The material contained in the ‘Market Commentary’ is for informational purposes only and is not intended to provide specific advice or recommendations for any individual nor does it take into account the particular investment objectives, financial situation or needs of individual investors. The information provided has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the material discussed, nor does it constitute an offer or a solicitation of an offer to buy any securities, products or services mentioned. The opinions expressed do not necessarily reflect those of ValMark Advisers, Inc. and are subject to change without notice. Past performance is not indicative of future results. Diversification cannot assure profit or guarantee against loss. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.
