We can see the other side

April 15, 2020

Last week I listened to a research call with one of the top portfolio managers at Capital Group, who has over 40 years of experience. He started the call by comparing the recent sharp downturn in the markets and economy to the financial crisis in 2008 and 2009 that led to the Great Recession. Back then, we had just tumbled over a cliff and we really didn't know if there was a bottom. The difference this time is we have stumbled off the edge of the cliff, but we can see the other side, we know what it will take to get there, and we are in much better shape to make the climb; but we just don't know how long it will take.
What will it take to get to the other side?

There can be no doubt that we have entered a global recession. The federal government has responded to the nationwide economic and social shutdown by passing the 2 trillion dollar CARES Act which puts a patch on the budgets of families, businesses, charities and state and municipal government- put simply, we have put it on the government's credit card to be paid back with future tax revenues. In addition, the Fed has cut interest rates to near zero and pumped massive amounts of liquidity into the bond markets to ensure liquidity and increase confidence.

Will this be enough of a patch? Probably not, as Congress and the President are already discussing the next package. Can we afford it? That's a more complicated question, but with annual deficits and total debt already at historically high levels, it is very likely that the cost of this patch on the economy will be a drag on growth for many years to come. Tough decisions will have to be made regarding spending and taxation. In addition, it's important to keep in mind that this isn't really a stimulus package, it's a stabilization package designed to replace lost revenue. Therefore, any predictions of an????

When will things get better?
The answer probably depends on where people live. If the curve continues to flatten and the rate of infections slows, we are likely to see a gradual reopening of some areas of the country, assuming there is adequate testing that so far has been too slow in developing. Substantial progress is now being made on the testing front. For more densely populated areas like New York City, it is unlikely that we will see significant reopening until there is a vaccine or viral therapies that dramatically reduce the devastating effects the virus is having on those who are most vulnerable. There are currently promising viral therapies being fast-tracked and over 70 vaccines at some stage of development or trial.
Our best-case scenario is for a choppy & shaped economic recovery, which we estimate will take 12 to 24 months here in the United States and longer in most other countries, especially the emerging economies.

The reality is when we do reach the other side, the economic terrain and horizon might look very different for quite some time, and maybe even permanently. Think about your own return to the outside world. Will you go on a cruise, eat in a crowded restaurant, or go to a concert or ballgame?
Many businesses will also reconsider all of the money they have invested in bricks and mortar maybe a better investment is in technology that would allow a big chunk of their employees to work from home? As we think about these long-term economic implications, it has a major impact on how we look at the changed investment landscape, too.

Markets and Investing
After the fastest and steepest market selloff in decades, the markets have bounced back sharply in the last couple of weeks as investors seem to be ignoring all of the current headlines and the avalanche of bad earnings reports that are about to come out, in a way just writing off 2020 and hoping it's the other side they see out on the horizon in 2021.
There can be little doubt that the numbers for the average company will be off the cliff bad this quarter and likely for a couple more. However, in past recessions and bear markets, the stock market tends to bottom 6 to 12 months before economic growth returns. Our best-case scenario for U.S. stocks is a choppy & shaped recovery, which could take 6 to 12 months. Please keep in mind that any discussion about the future shape of the stock market or the economy is not guaranteed and assumes that strict containment measures will not be required after the second quarter. It is also possible, and with history as a guide, likely, that the stock market could move lower than its low point in March as bad economic and earning numbers spill out.

Here are some of the key themes to our overall investment strategy:

Most importantly, ensure that your portfolio has enough allocated to bonds to satisfy your income needs for the next 6 to 8 years. This makes the question we ask about the stock market change from "Where will stock prices be in 6 to 8 months?" to "Are stock prices likely to be higher in 6 to 8 years?"
Continue to upgrade credit quality. We saw indiscriminate selling in March, unlike anything we have seen since the financial crisis. There was no place to hide in the bond market other than in U.S. treasuries and cash, which are both paying close to zero percent interest. The Fed's massive injection of liquidity has led to a sharp rebound in corporate bonds and our objective will be to increase the overall credit quality with a goal of having a bigger shock absorber if we do return to the March lows again later this year.

As we position to reach the other side, it is critical to consider which industries, companies, and countries are likely to get there first but also think about which ones will arrive permanently beaten up or possibly not arrive at all.

Large Cap U.S.
Focus on companies with wide economic moats which are growing their market share in a tough economy (a good current example is Amazon). Overweight market leaders in industries which are holding up better during social distancing and that tend to do better during normal recessions (technology, communications, consumer staples, healthcare) and reduce allocations to those which are being hit the hardest (travel, restaurants, energy, industrials, commercial real estate).

Small and Mid-Cap U.S.
Although we are still on the lower side of our normal target allocation, we are taking advantage of the sharp selloff to tactically reposition a few percent to mid-cap stocks, which tend to rise faster in the earlier stages of economic recovery.

We continue to be significantly underweighted and are taking additional steps to focus on funds in which the managers have the flexibility to invest significantly in the U.S. if that is where they find the best opportunities but tilt back toward Europe and Asian/Pacific Rim if conditions warrant.
I can't finish a discussion about portfolio positioning without acknowledging the unsettling emotions that many of you have experienced over the last month. You are not alone, and the fear of loss is a powerful emotion and at times, dangerous.

A few thoughts on how to confront the fear:
Limit how much you watch the talking head financial experts on T.V.
Resist the temptation to check your account balances every day online
Schedule a call with Bert, Katie or me to take a closer look at your personal situation.

Click here to read a recent interview I had with MaineBiz magazine about the challenges of running a business remotely while also navigating the worst market downturn since the Great Recession. Like many financial advisers, one of my heroes is Warren Buffett and I have quoted him many times in previous commentaries. The secret to his success is, in a way, refreshingly simple: be greedy when others are fearful and be fearful when others are greedy...and invest for the long term in durable businesses you understand. Seems easy...until it is tested by a down market and inevitably and unfortunately, the average investor fails the test by attempting to cash out and wait for things to get better, only to miss the majority of the next bull run.

It is your continued confidence in our process that allows us to "be like Buffett" and keep our focus on the path to the top on the other side. Now more than ever, we are grateful for that confidence and patience and look forward to the day when we can visit with you. It is also made possible by the extraordinary team you see pictured below working remotely.
Collectively, you are looking at over 140 years of experience and we are calling on every one of them to help guide you to the other side. At no time in our history have we had such a talented and dedicated group serving you and our firm. Please don't hesitate to reach out via email if we can be of service to your family or institution.


Brian Bernatchez CFP®
Managing Director