Over the last few weeks, financial news has been awash in stories about the CoViD-19 pandemic’s growing impacts on people, businesses, and entire economies. We’ve witnessed a startling crash in the price of oil, massive swings in global equities and a sea of red, downward-pointing arrows.
We are not expert in virology or epidemiology, and cannot, of course, comment specifically on the coronavirus contagion or the potential severity of its effects. Nor are we authorities on petroleum markets or geopolitics, so we won’t comment on OPEC’s strategy or where oil prices might go next. But we are observers of financial markets, and we’ve seen this pattern of market behaviour more than a few times in the past.
The fastest selloff on record
After making new all-time highs on February 19th and 20th, by the close of trading on Thursday, March 12th, which featured one of the worst single day losses of all time, Canadian equities had declined -30.4%1, and US equities had dropped -26.9%2 from their respective highs. This current sell-off has been the single fastest bear market decline ever witnessed, with the markets falling more than 20% from their peak in only 14 trading days.
Then the very next day, Friday March 13th, in a move that would make many bungee jumpers envious, stocks rebounded with one of the biggest single session gains in market history, recovering much of the prior day’s losses. (Canadian and US equity markets are now off -23.7%1 and -20.1%2 respectively from their highs, as of Friday’s recovery.)
When everyone (whether human or algorithm) suddenly rushes to sell or buy simultaneously, equity price movements can become highly volatile. The VIX Index (a measure of expected volatility in equity prices) spiked from 14 to a peak of 78, its highest level since the global financial crisis. Over the past five years the VIX has averaged below 15 and it has exceeded 20 only a handful of times.
But why is everyone suddenly freaking out? And why are they indiscriminately selling everything? It’s pretty easy to understand why shares of airlines or cruise ship companies might drop sharply given the current backdrop. But shouldn’t logic dictate that an online social media platform like Facebook, or a company like Microsoft that provides Skype and Xboxes, ought to significantly benefit from a scenario where more people are staying in their homes? Or consider Netflix and Domino’s Pizza, companies whose entire business models are exclusively focused on serving people who don’t want to leave home. And yet, from peak to trough, these companies’ shares sold off by about as much as the rest of the market. Something doesn’t make sense here.
Do fundamentals not matter anymore?
If you parsed through the crescendo of last Thursday’s wave of selling, you’d notice that both stocks AND government bonds were being sold aggressively, when they normally move in opposite directions. Even gold, usually the last stop on the flight to safety, declined sharply. This sort of cross asset class selling behaviour is characteristic of a liquidity crisis, where leveraged investors need to sell anything they can find a bid on, just to meet their dollar obligations or margin requirements. The falling prices push them further offside, making them even more eager to sell and driving prices lower still, establishing a devastating feedback loop. This prompted the Federal Reserve to take extraordinary action by stepping into the market midday with a $150 billion injection of liquid collateral. The last time we saw this type of scenario play out was in October 2008, and the Fed also intervened in that situation to provide liquidity and stem the downward spiral.
An even more atypical trend during this crash is that value stocks, ordinarily a relative safe haven in times of turmoil, have declined by MORE than growth stocks. From their peaks, the US broad market value and growth indices have declined by -23.9%3 and -19.4%4 respectively. This bizarre divergence may turn out to be a temporary anomaly, and some of it may be attributable to the energy sector’s woes, but nonetheless, it’s a strong indicator that fundamentals have not been the driving force here.
The broad, abrupt nature of this sell-off, and the similarly sudden rebound, are more indicative of sudden reversals in market sentiment, exacerbated by a frantic run on liquid collateral. Rational behavior has temporarily succumbed to the herd mentality. This sort of herd behaviour is not hard to identify. It sounds something like: “I don’t have a rational explanation why this stock’s price is falling so much, but since everyone else is selling, I should sell now before it falls even lower.” Being able to spot herd mentality in panics can be helpful, but it’s even better to avoid getting caught up in the stampede.
The calm before the storm
Financial markets had been lulled into complacency over a very long stretch of calm sailing. That period of very low volatility had emboldened asset allocators to overweight their exposure to equities in the hope of improving their return expectations. It had sent cash flowing into passive ETFs, which indiscriminately bought every stock in the index, with no regard to valuation. It had driven hedge funds to increase their exposure and leverage. Did any of this make sense? Not really, but everyone else was doing it, and nobody wanted to be the one to miss out.
Then in February, with rising concerns about the impact of the CoViD-19 epidemic, that smooth sailing suddenly slammed into a rogue wave. These speculative buyers were forced to re-evaluate their positioning and recognize that they were probably taking on more risk than they should have been. Many portfolio managers who rely on backward-looking, volatility-based risk models, were suddenly lit up with red flags showing that the portfolio had exceeded its risk limits. They would be forced to sell equities and reduce risk exposures – at whatever the price – and ideally before everyone else did.
Prioritizing capital preservation
At Northwood, we avoid this sort of complacency when seas are calm, because we (like pretty much everybody else) can’t know in advance when the winds might change and the waves could get choppy. Capital preservation is a multi-faceted concept, which includes goals-based planning, asset class diversification, and careful manager selection.
In practice, we start with a deep understanding of our clients’ financial goals, identifying when funds will be needed and in what quantity. From there, we ensure that our clients maintain enough cash and low-risk, liquid fixed income holdings so that the next several years of anticipated cash needs (and even some unanticipated cash needs) can be easily met, without any concern for what might happen in the markets. Longer term funding needs aren’t affected by short term turbulence, so they can have more market exposure and growth potential. For all but the most exceptional situations, the result of this goals-based approach is a portfolio that is broadly diversified across asset classes.
That portfolio level diversification helps to protect capital during downturns. While most attention has been focused on the plunge in equity markets, our conservative fixed income strategy has quietly risen in value by approximately 1.4% year to date 2020, as interest rates have fallen sharply. Any funds earmarked for near term needs have performed exactly as expected.
Additionally, when implementing investment strategies, we seek out managers who have a demonstrated track-record of protecting capital in downturns. We categorically avoid momentum-based trading strategies and stick to managers whose source of edge is fundamental research. We prefer investing in quality businesses with strong balance sheets, stable cash flow, and that are trading at reasonable valuations. These types of companies are intended to provide a margin of safety for such a time as this. History has generally shown that whenever there is a panic fire-sale in equity markets, quality and value stocks typically fall less and recover faster, while riskier momentum stocks get hammered. But so far, amid the widespread pandemonium of the last few weeks, even this quality and value bias has provided only limited benefit.
How have our equity managers’ strategies performed during this decline? We have spoken to our managers and based on their bottom-up perspective, they remain confident that their portfolios continue to provide defensive characteristics, long-term growth potential, and attractive valuations. They expect that many companies will experience some short-term negative effect on earnings, but those with strong balance sheets will be better positioned if economic conditions deteriorate further, providing downside protection and rewarding long-term investors. They have been making specific changes to their portfolio where they consider it appropriate, and they will continue to focus on each individual company’s evolving operating fundamentals, risk profile, and return expectations.
So far, these quality and value-biased portfolios have, on average, performed moderately better than the market, falling by less than their indices. We typically aim for downside capture ratios in the 60%-80% range, but so far have observed average ratios in the range of ~75% to ~95%. (A downside capture ratio of 100% would mean that the portfolio fell as much as the market.) We expect that as the panic subsides and normalcy returns, our portfolios’ holdings ought to recover more quickly and the downside capture ratios should improve. Time will tell.
Weathering the storm
But even if the value of stock holdings decline along with the market, losses exist only on paper unless they’re sold and realized. The most tragic and costly mistake that many investors make is needlessly selling their assets out of fear, which makes their temporary losses become permanent. Unless a client’s family goals have unexpectedly changed, there should be no reason to sell any assets at inopportune times or at undesirable prices.
When market prices fall due to panic selling, investors who are goals-based and diversified enjoy the luxury of being able to stand apart from the stampeding herd, know that their goals are unlikely to be derailed, and maybe even be buyers of equities instead of sellers – when and where the price is right, of course, and if it suits their particular circumstances.
For the last couple of years, we have been cautious about the levels of equity markets and have taken opportunities to limit equity exposure, to ensure clients held enough cash and fixed income in their portfolios to cover several years of spending needs. Conversely, for our clients who were building up their exposure to equities, we advised them to be patient, and spread their purchases incrementally over several quarters to accumulate their equity exposure gradually.
We certainly didn’t know if or when this stock market crash would happen, nor did we anticipate what sort of black-swan events might trigger it. But we could see that the market cycle was running exceptionally long, global economic growth was slowing, debt levels were rising, valuations were historically high, and investor sentiment was tilted much more toward greed than fear. So we were cautious.
But in the space of a few short weeks, the situation has changed significantly. In cases where clients had been gradually accumulating equity, we accelerated the pace of buying to take advantage of the severe pullbacks. We don’t know whether stocks are going to rebound further or whether they continue lower from here. Valuations have improved, but they are still higher than at the bottoms in previous bear markets.
But the market averages don’t tell the whole story. Recall the unusual trend of value stocks declining more than growth stocks. This selloff has created some pockets of value, which many overextended investors are simply unable to respond to. Over the last few days, some of our equity managers have started to take advantage of the dislocation to initiate or increase positions in quality companies whose valuations have suddenly become relatively more attractive. That doesn’t imply that the selloff is over – nobody can make that that sort of prediction reliably. Stocks could have much further to fall, but by virtue of the fact that prices have already fallen by a meaningful amount, the forward-looking risk-adjusted return expectation has certainly improved.
Staying the course
At times like these, it is important to remember that we have put in place the necessary precautions for long term capital preservation well before this market dislocation began. We have taken the time to develop cash flow projections based on our clients’ individual cash flow needs and goals. We have designed a plan that has been stress-tested with these goals in mind, and we have purposefully constructed client portfolios with carefully-selected investment managers whose strategies can safely navigate through volatile markets. As such, we are confident that if we maintain a long-term perspective there is no reason to deviate from the course that we’ve charted, no matter how rough the current seas.
Please contact your Northwood client manager if you would like to talk about this further.
1 S&P/TSX Composite Index (CAD)
2 S&P 500 Index (USD)
3 Russell 3000 Value Index (USD)
4 Russell 3000 Growth Index (USD)