March 2020 marked the statistical end to the longest running bull market in US modern history. 132 months, exactly 11 years after the Great Recession bottom in 2009. A bear market is defined as a 20% decline from the previous market high. Market highs were reached February 19th, lows roughly one month later. The market’s violent action was in response to the COVID-19 pandemic which slammed the brakes on global economic activity. Nonetheless, global economies are undoubtedly in economic recession and will be so for at least the near future. Where we go from here is speculation, but it will eventually end and recovery will begin.
Historically in times of economic contraction, investing in value stocks tends to outperform investing in growth stocks as investors become more defensive in portfolio allocations. The graph below shows relative performance differences under various seasonally adjusted annual rates of growth for Gross Domestic Product (GDP – SAAR). While value investing has been academically proven advantageous over long periods of time, there is little doubt that in periods of near-zero GDP growth or recession, value investing prevails.
Early-April Market Commentary
How markets behave as this recession plays out is a significant unknown. Already markets have strongly rebounded from their late March lows as Central Banks have flooded markets with liquidity and governments implement massive fiscal stimulus programs to cushion the negative effects of abrupt stops in economic activity. Should markets have rebounded so strongly? We have our doubts, but markets have become addicted to central bank liquidity and when the mother-of-all-liquidity infusions takes place, we are not surprised by market reactions. Academic theory states current markets empirically price in all that is known into asset valuations. We submit much could quickly change perceptions:
- COVID-19 – The virus clearly caught the world unprepared to mitigate its spread. Does the virus seasonally die down like some surmise (like the common flu)? Does a slow re-opening of economic activity reintroduce an acceleration of contagion? How long before testing becomes commonly available? Will the virus mutate? When will a vaccine be produced? Any of these issues could change the speed of a recovery.
- Federal Reserve Tactics – The Fed, as the globe’s leading central bank, has opened the liquidity faucet in unprecedented manner. In 6 short weeks, the Fed’s measures have surpassed those implemented during The Great Recession. Will such activity continue or better still, when crisis has passed, will the Fed’s balance sheet return to “normal”? Excess corporate and investor leverage precipitated some of the Fed’s actions as fear rose of a cataclysmic financial event. There is still an enormous amount of leverage on corporate balance sheets and private vehicle investments; the Fed’s liquidity infusion in theory has allowed time for such levered entities to systematically reduce their leverage. But will they? Will long dead inflation return? Such a massive balance sheet expansion can eventually only be managed one of two ways – slow and lengthy deleveraging or monetization. We have our doubts on the former.
- Low or negative interest rates – We’ve long stated that some of the equity markets historically expensive valuation has been based on historically low levels of interest rates; when you can’t earn sufficient economic return in the bond market, investors turn to other assets – stocks, real estate, etc. The dynamic has existed since the last crisis. Here’s another crisis, and the solution is more of the same – flood the world with liquidity. But how will asset valuations play out this time over the next several quarters? Initial impressions are that stocks are soaring and real estate may be cratering. While rates are low, construction loan and mortgage rates have yet to follow. Will low rates permeate throughout the economy or be reserved for US Treasury securities?
- Volatility – Will government programs to assist injured industries be in the form of benign bailouts or thoughtful capital infusions? Warren Buffet’s Berkshire Hathaway has a history of coming to the rescue of beleaguered companies with various kinds of recapitalization investments. But make no mistake, Mr. Buffett extracts his pound of flesh in such arrangements and so should tax payers. The SP500 currently has a dividend yield of approximately 2%. Have investors factored a potential collapse in dividend payouts as corporate managements’ keep cash to protect corporate balance sheets? How industry and investors get recapitalized will have dramatic effects on market activity. We do not believe volatility will go away.
No one really knows the answers to all these questions. Stocks may be in for a wild few quarters as all these forces exert their influence. Value should outperform as strength of balance sheet and resiliency of earnings should buffer such companies in recession. Additionally, if it was tough to earn economic return with the 10-year US Treasury at 2%, what will it be like when the same security is paying 0.50% per year? Odds are good investors will make more return over 10 years in equities than a US Treasury.