Traditionally, investors use comparisons as a tool for making critical judgments and grow comfortable with current events that are within the envelope of past experiences. Momentum driven investors prefer data in the mid-range of past experiences, whereas contrarians look for a reversal of "normal" trends. Both sets of investors may find the current marketplace unsettling. Some may be considering changes to either the structure of their investment thinking and/or their specific selections. Possibly turning off the autopilot based on past security price action, or viewing corporate results through the lens of political or economic pronouncements.
What has Changed?
If we have entered a period of fundamental change, it has not been going on long enough to catalog all that is changing. The following is a partial list of observations different than past experiences:
- US stock market indices have dropped more than 10% from record levels in six trading days. (Historically, a drop of 10% is labeled a correction, suggesting record price levels were not appropriately valuing current conditions.) In the latest week, our list of client owned funds or those of possible interest showed only 9% in the best performing quintile, compared to 35% for the trailing twelve months. (Obviously, the funds' managers were not positioned for the correction.) Within the S&P 500, they would have needed substantial holdings in Communication Services, Real Estate, or Healthcare, down -6.34%, -6.34% and -6.66% respectively. For the week, the best performing equity category within the index was Growth, which fell -7.15%. The ten best performing funds on the list fell under 1% and the ten worst declined -12.11% to -13.31%.
One of the base beliefs of many investors and particularly large investors, is that large market capitalization reduces risk. That was not the case this week, with the Dow Jones Industrial Average falling -12.36% vs. -10.54% for the Nasdaq Composite.
During the week ended Wednesday, ETFs had net equity redemptions of domestic investments of $14.5 billion, compared to $4.3 billion of domestic equity redemptions for the larger conventional mutual fund universe. I believe most of the trading in ETFs is done by investment advised retail accounts and institutional trading accounts, whereas most mutual fund redemptions come from retirement oriented accounts seeking to reduce perceived risks by cutting back on their equity exposure.
Each of the four largest private equity fund groups has over $1 trillion in assets under management. In total they are believed to hold over $2 trillion in "dry powder". Private equity and private capital (Fixed Income) used to be funded exclusively by institutional investors. Increasingly they are receiving money flows from retail investors, directly or indirectly. (This has led to a situation where the prices paid by private vehicles are higher than those paid by the public, which could drive deal prices higher and possibly result in more leverage.)
In fixed income there are risks from a slowing global economy due to a normal economic cycle. There are also temporary payment problems caused by Covid-19 and credit terms are growing looser in response to increased competition from higher flows. Simultaneously, some investment advised money is fleeing equity markets and rushing into fixed income markets, where interest rates are declining.
A change is likely in future weekly blogs regarding the alerts of news items with a contrary perspective. In the past, I have highlighted the negatives along with some positives. Going forward, I will redouble my effort to find positives.
China has experienced three long-term positives that have not gotten a lot of attention:
- The Chinese government has ordered its mines and refineries to open for business.
Apple (AAPL) stated that all its manufacturing plants are now open.
While the Apple store may not be open, I suspect customers are ordering merchandise and services on their Apple and other devices from their homes. Recent checks with companies reveal that much of their "intellectual" and service works are being conducted from employee's homes. (I have not been able to determine when this will be recorded in their financial records).
The spread between the 30-year US Treasury bond yield and the 3-month yield has gone negative. In the past this was a reasonable predictor of a recession. I suspect some small and mid-sized companies will fall behind in paying their bills, due directly or indirectly to the Coronavirus (Covid-19). In many cases, I believe their creditors will try to avoid starting the bankruptcy procedure, but some will be forthcoming. (The US Treasury should have sold all the 30-year paper they could, as demand exceeded supply. The average maturity on US government paper is about half the UK's maturity.
What to do Now?
- Recognize that the structure of the economy and markets is changing. Compartmentalize a single portfolio into sub portfolios based on payment responsibilities, separating risk appetites.
- Most patient investors don't need liquidity to get out of declining positions in the majority of their portfolio. From a risk standpoint, market capitalization is only critical in rare circumstances and can be expensive. More critical in the long run are the time and effort to follow what one owns, as well as any new opportunities. I personally address this issue by using both investment companies and individual stocks. For example, I believe a good investor should be exposed to healthcare, although I don't own a single stock in that category. What I do own is some specialized healthcare funds and more generalized funds that have good healthcare analysts and/or portfolio managers.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.