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Commentary | 1Q 2020

2020 Q1 Market Recap

In the first quarter of 2020, the stock market, as represented by the S&P 500 Index, produced a return of -19.6%. This extraordinary decline followed a fourth quarter return of more than 9%. The cautious optimism for returns in 2020 was overwhelmed by the harsh reality of a global COVID-19 pandemic which caused the outlook for all aspects of economic growth and corporate profits to turn decidedly negative during the quarter. The actions undertaken to mitigate the effects of the pandemic as well as the pandemic itself roiled markets. Returns in the stock market, the bond market, currency market, oil market and gold market were all driven by those forces.

In an attempt to slow the spread of the virus, which was at the center the pandemic, governments limited the movements of citizens, often requiring that they stay in their homes except for a very limited set of activities. In addition, travel restrictions were imposed, and all but non-essential businesses were required to close in most states. These actions brought about a slowdown in economic activity. The number of workers filing initial unemployment claims jumped to 6.6 million in the last week of the quarter. A total of 10 million workers may have become unemployed as a direct result of government restriction on economic activity and the mobility of individuals. Unemployment is expected rise to well over 10% in the near term. It is likely that real GDP will experience a significant contraction in both the first quarter and the second quarter as both the pandemic and Government restrictions on economic activity continue.

In the face of the major economic dislocation, the outlook for corporate profits has been revised downward. Given, the chaotic nature of the economic environment, any forecast must be part of a wide range of outcomes. Investor confidence was shaken as uncertainty clouded all expectations including valuations.

Stock markets experienced large negative returns on a global basis. The MSCI World index, ex the US, generated a return of -23.3%. The MSCI Emerging Market Index produced a return of -23.6%. In the US, value stocks, as represented by the S&P 500 Value Index, declined 25.3%. The S&P Growth Index indicated that growth stocks experienced a decline of 14.5%, and the S&P Small Cap Index fell 32.6%. No segment of the stock market was exempt from the severe decline, and an examination of more indexes representing additional segments of the stock market would show the same patterns.

The VIX, a measure of market volatility, began the quarter at 12.4 and ended the period at 53.5. During the quarter the VIX rose to a level of 82.7. The strong rise in volatility along with a downward revision in the outlook for corporate profits helped depress valuations.

In the US, bond yields declined, and bond returns were slightly positive. The Bloomberg Barclays US Aggregate Bond Index showed a return of 3.2%. The ten-year US Government obligation was selling at a yield below 1% at the end of the quarter. The thirty-year obligation yielded approximately 1.6% and the five-year yield was about .75%. These yields are extraordinarily low when compared to the historic yields for the same obligations.

Gold prices rose more than 16% in the first quarter as investors sought a haven from uncertainty. The return was the highest quarterly return for the metal in over thirty years. At the same time, the dollar drifted upward against major currencies as investors tried to move away from obligations of countries thought to be more vulnerable to severe economic contractions associated with the pandemic.

The price of West Texas Intermediate crude fell 66.5% during the quarter, the largest quarterly decline on record. This steep sell-off was triggered in part by a decline in economic activity arising from mandated government restrictions on consumer mobility and business activity. A second influence on oil prices was a confrontation between oil producers Russia and Saudi Arabia. The Saudis appeared to resolve to punish the Russians by maintaining or increasing oil output as demand contracted. The resulting decline in prices greatly reduced the profits of Russian oil producers. Unfortunately, the Saudi strategy also reduced the profits of US oil producers at the same time.

Economic Commentary

In the face of economic turmoil and a rapid rise in unemployment, the Fed and the Treasury were not static. The Fed abruptly reversed course and began adding to its balance sheet to promote quantitative easing. Early in the quarter, the Fed was allowing assets acquired during the financial panic that were part of the last recession to run down. The money supply grew at a rapid rate, approximately 16% on a year-over-year basis, towards the end of the first quarter. Congress and the Trump administration produced a $2 trillion spending package with the goal of supporting economic activity and providing workers with a source of income as their work-related activities were restricted. Whether or not these actions will produce the desired results is an open question.

The money supply is increasing at the same time the supply of goods and services is decreasing. Inflation is a more likely outcome of quantitative easing than is increased economic activity. Rising inflation could shake the confidence of bond holders and cause bond prices to fall, all other things being equal. The $2 trillion in increased government spending may or may not produce increased economic activity. History provides no clear evidence.

In 1921, Frank Knight wrote a book titled Risk Uncertainty and Profit. Nobel Prize winners from diverse schools of economic thought, Paul Samuelson, a Keynesian and George Stigler, of the Chicago school, consider it to be one of the half dozen most important economic texts. Knight offers many profound insights into the nature of economic systems as well as the concept of economic profits. A simplistic rendering of his argument with respect to the difference between uncertainty and risk would hold that risk is measurable and can be avoided, and uncertainty cannot be measured or avoided. Moreover, owners of capital earn profits by coping with uncertainty, because if risk can be measured it can be avoided and thus the assumption of risk generates no profit. Uncertainty may arise when information is scarce, non-existent, or difficult to discern. When these conditions exist, investors cannot rely on quantitative methods to help discern the future and must fall back on judgement formed using experience and the ability to wring from imperfect information what insights are relevant. The current pandemic and the legislated responses to that pandemic have produced uncertainty. No amount of torturing the data will produce clear insights into the range of outcomes. Investors are now forced to rely on self-evident truths and judgement.

Some try to make the argument that past pandemics provide useful insights into the course of this pandemic, but they do not. Each pandemic produces unique outcomes as measured by such metrics as duration, rate of infection in the population, and ratio of dead to those infected. Using historical data, we cannot come to know that we would most like to know, the future, except in broad measures. If investors accept those limitations on their knowledge, then an investment strategy can be formulated. This pandemic will pass, it is not an existential threat unless the response to it is mismanaged. The events that will transpire before the pandemic ends are difficult to discern, but a continued high level of volatility is likely. When the pandemic passes, it is likely the US economy will rebound, unemployment will decline, and the stock market will rise. Those who hold stocks will be rewarded.

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