Look Before You Leap
My approach to the markets is not much different from when I was a stock analyst and portfolio manager. I focus on fundamentals and valuations and adopt a three-to-five-year time horizon. This time horizon keeps me from getting too caught up in the short-term. History has shown time and time again that long-term investors have been rewarded for being optimistic. Historically, a strategy of adding risk during a bear market has led to higher returns for long-term investors.
With a three-to-five-year time horizon, we are likely to be well beyond this virus crisis and into another economic recovery. Today most risk assets have sold off, which suggests that a long-term investor should be adding to risk assets, adjusting allocations. I believe we investors should be moving in this direction, but want to be cognizant of the potential for a stunted recovery process that may create some tail risks (risk of permanent losses due to bankruptcy) and that prevents me from fully embracing risk. As such I can’t just point to areas that are inexpensive and say buy; I do need to consider tail risk.
Red, then Yellow, then Green
I see three stages to this crisis. The first is when the economy is shut down. Second is when we begin to reopen the economy. And the third stage comes with a viable treatment for COVID-19 and/or a vaccine against it. It is the second stage where visibility is quite low. What is uncertain is how long we stay in the second stage as well as the pace of economic growth that can be achieved during it.
Experts in the medical community suggest that the timing of a treatment is dependent upon whether an existing drug (or combination) works or if a new formulation is needed. The longer we stay in this stage, the more difficult it will be for companies to survive. Using 2019 year-end data (before the crisis) 13% of the companies in the Russell 3000 had more interest expense than earnings to service that debt (earnings before interest, taxes, depreciation and amortization). These are called “zombie” companies. Further, 26% of the companies in the Russell 3000 had interest expense greater than free cash flow. The economic shutdown and slow reopening will make it difficult for some of these companies to avoid bankruptcy.
One thing that appears to be broadly accepted by the medical community is that the virus will not go away on its own. According to Dr. Anthony Fauci, “we will have coronavirus in the fall. I am convinced of that.” And the head of the CDC (Dr. Robert Redfield) warned that a second wave this winter could be more difficult than the first. While this sounds distressing, it is likely that should the virus return, we are better prepared with greater test and trace capabilities that would prevent a wholesale economic shutdown.
US Government to the Rescue
One huge positive for our economy and markets is the monetary and fiscal response to this crisis. On the fiscal side, numerous spending packages have been announced amounting to nearly $3 trillion. This is WWII big; it’s nearly 15% of GDP. And, the Federal Reserve is demonstrating that it has more tools and capacity than many realized. These efforts are intended to help our economy get through the first stage with as little damage (permanent job losses) as possible. These efforts should also help in the recovery process and provide some support during the second stage. When I’m asked whether the stock market will test the low made in March 2020, I point to all of this announced stimulus that has come since the market made its low. This crisis would have to get a lot worse to offset all of this stimulus. Still, bankruptcies are happening and many small businesses that closed during the shutdown will not reopen. There are wounds that the government cannot prevent.
A Path Forward
For investors looking to take advantage of lower prices and yet avoid the risk of an extended second stage, I suggest two things. First, I would advocate for active management. An active manager with deep research capabilities and a strong risk management discipline could act as your first line of defense. Secondly, I would advocate for patience. Let the markets come to you.
A Shopping List
While it appears that asset classes are pricing in different outcomes, the main thread that ties all of the markets together is one of caution. Within equities, the winners have been those companies that are benefiting from the shutdown, as if this state will persist well into the future. It will not. We believe investors should consider those assets and companies that should benefit from the re-opening of our economy.
The Bloomberg Barclays U.S. Aggregate Bond Index is typically representative of the portion of the portfolio that is serving as a ballast to equity risk. And in this crisis it has served investors well. Unfortunately, it has come at the sacrifice of yield. We are now looking at all-time low yields for the Index.
Bloomberg Barclays U.S. Aggregate Index
The ability to both reduce downside risk and provide income is becoming even more difficult. Interest rates on U.S. Treasuries have fallen considerably and longer maturities are near all-time lows. I do not expect interest rates to rise much in the next cycle. This is why I think it is incumbent for investors to search for income while it is still available. Interest rates for bonds bearing credit risk have widened and in some cases are offering healthy yields. I don’t mean to suggest that one just moves into anything with a high yield, because there is a very real risk that some of it is going bankrupt. A selective approach seems more prudent. Consider turning to an active manager with flexibility to help source that income.
S&P 500 Index valuations have come down, but unfortunately not to levels that make it very attractive. At least not for the S&P 500 as a whole. There is a lot of bifurcation occurring within the Index with more cyclical companies pricing in a protracted downturn. The beaten down Energy and Financial sectors look interesting, though again, I would leave the stock picking to active managers.
Typically, in a recession-induced bear market, cyclical stocks underperform as investor shorten their time horizons and become more concerned with safety. Stocks in the value indexes tend to be more cyclical, and smaller companies tend to be more cyclical as well. Year to date, the degree of underperformance between small and large capitalization companies has been stark. Valuations for small and mid-cap indexes look much more interesting than those for large cap stocks. This looks like another area worth consideration for gaining additional exposure.
(Monthly data: March 1995 through April 2020)
*EBITDA=Earnings Before Interest Taxes Depreciation and Amortization
International markets also appear to be presenting opportunities given low relative valuations to the S&P 500. Much of the world was impacted by the coronavirus before the U.S., putting recoveries in those regions ahead of our own. Country-by-country differences in approaches to containing the virus, health care resources and fiscal and monetary responses should provide some diversification benefits. We believe in a more selective approach to gaining international exposure that can only be found with an active manager.
Price to Trailing 10 year Earnings Per Share
(Monthly data: December 2004 through April 2020)
Opportunities exist throughout the investment spectrum. However, history has demonstrated that long-term investors are best served by staying focused on their long-term strategic goals. We are reminded especially in uncertain periods like these of the importance of looking to the steady hands of financial professionals, putting emphasis on companies with strong balance sheets and lasting business models, and trusting in your investment strategy while remaining mindful of the risks of trying to time the market. Furthermore, we believe that environments that are more volatile create opportunity for active managers over the long-term.
The information provided represents Touchstone’s views and observations regarding past and current market conditions and investor behaviors. The information and statements provided here are believed to be true and accurate. There can be no assurance however that the beliefs expressed herein will be consistent with future market conditions and investor behaviors.
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy or a recommendation to buy, sell or hold any security. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Past performance is no guarantee of future results.
Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index comprised of U.S. investment grade, fixed rate bond market securities, including government, government agency, corporate and mortgage-backed securities between one and 10 years.
Barclays Capital U.S. Treasury Bond Index is a market-capitalization weighted index that measures the performance of public obligations of the U.S. Treasury that have a remaining maturity of one year or more.
Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
MSCI EAFE Index is a free-float-adjusted market capitalization index that is designed to measure developed market equity performance excluding the U.S. and Canada.
MSCI Emerging Markets Index is a free-float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
NASDAQ 100 Index includes 100 of the largest domestic and international non-financial companies listed on the NASDAQ Stock Market based on market capitalization.
S&P 400 Index measures the performance of the mid-capitalization sector of the U.S. equity market.
S&P 500® Index is a group of 500 widely held stocks and is commonly regarded to be representative of the large capitalization stock universe.
S&P 600 Index measures the performance of the small capitalization sector of the U.S. equity market.
Yield-to-Worst is the lowest amount an investor can earn if a bond is purchased at the current price and held until call or maturity.
The indexes mentioned are unmanaged statistical composites of stock market or bond market performance. Investing in an index is not possible. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Past performance is no guarantee of future results. Active Share is not a performance measurement. A high level of Active Share does not assure outperformance of a fund relative to its benchmark index. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
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