The COVID-19 health crisis was indeed an unexpected black swan event that triggered simultaneous credit and economic crises, as governments worldwide locked down their economies. To add insult to injury, Saudi Arabia intensified the world’s financial woes by boosting oil production, pummeling oil prices in an attempt to drive higher-cost, financially leveraged oil producers out of business. The International Monetary Fund (IMF) has declared the current economic downturn the worst since the Great Depression.
Markets reacted swiftly to the calamity, with the broadly based U.S. S&P 500 Index experiencing its steepest and fastest decline on record – down 35% in just 33 days.
Fortunately, governments and central banks reacted in record time as well. The massive monetary and fiscal support programs they enacted brought new meaning to “whatever it takes” and have virtually eliminated the risk of a depression.
Investors were impressed, and the equity correction came to an abrupt halt. Stocks staged their briskest recovery since 1974. By mid-April, the S&P 500 Index was down just 13% for the year to date (less than 6% in Canadian dollar terms). Over the same timeframe, Canada’s equity benchmark, the S&P/TSX Composite Index, was down 17%.
Remarkably, the Odlum Brown Model Portfolio* was down approximately 10% for the same period, buoyed by our cash, gold and meaningful exposure to high-quality U.S. businesses. While all losses are disappointing, being down only 10% in the face of the worst economic shock since the Great Depression seems too good to be true, or perhaps too good to last.
No two economic crises are ever the same, although they often rhyme with those that have passed. While the speed and magnitude of the recent stock market drop is reminiscent of the 1987 crash, and the shock to the airline industry reminds us of the fallout from the 9/11 terrorist attacks, the present situation doesn’t really compare to any cycle in the last 80 years.
Aside from the suddenness and magnitude, the most striking difference between this stock market setback and any other we have experienced (or even studied) is investors’ relative complacency. Indeed, we have had more clients excited to make opportunistic purchases than we would have expected under these circumstances. Investors are normally more fearful during a crisis.
Never before have we heard more market commentators quote Warren Buffett’s famous line, “Be greedy when others are fearful.” We’ve used the line often ourselves in past corrections, but it hardly seems appropriate today when so many investors are upbeat about the prospect of making money.
Please don’t take the title of this note literally. We don’t really think it’s a time to be fearful and make dramatic changes to our investment posture. We are cautious, not fearful. After all, the outlook is considerably better than it was just a few weeks ago. COVID-19 curves are flattening around the world; governments and the private sector are working vigorously on treatment options and vaccines; the U.S. Federal Reserve and other central banks are injecting massive amounts of liquidity into their financial systems; and sizable financial support programs are being rolled out to individuals and businesses.
Nonetheless, there are reasons to question whether investors are too upbeat and not being realistic regarding the scope and scale of the challenges ahead. The world’s current problems are a lot more complicated than the issues we faced in the 2008/09 Financial Crisis. While the collective response of governments around the world has been huge, we wonder if it will be effective. Socially, we are more divided than we have been in decades, and it’s impeding our ability to work together to fight a common threat. The approach thus far has been piecemeal when a globally coordinated, comprehensive plan is warranted. America could be orchestrating the effort, and instead they have suspended support for the World Health Organization. The lack of global leadership and coordination is notable, and disturbing.
There is a lot of pressure on politicians to restart their economies, but there could be a relapse if this happens too soon. Increased social unrest is also a concern. It’s uncertain whether stocks are discounting these risks. Individual and corporate balance sheets were stretched heading into the crisis, and they will be worse on the other side. An era of private sector deleveraging, where everyone focuses on paying down debt, is likely to follow, and could create troublesome deflationary pressures.
Economists call the phenomenon the Paradox of Thrift. It’s good to save individually, but paradoxically bad for society when we all do it at once, because one person’s increased savings is a reduction in another person’s (or business’s) income. It’s unclear whether all the government money printing, bond buying and increased spending will keep deflationary forces at bay, or if these policies will prove to be excessive and cause undue inflation. Regardless, bigger governments, bigger deficits and higher taxes are likely going to be realities for years to come.
While there are many reasons to be hopeful for a brighter future, it’s also prudent to plan for the possibility that the recovery will be long and bumpy. Quality and balance matter more than ever, and investors should be thinking about the trade-off between protection and growth of capital. We’d rather risk being too conservative and wrong than too aggressive and wrong, as it’s much harder to recover from the latter. Consequently, we have a defensive posture in the Odlum Brown Model Portfolio, with an elevated level of cash and a decent amount of gold, together with a collection of very high-quality businesses that we are confident will survive and thrive. Beyond our equity Model, investors should consider a more conservative overall asset mix of stocks and fixed income securities.
While Warren Buffett has been notably quiet since the crisis intensified, his right-hand man, Berkshire Hathaway’s Vice-Chairman Charlie Munger, recently made it clear to a Wall Street Journal writer that it is a time for caution rather than action. We agree.
Stay safe, everyone.
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*The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.
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