Signs of Stability, But a Tough Road Ahead

This post starts with a tough assessment of the current environment, and is a bit on the long side, but I hope you'll read to the end for some encouraging words from people who have been here before...

As we have written recently, the Federal Reserve and US Treasury have stepped up strongly in response to the severe economic and market liquidity challenges brought on by the COVID-19 pandemic.  Fiscal stimulus and support for many sectors are critical to stabilizing the US economy.  And it may need more.

Without question, the world is now facing a recession of magnitude not seen since WW2.  The duration and depth of the slowdown is difficult to determine, however.  As such, volatility remains high as investors grapple with new data and refine their views in real time.  

Is this like the financial crisis?

While markedly different from the financial crisis of 2008-09, especially in the rapidity of the market's recent decline (which was the fastest decline in history), the evolving nature of the current environment is reminiscent of that period.  That particular bear market took a while to find a bottom.  We expect that to be the case again, driven by news flow and the pace of infections being reported.  

Importantly, the market bottom during the financial crisis was reached while financial conditions continued to deteriorate.  It may be difficult to recall, but the DJIA attempted to bottom several times before making a final low at less than 8,000.  As we know, the Dow peaked at more than 29,000 in February.  This doesn't mean that the upswing is around the corner, but that stocks should eventually bottom even though health, economic and corporate earnings news may remain poor.

The market is a "discounting mechanism", tending to look forward nine months and factoring that view into current share prices.  At some point, investors will have digested the weak results that we inevitably be reported and will shift their focus to 2021 earnings. 

Many types of assets have been impacted

It's important to note that stocks were not the only assets impacted by the "flight to quality" that has been occurring.  The ripple effects of forced selling by leveraged market participants has impacted everything but the highest quality assets.  In short, massive selling overwhelmed investors' ability to buy, and prices fell to clear those sellers.  This has been the case even in the municipal bond market where yields versus taxable bonds has widened to a level last seen in 2009.  

Similarly, some stocks are inevitably undervalued.  Investors sometimes forget that many companies have operated over a long history of both robust and difficult environments.  Some have even raised their dividends through all of them.  It is hard not to get pessimistic when indexes are declining.  But if we remember that these indexes are made up of many strong companies, then we start to think more opportunistically.  

One indicator:  Stock rating service Morningstar stated this week that a full 80% of the companies under their coverage are now undervalued, earning four and five star ratings.  This last happened during the financial crisis of 2008-09.   

Words from history

Let's review the words of some famous investors who have weathered tough times.  The comments below are from Jim Fullerton, Chairman of Capital Group, one of the nation's largest and oldest fund management companies, spoken in September 1974.  They ring true today.

" One significant reason why there is such an extreme degree of bearishness, pessimism, bewildering confusion, and sheer terror in the minds of brokers and investors alike right now, is that most people today have nothing in their own experience that they can relate to that is similar to this market decline. My message to you, therefore, is: Courage! We have been here before. Bear markets have lasted this long before. Well-managed mutual funds have gone down this much before. And shareholders in those funds and we the industry survived and prospered."

Jim then shifted his speech to another time period: 1942. 

"A leading stock market commentator said: 'The market remains in the dark as to just what it has to discount. And as yet, signs are still lacking that the market has reached permanently solid ground for a sustained reversal.'

Yet on April 28, 1942, in that gloomy environment, in the midst of a war we were losing, faced with excess profits taxes and wage and price controls, shortages of gasoline and rubber and other crucial materials, and with the virtual certainty in the minds of everyone that once the war was over we’d face a post-war depression in that environment, the market turned around."

Jim asked, "What turned the market around in April of 1942?"

"Simply a return to reality. Simply a slow but growing recognition that despite all the bad news, despite all the gloomy outlook, the United States was going to survive, that strongly financed, well-managed U.S. corporations were going to survive also. The reality was that those companies were far more valuable than the prices of their stocks indicated. So, on Wednesday, April 29, 1942, for no apparent visible reason, investors again began to recognize reality.

The Dow Jones Industrial Average is not reality. Reality is not price-to-earnings ratios and technical market studies. Symbols on the tape are not the real world. In the real world, companies create wealth. Stock certificates don’t. Stock certificates are simply proxies for reality."

In closing, I'll quote the words of Mr. Dean Witter (yes, that Dean Witter):

“Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished. In fact, does anyone think that today’s prices will prevail once full confidence has been restored?”

That comment was made in May of 1932 — only a few weeks before the end of the worst bear market in history. 

Long term investors understand that bear markets happen with relative regularity. And diversified portfolios retain their long term growth potential.  

To paraphrase Jim:  Hang in there.  We've been here before.