Market Update: Analyzing the Recession

by: Brian Davies, CFA – Chief Investment Officer

I have always been fascinated with endurance athletes. I find it crazy that anyone can run a 50- or 100-mile race either by themselves or with a small group. My initial thought is these must just be tremendous athletes and the rest of us are simply mere mortals. In his book Living with a Seal, author Jesse Itzler hired a Navy Seal he met at an endurance race to train him. The Seal, David Goggins, explained to Jesse the key to endurance success was the 40% rule. The 40% rule is simple and explains why the average person can overcome great physical and mental stress. The rule states that when your mind is telling you are hitting a wall and you cannot move forward; you are actually only 40% done. Your body has the ability to push well beyond where you think you are hitting a wall. I was thinking of this rule a lot as we deal with the constant news flow around Covid-19. Every day, we are bombarded with news about the virus. Then we turn to the capital markets and we are spun around by severe volatility and dire economic news. Our mental capacity to deal with this every day is being constantly tested. The 40% rule would tell us that although things might feel like we are being overrun, we have the ability to move through this difficult time and come out the other side. I know it might seem simple to think of things in this way but, for me, it helps. In investment management and financial planning, we take long-term views but in the short-term, we need to endure disruptive periods. Our ability to endure periods of stress will allow us the chance to generate the returns you need over the long-term to meet your financial goals.  I have said this in all communications recently and will say it again here; if you have any worries or questions about how the current environment might be impacting your financial plan and goals, please reach out to the team here at Shepherd Financial Partners. We will work together with you to navigate through this challenging time. 

            On behalf of the Shepherd Financial Partners team, I would like to take a second to thank all of the frontline workers fighting the Covid-19 battle. They are definitely an example of the 40% rule in full effect as they endure the most challenging mental and physical conditions imaginable. We say “thank you” to all of them and hope they stay safe. 

            For this quarter’s update, we will focus on what’s to come and our thought process. We will cover the economy, as well as our thoughts on different parts of the equity and fixed income markets.  There will be some review to help put things in context but, for the most part, this writing will discuss where we think we are going, how we view risk in light of what’s happened, and what tactical changes we are making in the portfolios.  

The Economy:

            There is no way to sugarcoat it, the global economy is in a recession. You cannot stop an economy in its tracks and not expect to see dramatic drops in activity and employment. For the first time since World War II, world GDP will most likely see a negative growth rate. It’s just unavoidable. In the U.S., GDP growth coming into March was growing at a trend growth rate of about 2.0%. Now, we will see a drop-in activity that we have not seen since the Great Financial Crisis. We have already seen over 25 million people file for unemployment in only a few-week span. The April jobs report showed an unemployment rate of 14.7% (released Friday May 8th). Our internal estimate is for the May jobs report (due June 5th) to be a number close to 18%. After that the trend will be based on how successful we at re-opening the economy.  

            So, we know the contraction will be deep but the question is how long will it last. While we are fairly confident it won’t be measured in multiple years, we are not in the “V” shape recovery camp either. The virus will determine the path. We have seen countries like China, South Korea, and even parts of Europe bend their curves and countries have started to re-open their economies. The curve in the U.S. has improved with states like New York and California seeing improvement but other states still seeing cases increase. Overall, growth rates in new cases per day is slowing. We are testing more frequently but still need to see continued progress on this front. As we stare down the Covid-19 tunnel, we are seeing some light at the end. Hopefully over the next few weeks and months, that light will get brighter and brighter and more and more states can join the reopening game. 

            As we think about the virus curves bending, we can see our economy rebound most likely in 2021. This, of course, depends on the duration of the government induced shutdown. The longer we stay shutdown, the longer it will take to recover. This is not to argue against the shutdown but to be a realist regarding its effect and impact on the long-term.  Consumer spending is the biggest driver of the U.S. economy, and the ability of the economy to bounce back from this recession will depend on the path of the consumer. The willingness of consumers to venture out and spend like they did pre-Covid-19 will be challenged moving forward. We find it hard to believe that everything will just go back to normal once the government starts to reopen the economy.  Building cash reserves might take priority over immediate spending. Reluctancy to gather in large groups may limit spending habits until a vaccine is in place. We feel it’s reasonable to think this event will change consumer spending patterns for some time to come. This does not mean the economy won’t recover, but it will take time and we think it’s important to try an understand how spending patterns might be changed as a result of this period. 

            Spending will also be impacted by trends in employment. As mentioned before, the current level of unemployment is going to exceed the great financial crisis. Our hope is that the swift monetary and fiscal response will help limit the duration of these extreme unemployment levels; however, a full recovery back to pre-Covid-19 levels will take years. On average, post-World War II economic recoveries have seen employment take between four to six years to approach prior cycle lows in unemployment, and we don’t think this cycle will be any different. We could see a quick reversal of the unemployment rate to just below 10% but, based on history, a move from there could take many years. 

Equity Markets:

            Before diving into the markets, I thought I would give a quick reminder of how we were positioned coming into this year. As the markets rallied last year (that 31% return on the S&P 500 last year seems like it was a decade ago), we thought it was prudent to take risk off the portfolios throughout the year. Coming into the year we were essentially neutral across our models relative to stated benchmarks. For example, in our Growth & Income Model we were 60/40 stocks/bonds. We had been as high as 68% to start 2019 but cut that target back as we moved through the year as it seemed to us that the equity market sentiment was getting a bit to euphoric.  So, before Covid-19 struck the markets in February, we had already taken a more cautious view of risk assets for 2020.

By now everyone knows about the extreme moves in stock markets across the globe. We saw a dramatic 35% drop in the S&P 500 from the intraday high in Feb 19th to March 23rd. From there we have seen a very strong rally of over 30% in the S&P 500 as of this writing. Globally, the virus travelled fast and the data caused markets to react in full panic mode. The resulting speed and scale on the part of fiscal and monetary authorities around the globe is like nothing we have ever seen before, and as a result, the markets have swung dramatically in the other direction. This warp speed seems to be giving most investors motion sickness as they try to digest the constant deluge of information. It’s our practice not to overreact on both the upside and the downside. We try our best to take a prudent approach to evaluating markets and let our disciplined process guide us. 

While investors seem to be wanting to price in a “V” shaped recovery, we are less optimistic. We know from history that markets bottom on average 4-months before a recession ends (Source: Ned Davis Research). So, if March is the true bottom then history would say the recession would be over by late summer and early fall. That seems overly optimistic; it’s most likely that the recession is with us through 2020 and the very early part of 2021.We do believe the worst of the recession will be in Q2 and that Q3 & Q4 of 2020 will show growth off Q2. The trends moving forward will be challenged by very high unemployment levels and PTSD on the part of consumers who have rejoined the workplace and have the ability to spend. When states open up in May and June, it’s rational to think consumer behavior will remain low for the first few months. Consumers will wade slowly back into a “normal” life but only as they feel comfortable doing so. We ultimately think consumer spending will come back but it will just take time. Time to get comfortable stepping out again. Time to build up personal rainy-day cash savings to withstand potential issues in the future. By some point in 2021, we think time will have allowed consumers to attempt to return to normal. A vaccine will go a long way to achieving this return to “normal”. If we see one in 2021 and billions can be vaccinated, then we may see a period of outsized growth as confidence combined with pent up demand drive spending. But this is most likely a 2021 event. We can hope it’s earlier but we believe rational thinking says production and distribution of an effective vaccine will be a 2021 event. 

Growth has been the dominant theme in the rally. However, areas like developed international, emerging markets equities, and small caps have all seen aggressive rallies through April. We favor domestic equities in the near term to international equities and large cap companies to small.  The markets seem to be ahead of themselves in the short-term, and as a result, we continue to take a patient and prudent approach to adding more equity exposures to portfolios at this time. Market rallies don’t go straight up and we want to have capital available to purchase risk assets when we believe the future risk adjusted return is most optimal. Our strategy from the onset has been to acquire risk in stages. We rebalanced into equities in mid-march, but kept our target allocation below neutral. Given the level of uncertainty today, we feel it’s only prudent to continue our cautious approach to equities and risk.  

Fixed Income Markets:   

            March saw one of the worst months in history for fixed income. A liquidity crisis, spurred by The Great Shutdown as well as a route in oil markets, had markets in panic mode. Credit spreads widened to levels not seen since the Great Financial Crisis. Even the treasury market was upended for a few days. We saw correlations between risk and risk-off assets go to one, which means securities that normally do not move in tandem did. These events happen only in the most stressful market environments and March was one of those. The Federal Reserve stepped in with speed and force to provide liquidity when it was desperately needed. Since then, calm has returned to fixed income land especially in treasury bonds. The Fed soothed fears by essentially expanding the play book from ‘08/’09. They are providing support in some way to almost all areas of the bond market. For the first time in history, they are buying investment grade credit and also dipping into junk bonds. Whether you agree with these moves or not, the fact is the Fed is aggressively attempting to back stop the bond market and will be doing it for some time. They realize the global system is fragile as a result of the shutdown. As the lender of last resort to the world, they have taken the stance that they have the wherewithal to do what other central banks cannot do and believe it’s their duty to provide assistance as they deem necessary. We have operated under the belief that these programs are not in perpetuity and at some point, they will expire when the Fed feels the torch can be passed on to the private markets. When that will be will depend on the duration of the recession and how quickly the economy and markets can recover.

            As for our portfolios, we came into the year with minimal exposure to corporate credit since the pricing was not right for attractive risk adjusted returns. Here, we mean that the spread, which is the difference between interest rates on High Yield Bonds and the 10-year Treasury, was not great enough to be attractive for investment. Well, that changed very quickly in March, and today spreads are double what they were before Covid-19 struck. The risk adjusted return profile is now in the long-term investor’s favor. During March, we used this volatility as an opportunity to initiate a high yield position across balanced models. While credit could still be volatile over the next 12-months, we feel very confident we have bought at such a price that our return profile will exceed the risk that may be present in the market today. In another tactical move, we increased our investment in treasuries to properly balance risk in our bond holdings given that high yield bonds are highly correlated with stocks. As always, this decision was made with a long-term framework in mind. 


            We are in a deep but hopefully short recession. The timeline until recovery is uncertain. We think it’s rational to believe the recession is with us through 2020 and the very early part of 2021. From there it depends on whether or not we see a resurgence in the virus and the capacity and availability of medical supplies and vaccines. The recovery is also contingent upon the consumer and how the consumer emerges from the crisis. As for the global economy, it is slowly reopening but we have to emphasize the word “slowly”. Patience will continue to be needed. While economy and markets will ultimately recover, history shows recoveries from events like this take time. 

Our investment process is data dependent and when the process tells us it is time to move allocations one way or the other, we will do that. Uncertainty reigns today and being able to lean on the process we have in place has been incredibly valuable. We will continue to focus on being prudent and patient with portfolio allocations. That’s what we have been doing since the beginning and our process tells us that is optimal today.

            We fully understand these are challenging times. The entire Shepherd Team is honored and thankful you have chosen to put your trust in us. We are working hard to maintain that trust and build on the relationship you have with us. If you have any questions or concerns about how your financial goals will be impacted by the events of today, please reach out to the team. We are here for you. The team will continue to reach out and check-in. Please be safe and be healthy.

Shepherd Financial Partners


Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes.  The purchase of certain securities may be required to effect some of the strategies.  Investing involves risks including possible loss of principal.

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