The perceived catalyst for any stock market correction is analyzed and discussed in the financial media at a never-ending pace. Today, the Coronavirus (COVID-19) has everybody on edge and as of this writing, the S&P 500 is off 10.0% from recent highs, entering a market correction. The equity selling came off the back of news that the COVID-19 has spread in parts of Italy, Iran, and South Korea. Market participants are weighing the potential economic impact that the virus may have given the uncertainty around global containment. Haven assets like bonds and gold have rallied while global risk assets have corrected. Many US firms that have supply chains dependent on China have adjusted their profit outlooks and indicated that the COVID-19 will adversely impact earnings through Q2 of 2020. We thought this would be a good time to reach out and reiterate our views that we discussed coming into 2020. In this quick note, we will discuss thoughts on both volatility and equity/fixed income allocation.
We said coming into this year that U.S. equity markets were too complacent. When we discussed our outlook for 2020, one of the themes was that the low level of volatility seen at the end of 2019 will not last far into the next year. We can never predict what will cause volatility to pick up. Sometimes investors just need an excuse to sell. The CBOE Market Volatility Index (VIX) has spiked to a level not seen since the December 2018 market correction. While coronavirus is blamed, we think the market had gone too long without seeing a pullback and was due for a correction. Before this week, the last 5% sell-off was seen in July 2019; that was seven months ago. We have not seen a sell-off greater than 10% in over 14-months. History tells us we should see a few 5.0% sell-offs every year and at least one 10% sell-off per year. As students of history, we expect multiple periods of stock market volatility per year. We view these corrections as a function of markets, not a flaw. We are currently in the midst of one right now and I suspect it will not be the only one this year. We have reiterated many times over the years that we use volatility as a source of future returns. In our minds, volatility is not risk. When volatility spikes, prices get dislocated in the equity markets and that creates opportunity. We want to be in a position to take advantage of that opportunity. This should not be taken to mean we are buying today but that we are intensely monitoring the situation and looking for the right time to potentially add risk to the portfolios at an appropriate price. We have developed a process that we believe in to determine where we are positioned in the cycle and whether it is an opportune time to take risk off or put risk on. This data-driven process uses the daily flow of data to make educated and prudent investment decisions for clients.
Last year we used strong equity market returns as a chance to prudently take profits in portfolios throughout the year. We started 2020 with a slight overweight to equities in balanced portfolios as we believe the risk-adjusted return profile still favors stocks over bonds. The rush into safety assets has dramatically reduced interest rates as investors crowd into the U.S. Treasuries. As of this writing, the 10-year treasury is 1.32% which is an all-time low. The real yield (net of inflation) is now -68 basis points (bps) if you use a 2.0% inflation rate. These are just not attractive statistics when contemplating where to allocate a client’s money for the long-term. The year-to-date performance of long duration treasuries has been off the charts. The ICE U.S. Treasury 20+ Year Bond Index is up 11.9%. Annualizing long-dated treasury returns would imply long duration treasuries will be up over 72% this year. That seems highly unlikely in our estimation. Let’s assume long duration treasuries flat line from here for the rest of the year. Given that the 20-year Treasury yield started at 2.0%, at 12% return would mean only 17% of the bond’s total return would be from income. A staggering 83% of the bond’s return for the year would be from price appreciation. That is how stocks historically behave, not bonds. If bonds are going to drive 80-90% of their total return from price appreciation then they are becoming more prone to price volatility. Duration in fixed income land seems expensive in light of these moves. The crowd has decided the only way to unload risk is by purchasing duration, and they need to do a lot of it now. We think valuation in US Treasuries is getting too stretched. Interest rate risk is being ignored across a lot of the bond market. The popularity of this trade is perpetuated by the US Federal Reserve and other central banks taking an accommodative stance. That does not mean we can just ignore the interest rate risk inherent in buying duration at such low rate levels. The yield per unit of duration in a lot of fixed income is well below historical norms. While certain structural changes like demographics are driving the bond market frenzy, this recent move is introducing too much future risk for our liking.
The key for us as investors right now is to balance the uncertainty of the virus’s duration with the opportunities that will eventually come our way as a result of the dislocation in market prices. We have a disciplined process in place that will guide us through this. We will always have a long-term mindset and look for the most attractive risk-adjusted returns. When extremes are reached in either our fundamental or sentiment indicators we will react accordingly. We hope you found this note useful. Please do not hesitate to reach out to your advisor if you have any questions.
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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.