Summary of 1Q/2020: One Event to Rule Them All
The first quarter of 2020 was filled with important events such as the targeted killing of Qasem Soleimani, the Iowa Caucus debacle, and the de facto clinching of the Democratic nomination by Joe Biden. However, as we all know and now live with every day, the Coronavirus pandemic eclipses all of them.
Based on the Dow, the market delivered its worst quarter since 1987 with repeated days of insanely high volatility. We are living through an unprecedented general shutdown of the economy that is expected to continue at least until the end of April. Last week saw a record number of unemployment claims, with the coming weeks expected to get worse. The question is not whether we will have a recession but rather how deep a recession will we have?
Essentially firing its remaining bullets, the Federal Reserve has revived its Zero Interest Rate Policy and introduced an extended version of Quantitative Easing that reaches into the corporate and municipal bond markets, both of which were suffering. Now that monetary policy has been fully utilized, all eyes turn to Washington to quickly deliver its fiscal stimulus package (the CARES Act) valued at over $2 trillion with more to come. We discuss the ramifications for retirement accounts here.
The table below summarizes the estimated returns for various asset classes based on the performance of Vanguard index funds. Please note that they do not represent the returns of the funds or portfolios utilized by Clarity Capital Advisors.
Asset Class Ticker Used 1Q/2020 Return
US Total Market VTSAX -20.9%
US Large Growth VIGAX -13.7%
US Large Value VVIAX -25.0%
US Small Growth VSGAX -24.2%
US Small Value VSIAX -34.9%
International VTMGX -24.0%
Emerging Markets VEMAX -24.6%
US Real Estate VGSLX -24.1%
Int’l Real Estate VGRLX -27.8%
US Bond Market VBTLX 3.3%
US TIPS VAIPX 1.8%
Source: www.vanguard.com
Once again, the leading segment of the US stock market was large growth which is dominated by information technology companies. Smaller companies tend to perform worse in a downturn because they are more thinly capitalized and thus vulnerable to shutting down. The explanation for value underperforming growth appears to lie with several sectors including financial, transportation, and energy. The Vanguard Financial Index Fund (VFAIX) was down 33.1% in response to the steep drop in benchmark interest rates such as the 10-year Treasury, and the Vanguard Energy Index Fund (VENAX) was down an astonishing 52.4% in the face of collapsing oil prices. Airlines and hotel companies are down in similar amounts, unsurprisingly. Hotels are an important component of real estate investment trusts which took a bigger hit than the overall market.
What are some of the lessons we have learned (or re-learned)? First, dividend-paying stocks are no substitute for bonds. The Vanguard High Dividend Index Fund (VHYAX) was down 23.9% for the quarter, and it would be quite surprising not to see some dividend cuts from major companies. Second, the additional income of high yield bonds is not a free lunch, as the Vanguard High Yield Corporate Fund (VWEAX) lost 10.6%, and this fund tends to stay on the safer side of the high yield spectrum. Investors who used junk bonds as a substitute for investment grade bonds have found rebalancing from bonds to stocks to be challenging. Third, the COVID-19 pandemic has provided us a textbook example of systematic risk, a risk that is inherent to the entire market and cannot be diversified away. Undoubtedly, there are many other lessons that we will be discussing in the next few months.
What do we expect going forward? Based on past experience with recessions, we should expect a market recovery well before an economic recovery. Assuming we get through this pandemic in the next few months, is it realistic to expect the market to quickly return to its high-water mark set on February 12th or even its December 31st level? There are two reasons to remain skeptical. First, there is now a well-founded opinion that COVID-19 will return in the fall, as expressed by Dr. Anthony Fauci. Although we will certainly be better prepared, another round of social distancing will depress corporate earnings and many other important economic variables. Second, and please forgive us for getting a bit technical, the risk-adjusted discount rates used by active investors to calculate current values should now be higher to reflect a risk that may have not been properly incorporated pre-COVID-19. A higher discount rate equates to lower prices, but on the brighter side, it also corresponds to higher expected future returns. Note, the steep drop in long-term Treasury yields may at least partially compensate for the discount rate increase associated with a higher level of systematic risk.
Even (or especially) in times like these, our advice is to be invested and stay invested at an appropriate risk level, and by appropriate, we mean an asset allocation to meet your goals that you will hold through all different types of markets, including the one we are experiencing now.