Given the volatility in the financial markets beginning the week of February 20, 2020, it’s helpful to review the state of the U.S. economy entering into this stressful period, what’s happened since, and some of the potential economic impacts. Here is our take on those topics.
1. At the beginning of 2020, the U.S. economy was in very strong shape, with unemployment falling and the labor force participation rate and wages rising.
2. Compared to 2008-09, this is not a financial crisis but rather a health crisis, which tends to be much shorter in duration (typically several months) and which should lessen in magnitude as the Northern Hemisphere approaches spring and summer. Banks are in the strongest capital positions ever, and strong banks with the ability to lend are obviously important to the sustainability and health of the economy. Further, the ratio of consumer debt to gross domestic product (GDP) is about 75%, its lowest since 2002, down from almost 100% in 2008.
3. Lower interest rates will help governments, consumers and corporations refinance debt, leading to lower debt burdens within those sectors of the economy. However, lower interest rates, along with lower stock prices, will put further stress on state and local pension plans, many of which are already severely underfunded. In order to minimize risk, we have been avoiding buying bonds from a significant number of these states. A sustained period of low rates will also impact savers, increasing the need for other parts of the portfolio to generate the returns needed to fund retirement and other goals. We also expect that we will see yields on short-term fixed income, such as money market funds, drop substantially as well, increasing the “cost” of cash.
4. While bad for energy companies, their stockholders and potentially their bondholders, collapsing energy prices are effectively a big “tax cut” for consumers. Also, companies that are heavy energy users (e.g., airlines) will benefit, to some degree offsetting the losses associated with lower energy prices in other sectors of the economy. However, there is significant risk to the high-yield corporate bond market, as there is $85 billion of high-yield debt issued by energy companies, and with oil prices below $40 a barrel, many of these companies will struggle to generate profits. Much of that debt matures in the next four years. In this type of environment, one can expect the high-yield corporate bond market to be highly correlated with the stock market, which is one of the reasons we generally do not recommend high-yield bonds as part of client fixed-income portfolios. High-yield bonds do not provide effective diversification within a portfolio that already owns stocks.
5. The U.S. has the lowest percentage of trade relative to GDP, at about 12% (country trade-to-GDP ratios). In comparison, most of Europe varies from around 50% (Germany) to the high 80s (Belgium, Netherlands). Japan is about 16% and the UK is about 30%. So, if there is a prolonged deterioration in trade, the U.S. should be less impacted than most countries.
6. If the economic disruption associated with the coronavirus worsens, governments are likely to take action to address issues, such as coming out with loan programs to bail out specific industries (as the government did during the 2008-09 crisis for General Motors and the banking industry) and enact fiscal stimulus (tax cuts or other programs to more directly help those financially impacted by the coronavirus). Given possibilities like this, one must also keep in mind that markets are forward-looking, recovering well before the economy does, just as they tend to fall before the economy is materially disrupted.
7. Markets generally do a good job of incorporating both good and bad news and anticipating potential impacts on the economy. When we see markets change, it is almost always because of new information that couldn’t have been reliably forecast in advance. However, markets can also fall for noneconomic reasons due to a cascade of sellers who reach their get-me-out point, have margin calls, or are covering short put options positions; or market participants who are trading with the trend. These market participants can sometimes exacerbate downward trends in markets, but we still believe it’s best not to try to predict these occurrences but rather to be aware they are possible. Further, if you sell, you have no way of knowing when to get back in or when trends like the above could reverse.
8. While stocks and risky fixed-income assets or pseudo fixed-income strategies, such as dividend paying stocks, REITs (real estate investment trusts), etc., are falling in value, safe bonds are rising in value, demonstrating their value as dampeners of portfolio volatility, which is why we include them in portfolios. Some “true” alternative strategies, such as marketplace lending, reinsurance and trend-following, have held up very well and have generally generated positive returns on a year-to-date basis.
Finally, remember that bear markets are periods when stocks are transferred from weak to strong hands, as does wealth when recoveries occur. We have recovered from every past crisis, which we tend to experience with great frequency, about every two or three years. Further, we recovered quickly in the past from the health crises of SARS, MERS and Ebola.
We are here to answer questions, help with concerns or just to listen. The best advice I have is this too shall pass.
Allan Rufus, in his book, “The Master’s Sacred Knowledge,” says, “Life is like a game of chess. To win you have to make a move. Knowing which move to make comes with insight and knowledge, and by learning the lessons that are accumulated along the way.”
The phrase “life is like a game of chess” has become a well-worn adage, and, like many other old adages, this one has some significant flaws.
You see, in chess, all the right moves are knowable. They may not be known by you or me, but they are knowable. And this is the significant error when comparing life with chess.
Life is much more like a game of poker. In poker, there are four main scenarios:
- You have a good/great hand, and you make correct decisions.
- You have a good/great hand, and you make incorrect decisions.
- You have a bad/terrible hand, and you make correct decisions.
- You have a bad/terrible hand, and you make incorrect decisions.
Here’s the conundrum about poker (and life and investing): You can hold a great hand and make all the correct decisions, and you can still lose. It happens more often than we all may like to think. And, while such situations are painful for everyone, how many people react or potentially change their behavior based on these unlucky instances can be far worse than the original unlucky occurrence.
Let’s look at an example:
In chess, you virtually always sit in two of the table’s four boxes, i.e., good decisions lead to good outcomes and bad decisions lead to bad outcomes. In poker and life and investing, we sit in all four quadrants.
As difficult on the psyche as it can be to have an outcome in the table’s top right quadrant (good decision, bad outcome), I believe the bottom left quadrant (bad decision, good outcome) can be more harmful for folks in the long run. Especially if they don’t realize they’re in the bottom left quadrant (and I suspect that most don’t).
For starters, if your luck does run out, the results can be disastrous. Think back to our table. Maybe a driver assumes he has a 99% chance of running a red light and getting away with it, and maybe that driver is right. But the odds of successfully running two red lights fall to 98%. Three lights? 97%. Do it 75 times and you’re down to less than a coin flip. There’s a fine line between calculated risk and reckless behavior, and the slope can become slippery.
Plus, personal experience can drastically affect one’s perception of risk, and those experiences can lead us to take on too much or too little of it. So, it’s critical to be self-aware of how our personal experiences shape us.
A Few Takeaways
Looking inward at the way we make decisions can teach us some valuable lessons, whether we’re talking about poker or life or investing. First, you need to weigh the severity of a negative outcome in addition to the probability that it will happen. I’ve often heard folks talk about how they’d like to spend their last dollar while taking their last breath. They know they can’t take it all with them to the Pearly Gates. But, what’s worse? Passing away with gobs of excess money, or knocking on your kid’s door in your 80s because you’re out of cash and moving in? Having some financial buffers is wise.
Life insurance is similar. Sure, the actuarial tables suggest that I pay a little more money in life insurance premiums than the (thankfully) low odds of me passing would seem to require. Yet, I happily write that check every month because, even though the probability is low, the severity of a negative outcome (my premature death) is extremely high for my family.
Second, in poker, it’s OK to fold sometimes. In fact, it’s more than OK; it’s advised. It’s rarely culturally acceptable to tell others to just quit something, whatever the thing happens to be. But, good poker players “quit” all the time. This, of course, is known as folding. When the odds and chips are stacked against you, folding is a wise strategy.
It’s the same in life. There’s often a huge opportunity cost in holding a bad hand. That bad hand might be a job you hate or a toxic relationship or a financial situation that puts you under a load of stress. Sticking with these things creates negative expected happiness, negative expected self-worth, and negative expected real wealth. Don’t be afraid to fold and move forward. Third, be wary of concluding too much from any single outcome. Having a process for making decisions will help prevent you from impulsively reacting when unlucky outcomes occur. In that vein, I believe there are three critical aspects of wise decision-making.
- Discipline: In poker, the discipline to not chase a juicy pot when the odds aren’t there for you will lead to superior outcomes. In investing, the discipline to not simply chase the high-flying investment of the hour is vital to superior long-term returns.
- Patience: In poker, you will experience long stretches of bad hands. Patiently waiting to play only good hands – even when you’ve seen others win with bad hands – is key to long-term success. In investing, you will experience periods where a diversified portfolio feels bad because others – who are less diversified – are “doing better.” Ignoring the noise and staying patient is the second characteristic of successful investors.
- Faith: In poker, without faith that you have the proper strategy, your discipline and patience will eventually give way. It’s the same with investing. Whatever investing strategy and allocation you determine is best, maintaining faith that it’s a prudent path to your most important life and financial goals will allow you to fly above the storm clouds that inevitably arise from time to time.
I’m confident every superior chess player exhibits exceptional intelligence. Not so with investing. To paraphrase Warren Buffett, temperament beats brains. That’s why I’m also confident every superior investor either exhibits exceptional temperament or chooses to lean on someone to help them filter out all the noise and focus on what truly matters.
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The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Partners®. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
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