Commentary: Historic Volatility

March 18, 2020

Mark Oelschlager, CFA

After a brief rise to start the year the stock market has sold off dramatically in 2020, with the S&P 500 down roughly 30% from its February 19 peak as we type this. The swings have been violent, as there have been five days of 4+% gains included in that 30% decline. In concert with this, the volatility index (VIX) has reached 75, an extreme level attained only once before: during the 2008 financial crisis. (The VIX has existed only since 1989, so it was not around for the Great Depression or Black Monday in 1987.)

The correction is reflective of concerns about the US and global economy, which are either already in or entering recession. The coronavirus pandemic has forced us all to change our way of life, with social interaction now a major risk to the health of us and others. Government authorities, while perhaps slightly behind the curve, now seem to grasp the seriousness of this pandemic and have wisely laid out new rules for how we should go about our daily lives in an attempt to limit the spread of the potentially deadly virus. This is having a major impact on the economy and corporate profits. The Federal Reserve has slashed short-term interest rates to close to zero and has committed to purchasing massive amounts of fixed-income securities in the market. Given the nature of this situation, we don’t believe the rate cuts will do much to stimulate the economy, but in general the Fed’s actions should boost financial market liquidity. With this pandemic, the problems the economy faces are different than they were in past recessions, or in the 2008 financial crisis, and therefore the prescriptions need to be different. Rather than trying to restore confidence in the economic system, as was necessary in 2008, authorities need to figure out how to prevent massive defaults by both corporations and consumers. When business in selected industries abruptly stops or is dramatically curtailed (restaurants, airlines, cruise lines, movie theatres are just a few examples), it becomes impossible in many cases for the affected companies to make payments on their debt, or to do so for very long. And it becomes difficult or impossible for these companies to pay their employees because they have little revenue coming in. In order to avoid a cascade of loan defaults leading to a downward spiral of the economy, our leaders need to create some sort of backstop or provide some sort of intervention so that the economy can resume its normal functioning, or something close to it, when the virus is under better control. Our guess is that they understand this, though determining the optimal form that these measures should take likely won’t be easy.

Of course, managing the spread of the virus is everything. We in the US are actually fortunate that other nations had to manage the outbreak first, as it offered a lesson in what we need to do. If the virus had started here, it is hard to imagine the public fully appreciating the danger and altering their lifestyles until it had exploded. As you have heard by now, the key to minimizing the damage of this pandemic is to “flatten the curve,” or stretch out the number of infections over as long a period of time as possible, so as to control its spread and to lessen the shock on the healthcare system. Unfortunately, this means changing how we live.

The current situation also puts into perspective how good we have had it for so long. 9-11 was horrible, and the mass shootings of recent years are soul crushing, but generally speaking, from a humanitarian and economic perspective, the last 40 years have been very good, despite what the negative headlines might lead us to believe. Consider the 40 years from 1910 to 1950 by comparison. First a world war broke out. Then the Spanish Flu killed over half a million people in the US alone. The Great Depression lasted for years and was followed by another world war! Deadly viruses used to be common and often cost an unthinkable number of lives. But despite all of the advancements in medicine, they haven’t been and likely never will be completely eliminated.

The market is grappling with how long the coronavirus will impact the economy and therefore corporate profits. Nobody knows. It is entirely possible that the virus will be with us for many months. It’s also possible that, like the Spanish Flu, the rate of infection falls off and then increases again. Whatever the path, the economy will eventually recover. Things could get worse, and indeed are likely to get worse. From an economic standpoint, it is difficult to compare this to the 2008 financial crisis because it is so different. In 2008, it felt like the entire economic system was at risk of collapsing due to rapidly deteriorating confidence. Today’s events fall into the category of an exogenous shock, albeit a huge one with an open-ended duration. In both cases certain parts of the market reacted differently than others; this created opportunity in 2008. We suspect that will be the case this time around too.

As always, we believe it is important to maintain a long-term perspective in assessing the appropriate actions. We want to focus on the long-term earnings power of a company and compare it to the prevailing stock price, rather than getting caught up in trying to figure out short-term effects. Of course, the pandemic may very well have an impact on the long-term profitability of various corporations, and we would be foolish to ignore that.

Early in the year our portfolio was much more conservatively positioned than it would be typically, given our assessment of the risks in the economy and the market. We were concerned about the extreme level of optimism in the market and the forecast of recession by the world’s greatest economist in April 2019. Who is the world’s greatest economist? The yield curve. When short-term interest rates exceed long-term rates, it has been an incredibly reliable predictor of economic recession sometime within the following 18 months. With each economic cycle various experts denounce the relevance of the yield curve, saying it’s different this time, and then it proves prescient once again. One of the reasons it works is that a rise in short-term rates, which are controlled by the Fed, acts as an economic headwind. If you look at a historical chart it is remarkable how consistently an inverted yield curve augurs recession. To be clear, the yield curve didn’t know there would be a viral pandemic that would hit the economy. And the virus will make this recession far deeper than it would have been otherwise. But it’s possible we were headed into recession regardless; we will never know for sure.

Frankly, we didn’t execute as well as we would have liked in our defensive portfolio positioning, as some stocks we purchased turned out to be less defensive on the downside than we had thought. That said, the portfolio has held up modestly better than the market since the peak on February 19. It might not sound rewarding to be “down less than” the index - we’d all like to see our investments never decline in value – but limiting damage in corrections is a huge factor in achieving long-term outperformance. Paradoxically though, in general the time to limit the damage from corrections is by managing risk before the carnage hits. Things like GDP growth and unemployment are coincident or lagging indicators - stocks move well in advance. Conversely, we believe the time to become more aggressive is when valuations are low, conditions are poor, and fear is palpable. During this selloff we have adjusted our positioning quite a bit but are not in full risk-on mode. Stocks appear to be more attractive than they were two months ago, and there are some good signs from a psychological standpoint, but conditions are far from giving the signal that it’s time to move all-in on shares of economically-sensitive companies, in our opinion.

To close on a positive note, it is heartening to see so many people rising to the occasion to help others during this difficult time. Stories abound. We wish your family the best of health as we make our way through this.

Best regards,

Mark Oelschlager, CFA President and Chief Investment Officer Oelschlager Investments

Investment Considerations:

There can be no guarantee that any strategy (risk management or otherwise) will be successful. All investing involves risk, including potential loss of principal. Past Performance Does Not Guarantee Future Results.

You cannot invest directly into an index. S&P 500 Index: Market capitalization weighted benchmark of 500 stocks selected by the Standard & Poor’s Index Committee, designed to represent the performance of the leading industries in the U.S. economy. Gross domestic product (GDP): The sum total of all goods and services produced across an economy. Standard deviation: A quantitative measure of deviation within a group. Valuationrefers to various measures that relate a financial characteristic of a company to the valuation accorded it by the market. Examples include price/earnings, price/book value, price/sales, and price/free cash flow. Price-to-earnings ratio (P/E ratio): The ratio for valuing a company that measures its current share price relative to its per-share earnings

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Towpath Funds are distributed by Ultimus Fund Distributors, LLC (Member FINRA). Ultimus Fund Distributors, LLC and Towpath Funds are separate and unaffiliated.October 30, 2020