First Quarter 2020 Commentary: Bull Market, Bear Market, Bull Market

April 3, 2020

Mark Oelschlager, CFA

What a quarter. Stocks began 2020 in a bull market and continued their ascent until February 20, when they commenced the fastest 20% decline from a market peak in history. From the intraday high on February 19 to the intraday low on March 23, the S&P 500 index fell a staggering 35.4%, as fears of a deep recession driven by a pandemic took hold. The US government and Federal Reserve responded with various measures to address the economic fallout caused by mandated business closures and social distancing. This calmed investors’ nerves and spurred a dramatic rise in stocks. Over the course of a mere three trading days in late March, the Dow rose 20%, the quickest such rise ever from a bear market low. Any time the market rises/falls by 20% it is considered a bull/bear market. So, we started the year in a bull market, shifted to a bear market, and ended in a bull market – all within one quarter. Of course, it certainly doesn’t feel like we are in a bull market, as stock prices remain more than 20% below their peak and volatility is still elevated (March saw the largest average daily change in the history of the S&P 500). Estimates for second quarter GDP are wide-ranging, and it’s not unreasonable to think that output could decline by 25% or more. For perspective, GDP fell by about 4% in the Great Recession. In addition, weekly unemployment claims in late March broke the previous record by a multiple of 17. Unemployment rose to 10% in the Great Recession; depending how long Covid-19 keeps the economy from functioning, the rate could be double or triple that. These numbers are so extreme because of the suddenness of this economic downturn. Normally, recessions happen gradually over several quarters, as businesses and consumers adjust to changing conditions. This time it happened so abruptly. What will be critical for the economy is the duration of this shutdown. The longer people are out of work, the more lasting the impact will be on the economy. If this is relatively transitory, and companies resume operations quickly, the effects should be manageable. But if demand is suppressed for many months, a large portion of the jobs may not come back for some time. That is why Congress was so eager to pass a stimulus plan to get money into the pockets of Americans whose incomes have been halted and to provide loans to businesses whose revenue has dried up. These measures are designed to be a bridge to the other side of this pandemic. The aid package which passed on March 27 was $2.2 trillion. For comparison, the 2008 stimulus plan, which was implemented to ward off economic collapse, cost about a third of that but was still considered colossal – because it was. I’m not sure then what we should call this one. What is three times “colossal?” As large as this amount is, it may not be enough. If lockdowns continue into June, or if we return to normal only to have a resurfacing of the virus, more aid may be needed. As of the end of 2019 our national debt stood at $23 trillion, so this stimulus plan adds roughly 10% to the total. This number is so large that it can be difficult to comprehend. The US population is 327 million. With a debt of $25 trillion, this comes out to $76,000 per person. To clarify, we are talking only about federal debt, not debt owed by individuals. Debt tends to mushroom, especially when receipts decline as is happening now. Something else that makes it grow is the cost of servicing it, i.e. interest cost. The US government spent about $400 billion last year just on interest on its debt. Its average interest rate was about 1.8%. The US and other sovereign nations have been very fortunate that rates have been so low for so many years, and they have fallen even further during this crisis. But if interest rates rise back to even mid-single digits, which would still be lower than what they have often been over the last 50 years, interest costs on the national debt would explode and would represent an increasing portion of the annual budget. In a time like this, when rates are being suppressed by a variety of forces, this issue does not garner concern from many people. But when things change, they tend to change quickly, and usually when authorities are unprepared. In 2008, as negotiations over the stimulus package were taking place, there were two sources of resistance. One was moral hazard. Legislators didn’t want to be seen rewarding “bad actors.” The other was fiscal ramifications – the effect it would have on the budget deficit and the national debt. Today, moral hazard isn’t an issue because, while there may have been excesses built up, the sudden stop to the economy was due to a global health crisis. The fiscal issues would seem to be of even greater concern in 2020 versus 2008, given the fact that our national debt has more than doubled while GDP has not kept pace. But nary a word. That’s not to say that the government should not have provided the aid. But it is at least a little concerning that the fiscal consequences were given such little thought – by both elected officials and the media. It is worth noting the action in the Treasury bond market. Not surprisingly, yields plummeted during the quarter, as investors sought what is generally perceived to be a safe haven. But an interesting thing happened in mid-March as the stimulus plan took shape. Treasury yields rose. After bottoming on March 9 at 0.54%, 10-year yields rose to 1.19% on March 18. Thus, buyers of these bonds were demanding a higher return to lend the government money. Concurrent with this, credit default swaps on US Treasury bonds (instruments that pay off if the US defaults on its debt) spiked in value. To be clear, the prices on these swaps still imply a very low chance of default, but our leaders should take heed – there is no free lunch. Back to the stock market. Q1 was the fifth worst quarter for stocks since WWII. Often in a major correction, internal dynamics can become dislocated, and this time was no different. Empirical Research Partners tells us that valuation spreads – a measure of how disparately stocks are being valued in the market – reached 4.5 standard deviations above the mean during the quarter. This had happened only twice in the last 100 years: in 2008 and in the Great Depression. What this means is that the stocks that are trading at lower multiples of measures such as earnings are being valued far lower than usual relative to the rest of the market. So, if stock XYZ normally has a price/earnings ratio of 12 while the market’s is 18, its P/E might now be 6 while the market has only fallen to 15. Paying attention to valuation is always important in investing, but historically when valuations have widened like this it has paid to emphasize valuation even more than usual in the analysis of securities. Given the market correction, in our portfolio we have dialed back some of our conservatism, but not all. Portfolio management is very much about risk management, and we will continue to adjust our exposure based on how conditions change. This doesn’t mean we will buy when there is a positive headline and sell when there is a negative one. That’s reactionary trading, a game that is not only difficult but often counterproductive. We prefer to assess how the market is behaving, consider the long-term picture, and identify the resulting opportunities, preferably in companies that have durable competitive advantages. We hope that you and your family are healthy. 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 An investor should consider Towpath Focus Fund’s investment objectives, risks, charges and expenses carefully before investing. This and other important information about the investment company can be found in the Fund’s prospectus and summary prospectus. To obtain a prospectus or summary prospectus, call 877-593-8637. Please read the prospectus carefully before investing. Towpath Funds are distributed by Ultimus Fund Distributors, LLC (Member FINRA). Ultimus Fund Distributors, LLC and Towpath Funds are separate and unaffiliated.