A Smarter Way to Invest Market Summary 3-4-2020

MARKET SUMMARY

Provided By: Adam Blocki, CFA, CFP® – Senior Portfolio Manager

I bet you can’t guess what we’re going to discuss this month. Stock markets spent the first half of February gradually climbing toward new record highs, seemingly shrugging off the continued spread of the 2019 Coronavirus (COVID-19) throughout China. That immunity seemed to crack in the second to last week of the month before a downward spiral began in earnest during the final week of February. From the all-time closing high on February 19th, the S&P 500 fell as much as 15.7% at its lowest point on February 28th, only seven trading days later. The S&P 400 Mid Cap Index (-15.6%), S&P 600 Small Cap Index (-14.5%), Dow Jones Industrial Average (-15.9%), and NASDAQ Composite (-15.8%) all saw similar impacts over the same time frame as no area seemed resistant to the selling pressure. The last hours of trading on the 28th saw a slight rebound, but the damage was still significant.

Among the biggest losers were airlines and travel booking companies. Fears of travel restrictions and reduced demand for recreational international travel diminished their prospects for at least the first quarter of 2020, if not longer. Even business travel was seen as being potentially impacted as companies enforced temporary work-from-home policies aimed at stopping any spread among employees that could hurt firm productivity. Energy was by far the worst-performing sector for the month (XLE, -15.3%) as the impact on the global demand for oil was factored in. Finally, bank stocks were an unlikely victim of the panic selling as the financial sector ETF XLK lost 11.2% for the month and 14.6% from the February high. As securities across the board sold off rapidly in successive days, the fixed income market began to price in future rate cuts from the Federal Reserve, a move that would have an impact on bank profitability.

If you dug deep enough, there were small pockets of winners, however. Teleconferencing stocks such as Zoom (ZM, 37.6% for Feb) saw many investors pile in. While the temporary need to work from home may be short-lived, some hypothesized that as people tried virtual doctor’s visits as a result of the virus, they would see the ease-of-use and continue using those services in the long-run which would create sustainable demand from an impermanent event. Netflix (NFLX, 6.9% for Feb) and other stay-at-home entertainment options also saw mixed returns for the month under the assumption that if people have to stay home, they are going to use those services more. Finally, the biotech sector showed resiliency as investors sought out the names that might play a role in containing the outbreak or creating a vaccine. Gilead (GILD, 9.7% for Feb) was the standout here as one of their drugs showed promise as an ingredient in an eventual vaccine.

Finally, “safe-haven” asset classes saw mixed returns for the month. Treasuries (IEF, 2.8% for Feb) saw a large surge in the final week of the month as assets rotating out of stocks seemed to find refuge there. Corporate bonds (VCIT, 0.9% for Feb) were more mixed but still held up nicely as a whole. Gold (GLD, -0.6% for Feb) was relatively safe compared to other asset classes but still fell by 2.2% during the sell-off that began on February 20th. Finally, commodities (DJP, -5.7% for Feb) got hit hard as plummeting oil prices took their toll. The fact that gold did not rise and actually fell during the worst of the sell-off was interpreted as demonstrating that the end of month selling was more of a panic-induced flight to cash than a true rotation to safety.

The Smarter Way models and allocations held up surprisingly well during the end of the month. All three of our indicators (Alpha, Omega, and CIGNX) had flashed negative signals long before any coronavirus fears manifested. As a result, our dynamic allocations were all in their most conservative state with reduced equity model weightings, increased fixed income positions, and the addition of our Diversified Asset Blend model which holds a mix of gold, cash, short-term fixed income, and commodities. Within the models themselves, we had even more weightings in safe-haven assets. Our Large, Mid, and Small Cap models all had their maximum 20% cash position within, meaning that they were only 80% exposed to the drop in their respective benchmarks. Even within that 80%, we were fortunate enough in some models to have those individual stock positions outperform their benchmark as well. Additionally, our Hedge model was 100% in cash meaning it had a return of 0% for the month before fees. Finally, the Titan Ultra Growth and Titan Growth models that we incorporate into our Growth and Blend allocations rose for the month thanks to their conservative fixed-income positions. All of the model and allocation return figures for the year-to-date are spelled out in full below and should provide some comfort to clients who were watching the selling and worried what the impact on their investments would be.

I want to emphasize that the negative reading from our indicators WAS NOT predicting the spread of the virus and the ensuing panic. We were fortunate that they helped favorably position our strategies. While we can model and try to predict fundamental and technical aspects of the market and economy, there is no investment tool that we use that predicts biological events. The timing of the virus-induced sell-off could have been pure luck on our part, but it is also possible that markets were looking for an excuse to go through a correction that would bring stock prices back down to more reasonable levels. For most of 2019 and the first month and a half of this year, investors seemed to reliably buy the dips and deprive the market of the healthy correction that it needed. From that perspective, one could argue that our indicators picked up on that fact, became negative, and were positioned to benefit from the eventual correction.

While cases in China seem to be leveling off, the looming question is how the virus will spread elsewhere. China was able to take drastic steps by quarantining the entire city of Wuhan, an action that has been praised for its effectiveness, but other countries with less control over their populations might not be able to minimize the spread as successfully. With respect to economic output and the long-term impact on markets, things are still quite uncertain. This is not something that can be incorporated into investment algorithms as easily as economic data or price movements.

What will the actual impact on economic output be both globally and in the U.S.? The panic from last week would seem to imply that a big slowdown is expected. Some have called for zero growth in 2020 at both the company and GDP level as companies revise their earnings guidance downwards[1]. A second question is whether consumer demand will see a dip in the near term before returning to normal levels thus permanently losing that period of growth, or if pent-up demand causes a short-term surge that makes up for the brief slowdown. Those two scenarios would have quite different impacts on stock prices.

Analysts at some of the big banks have predicted three rate cuts by the Fed in 2020[2]. On Tuesday, Fed Chairman Jay Powell proved those predictions at least partially correct with the dramatic step of a mid-meeting emergency rate cut of 0.50%[3]. This is the first such action by the Fed since December 2008 during the financial crisis. During his press conference, Chairman Powell cited the fact that the spread of the virus was having a material impact on the economic outlook. Even before the actual decision to cut rates, critics were questioning how effective that action would be given how little room the Fed currently has to manipulate the economy in the event of the next slowdown[4]. Based on the reaction from the stock market, investors also questioned the move either calling into question its efficacy or implying that they wanted something more. Immediately following the announcement, the S&P 500 and other equity indexes rose above their Monday close before selling off as much as 3.6% and continuing their slide.

For individual investors, it is important to keep in mind your long-term goals and not make rash decisions when things get a little chaotic. It is human nature in times like these to have a reactionary response that leads to buying high when stocks are rising and things seem safe and then selling low when fear takes over[5]. Working closely with your advisor before even considering a shift to more conservative investments will help you gain clarity whether your actions are intended to be a way to sit out the storm in the short-term, or whether this is a long-term change to your investment strategy.

OUR MARKET SIGNALS

CIGNX (Economic Strength Indicator)
 
CIGNX is our indicator for determining the health of the United States economy and the chance of an upcoming recession. A recession is two consecutive quarters of negative GDP growth; thus, it is impossible to know with 100% certainty that we are in a recession until 6 months after it has started. CIGNX aims to circumvent this 6-month delay. CIGNX gives us a measure of the strength and trend of the U.S. economy on a scale of 0% to 100%. Anything above 50% is a positive trend; anything below is a negative trend. When the reading dips below 40%, a recession may be nearing and our models would be adjusted accordingly. It is used as an input for managing our Dynamic and 401(k) Allocations.

CIGNX’s current reading is 32.5%, which is an increase of 1.9% from last month’s revised reading of 30.6%. This remains below the 40% level that would normally necessitate a reduction of risk within allocations, but is enough of a rebound from the current cycle low to switch its reading from negative to positive. As a result, we will be placing trades this week within our dynamically managed allocations to increase risk levels to halfway between their maximum and minimum levels. They will stay this way until Alpha and Omega also reverse their signals.

Alpha/Omega (Equity Market Indicators)

Alpha and Omega are a pair of equity market indicators managed by our partner firm Titan Capital Management. Alpha is a short-term indicator that tends to be more active, while Omega indicates longer-term trends and is less active. We use these models to provide input for our Hedge, Large, Mid and Small Cap models; as well as our Dynamic and 401(k) Allocations.

There were no changes in either Alpha or Omega this month. Both indicators remain negative and the models managed by Titan Capital continue to provide a hedge against market volatility.