On February 29th, we sent a Heritage Update on the Impact from the Coronavirus (COVID-19) Outbreak. In that communication, we provided a broad context on market declines during previous epidemics and presented at a high level our expected portfolio response. Since then, global markets continue to face high levels of daily volatility and we want to update you with more specifics surrounding the potential economic impact of COVID-19 and what portfolio adjustments we may make.
Communications decisions during times like this can be challenging philosophically for wealth managers. We know our clients have questions and concerns and we want to help you navigate these stressful markets, while not deviating from fundamental tenets of successful investing. Enduring periodic times of high market volatility and unexpected negative events have historically been normal aspects of a functioning market. And, true financial reward is ultimately delivered to those who maintain a disciplined long term investment strategy, especially in the face of adversity.
Therefore, let us start by emphasizing that while the speed of this recent stock market decline has been noteworthy, the overall percentage decline has not. As you can see in the S&P 500 chart below, over the past 40 years the average intra-year U.S. stock market pullback has been -13.8% and so far, we are down about 18% from the recent peak. While things could definitely get worse before they get better, we believe that markets will eventually rebound and long-term investors will continue to reap the attractive annualized returns of the stock market.
Source: J.P. Morgan Asset Management, FactSet, Standard & Poor’s as of March 5, 2020.
Source: YCharts (2/19/2020 – 3/9/2020)
It is reasonable to assume that global economic activity will retract in the near term as the world tries to slow the rapid spread of COVID-19. Slowdowns in manufacturing, interruptions to supply chains, and travel restrictions will have a negative economic impact, as will the damage to more sensitive specific industries and sectors.
We cannot predict the extent of the potential economic decline, nor the exact timing of the slowdown and eventual recovery, nor do we think anyone else can. We do know that stock markets are a leading indicator of future economic activity, which simply means that stock markets move in anticipation of economic events down the road and not after they have been confirmed. Therefore, just as this stock market sell-off is signaling slower economic activity, the market typically begins rebounding before the economic slowdown bottoms out. This is a round-about way of saying that we can’t wait for signals in the form of actual economic data to tell us when to get in or out of the stock market.
At Heritage, we don’t try to time the markets in an attempt to avoid short-term declines since determining when to optimally buy or sell is a fool’s game. It’s time in the market, not timing the market, that delivers the best long-term results.
We build long-term investment strategies to stand the test of time after clearly understanding your financial situation, and most importantly, when you will need to withdraw assets from your portfolio and in what amounts. The asset allocation and design of your portfolio was structured to avoid having to sell a meaningful amount of equities at a loss when markets decline to meet your spending needs. When the stock market is down, we generally withdraw from other asset classes to fulfill your short and intermediate cash flow needs and allow your stocks the opportunity to recover from corrections or bear markets.
Interest rates have also been plummeting at an unprecedented level during this stock market decline, which has pushed bond prices to all-time highs. Last week, the Federal Reserve Bank implemented an unexpected 0.50% rate cut and the 10-year Treasury note just recently dropped below 0.50%. It’s times like these where diversification plays an important role and it’s nice to have a multi-asset class portfolio when facing withdrawal needs.
Discipline is extremely important. Reacting to a stock market decline can be tempting, but in our professional view, there are three paths to consider:
1. Reduce risk to limit losses assuming markets continue to decline
2. Increase risk by buying assets at cheaper prices
3. Stay the course, consistent with a long term strategic approach
There are pros and cons to each option.
Option #1. At Heritage, we believe our clients’ portfolios already have enough protection in place so additional risk reduction is typically not necessary. The diversification we employ reduces risk from any single equity market and we do not maintain concentrated portfolio positions. Additionally, taking the path of risk reduction comes with an opportunity cost, because at some point, markets will rebound and investors could be left with too conservative an allocation, causing them to miss your their share of the recovery.
Option #2 is tempting. “Buying low” is a great way to make money long term. However, if investors increase risk too early, it could exacerbate losses on a greater decline. Good investors, with a diversified portfolio, frequently choose this path, but the hard part is determining exactly at what level to increase risk. We will discuss this option further below.
Option #3 reflects the strength of a long term prudent and successful investment plan. It historically works since markets have rewarded patient, disciplined investors who accept the ups and downs of the markets while strategically rebalancing their portfolio when opportunities arise.
What guides Heritage’s investment strategy in these circumstances? We choose a combination of options #2 and #3. We don’t want to jump into a modest decline, such as an average calendar year -14% “correction”. However, when you get to a more substantial pullback or bear market, such as a 20% to 30% drop, these have historically presented excellent buying opportunities. At these levels, you will rarely regret adding to equities with a long term perspective. As in the past, we regard a 20% decline from the top in the U.S. or global stock markets as an attractive opportunity to add stocks to your portfolio while reducing exposure to bonds and/or alternative investments. This could happen by a combination of rebalancing the portfolio back to its initial target weights and increasing the target allocation to stocks. The extent of the buying opportunity will be dependent on the severity of the decline and we have internal triggers in place to take advantage of these opportunities if they arise.
At Heritage, we aim to deliver sensible and prudent investment strategies to stand the test of time while accounting for inevitable market declines. We’re here to help you look past the short term headlines and noise in the media that can sidetrack non-disciplined investors and instead focus on your financial planning goals and achieving sound long term investment results. We will continue to monitor daily market moves and implement changes in your portfolio as appropriate. As always, if you have any questions, please reach out to your wealth management team and look for additional communications as we work our way through these unusual times.