Coronavirus Portfolio Update
Last week we updated the Crying Wolf Barometer (CWB) after the S&P 500 made new highs on February 19th. The Coronavirus, officially known as COVID-19, first hit the news wire on January 24th. News of the mysterious new virus led to a 3% sell-off in stocks. After it appeared the virus was successfully contained, markets bottomed out on January 31st. The S&P 500 then rose 5% and once again made new highs. What a difference a week can make. The virus has escaped China and has moved from being an epidemic (an outbreak of disease that attacks many peoples at about the same time and may spread through one or several communities) to a pandemic (an epidemic that spreads throughout the world). Stocks sold off more than 8% on this news and are now down 3% for the year.
The impact this virus is having on human health is, of course, the primary concern. Nevertheless, our job is to understand the economic impact and position portfolios accordingly. Since we are not experts in virology, we don’t have the competitive advantage of understanding this virus at a deeper level than the general public. While we are spending time reading and listening to the experts, it’s foolish to think we somehow are more expert than the average person. A critical component of our investment process is accepting this reality. That’s why we do our best to avoid allowing headlines to affect our decision making. That said, some headlines such as the Coronavirus have the potential to greatly impact the economy and we need to closely monitor its economic impact. Generally speaking, headlines move markets short-term, economics move markets long-term. Currently, we are not looking to shift to a more defensive position. That may change. Last week we wrote about our concern that stocks were becoming a little “frothy”, specifically that stock prices had outpaced stock earnings and stocks were trading at an 18.7X multiple to earnings. With this current sell-off, our frameworks are now telling us that stock valuation has returned to neutral.
Periods like this are trying for all investors. It’s also a good reminder of why proper portfolio construction is so important. During good times, it’s easy to question why you don’t own more stocks. During times like these, we quickly understand the benefit of owning negatively correlated bonds. Not only do bonds provide positive returns when stocks sell-off, but bonds also lower the overall volatility of the portfolio. This means your portfolio compounds more efficiently. Efficient compounding is a critical component in maximizing your wealth. Here is an example of two investors, Investor A and Investor B; Both investors are given $100 to invest. Investor A decides not to diversify her money. She buys an individual stock that is highly volatile but has an average return of 25% a year. Investor B decides to invest her money in a diversified portfolio that is much less volatile but averages only 10% a year. Two years later both investments perform as expected. As the table below shows, despite the higher average return that Investor A achieved, she ended up with less money than Investor B. Investor A’s higher volatility led to inefficient compounding which harmed her ability to accumulate wealth.
No one can predict with certainty what the economic impact of COVID-19 will ultimately be. Some are forecasting an economic collapse with worldwide travel and trade coming to a halt. Others expect that COVID-19 long-term will have no more impact than the seasonal flu. Regardless, the fear of Coronavirus in the short-term has and will lead consumers to travel less and spend less money. Being around crowds at restaurants or entertainment venues is suddenly undesirable. This definitely has a negative short-term impact on the global economy, but we don't expect this will lead us into a recession. Obviously, if the more dire predictions of the Coronavirus are realized than a recession may very well be the result. While it’s still very early, through the end of last week there were no signs the COVID-19 is harming S&P 500 revenues or earnings. It should be noted that analysts have been cutting their Q1 and Q2 estimates though, which partly explains the sell-off in stocks.
The primary tenet of GreenPort's investment process is that the long-term relationship between observable economic data and financial markets repeats itself over longer-term investment horizons. Our process explicitly acknowledges the lack of explanatory power that short-term forecasting has. This has treated our investors well. While we don't want to bury our heads in the sand during periods like this, we must also resist letting emotion get the upper hand over logic. We will continue to monitor the economic data and markets. If we see a new trend developing, we will adjust the portfolios. In the meantime, we are not making any major shifts in the portfolios. Stay Healthy, The GreenPort Team