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Given the massive volatility on financial markets in the past month we wanted to update some of our thoughts on investment strategy currently. While our offices are running on only revolving single attendees, we’re all working remotely and have the systems and functions such that fund management, research and analysis are are fully operational. The lessons of 9/11 and the Financial Crisis as well as the massive growth of operating software, cloud services and faster processing has allowed many service businesses such as ours to continue to operate normally even in these conditions.
In terms of financial markets, up until a few weeks ago the stock market, particularly in the U.S., had paid little attention to the risks from the Coronavirus. In fact, stocks had hit record highs only a month ago today and were flying high on low interest rates, optimistic views about the economy, some reductions in trade tensions, ‘buyback induced’ earnings growth and massive money flows into passive index funds. All of that changed dramatically as Covid-19 spread across the globe and businesses everywhere went into shut-down mode with little idea as to when things would start to normalize. This had become much, much bigger than just a problem for the cruise industry, airlines and China. On top of all the virus-related risks, OPEC and Russia decided that now was the time to begin a war for market share in the oil industry. While a demand shock was already being experienced due to the reduction in air and other travel as well as generally slowing economic activity, the markets then had to absorb a ‘supply shock’ as Saudi Arabia and Russia both ramp up production and start to offer large price discounts to their larger customers, particularly in Asia. This put much additional pressure on North American markets where both the U.S. and Canadian economies are net energy exported and therefore much more negatively impacted by the slowdown in that industry. Virus issues aside, the energy debacle could take a lot longer to sort itself out and we expect to see multiple bankruptcies and a further headwind for both the banks and the credit markets as many energy companies were highly-levered financially.
Like all downturns in the past, stocks effectively ‘take the escalator up and the elevator down!’ But this is also the first significant downturn we have seen both in the age of social media as well as a time when algorithmic (programmed) passive trading had become the largest players in the market, meaning that automated programs were driving a lot of the selling. The downturn played out in a major way and faster than any other in the past month as the stock market had its quickest 30% downturn on record, including the period after the crash of 1929 and the depression. Investors basically ‘sold first and asked questions later’ and the selling became very indiscriminate as investors, hunger for cash, first sold what they wanted and then began selling whatever we could. Traditional hedges such as gold, failed to provide their normal ‘safe haven status’ as it just became another source of assets that could be sold. While we agree that investors should be worried about the economic impact of the coronavirus since the shutdown of manufacturing and the reduced level of consumer spending and movement will undoubtedly push the global economy into at least a short recession. While our view had been that the stock market was overdue for a correction, the veracity and speed of the downturn has surprised even us. Market volatility has also shot up to record levels in a hurry from all-time lows, but that might be one of the signs we need to see in order for stocks to start to make a bottom. The key measure of stock market volatility, the VIX, has shot up to and above levels seen in the financial crisis and long before that. 
But volatility spikes like that have never lasted for long periods of time and are always associated with stock market lows. One more aggressive strategy we have put in place in our Hedge Fund recently was to begin adding ‘short positions’ to the Fund which are proxy measures of volatility since we expect the volatility to begin to recede. Just like after the stock market crash in 1987, we had some of our largest moves, in both directions, in the following month. Ditto for 2008. The fact that we are becoming accustomed to 1000+ point moves in the Dow Jones on a daily basis is another example of increased volatility after a major market event. But that will start to slow down. In the past week we have seen a few major ‘up’ days as well and are starting to form a bit of a base around the late 2018 lows. While not attempting to be ‘Pollyanish’ about stocks or dismissing the gravity and risk of the viral crisis, we are starting to see some indicators that could indicate at least a short-term bottom in stocks and some stability. Technology stocks, the prior market leader, are starting to show some downward resilience. We added Apple and Microsoft late last week and, despite the continued carnage this week, both stocks are still trading above the levels we bought.
In terms of the market strategy in a nutshell, while we were prepared for some market downside and positioned very defensively, we certainly didn’t foresee anything like the 30% meltdown we’ve seen since the market highs less than a month ago. Our large position in bonds, particularly US treasuries, were a very good portfolio hedge but our other hedges in gold and value stocks have not helped since the selling has been indiscriminate and pretty much “across the board.” First investors sell what they see as having the most risk (i.e. cyclical stocks) but then, in a panic situation, people sell what they can sell. That is where, in our view, the opportunities are being created and we have been putting the large cash balances in client accounts to work. The indiscriminate selling has taken most stock groups down at similar rates, even though many companies and industries will experience a much smaller negative impact from the current crisis. While we admit we’ll never hit a bottom right on and are certainly looking at a few miserable quarters economically, stocks always bottom long before the economic data does and the values we are seeing right now are the types we have seen at prior market lows, much like we did in 2008/9.
Specifically, we have added to those names where debt is not an issue, where earnings are not tied to global economic activity and where the dividend yields are well above average. The pipeline, utility and telecom stocks up here all fit that profile and we have been adding to names like Enbridge, Keyera, TransCanada, Telus, Rogers and BCE. All of those have significant dividend yields which we see little risk of dividend cuts. The pipeline companies mentioned have no debt maturities due over the next two years and are driven more by the volume of liquids and gas moved along their systems, as opposed to the price. Telecom stocks could actually be one of the beneficiaries in this environment as they will see large traffic increases as more business is conducted online and streaming activities continue to replace social gatherings such as concerts and movies. The quick moves by BCE, Rogers and Telus to waive ‘overage fees’ will also help in their public profile as not trying to take advantage of the situation. In the US, the technology sector has been hit hard and yet the earnings will be mostly insulated from the downturn since people are spending even more time online and demanding more data and faster speeds. We have added Apple, Microsoft, Facebook and Alphabet in past few days. Valuations are actually around market multiples, yet the growth rates are far superior, the cash generation is huge and the balance sheets are in great shape. The gold stocks have been surprisingly disappointing, as has gold, but the trader positioning going into this was somewhat overbought so I think the biggest part of the decline is just an unwind of those bets. With the US Fed cutting rates to zero and the US economy heading into at least a two quarter downturn, the US dollar has got to crack at some point and gold will be the beneficiary. It had been rallying even in the face of a stronger dollar until the last few weeks and I expect that strength to resume. It’s also a good longer-term story as a hedge against the monetization of the record levels of global debt (i.e. the South American solution of the 1970s…..only way to get yourself out of a massive debt is to depreciate your currency and reduce the liability…….all very good for gold!)
What we’re also doing is taking profits on the bonds. With US 10-year treasury yields down to 1% and very little likelihood they will go negative, the risk-reward of continuing to own them at this level seems pretty thin. Moreover, if governments begin to enact that fiscal spending that is absolutely necessary to go along with all the monetary easing we have seen lately, we are going to see an explosion in government debts and borrowing which will entail higher interest rates to attract the necessary capital. Another area we continue to avoid is the Financials. Even though they are off more than 30% and looking cheap on book value, they have some serious headwinds ahead with rising loan losses and an interest rate structure not at all conducive to their normal profit models. They make money on the interest rate spread and that has shrunk to almost nothing or even gone negative. Same logic applies to life insurance companies. How can they be expected to fund long term liabilities in the 4-6% range when their risk free rate of return is only 1-2%?
Those are the current strategies. While clearly not a pleasant month for most investors by any stretch of the imagination we think its important to look ahead, like other downturns, to the opportunities that get created for the next cycle and not get overly influenced by the gravity and negativity of the current situation.