Over the last month, the COVID-19 disease has turned everything on its head. We have changed from complacency to acute awareness of our surroundings, from social beings to suspicion and isolation, from personal interaction to representation by Face Time and Zoom, from expectations of a functioning society to concerns of shortage. It is all due to a microscopic bug, and perhaps even more importantly, our reaction to it.

The Economy

This newsletter is called Outlook & Trends, because the Outlook for the future can usually be extrapolated with a fair degree of accuracy from observable Trends. Occasionally there are points of discontinuity that make some trends of the past irrelevant. This may be one of those times. The fact that we have seen unemployment of 3.5% recently means nothing today, if the Federal Reserve's estimate of 32% turns out to be correct. The fourth quarter 2019 GDP increase of 2.4% means little, if April-June results are an annual contraction rate of -10 to -15% as suggested by some economists.

The Markets

The value of the stock market fell 34% over four weeks. This was the fastest 30% decline ever seen from a prior peak. Faster than 1929. Faster than 1987, 2000, or 2008. Government backstop policies have arrested that fall, at least for the moment. Adding to the distress, typical diversification strategies also did not help much. Long-term treasury bonds fell 13% over eight days, and corporate investment-grade bonds dropped 21%. Excessive volatility was commonplace. One 9.2% daily gain was more than erased by an 11.63% loss the following day. These movements are more typical of an entire year’s change than a day.

We have previously mentioned that the media somehow changed the definition of a bear market to describe a down trend based on meaningful economic conditions to an arbitrary definition of a 20% drop. We have been reporting the status of the Dow Theory definition that recognized the bear in late 2018. It has never changed since then, because the Transportation Average never regained its prior highs. The Dow Industrials may have been rising and unemployment low, but the economy remained weak under the surface. The venerable Dow Theory has apparently been vindicated and is not likely to change its prognosis any time soon.

The Response

In our opinion, one of the reasons that the financial markets reacted so strongly and quickly is that they have been propped up by Federal Reserve rescues over the last several decades whenever conditions threatened a bear market. This support was first called the “Greenspan put”, combining references to former Fed Chairman Allen Greenspan, and a “put option", a financial instrument that protects against loss. The policy of providing monetary support has led market participants to believe that market risk is minimal, overextend themselves, and contribute to the historically excessive valuations (and risk) seen through much of the last two decades, including market peaks in 2000, 2007 and now.

We have also referred in the past to an analogy from the book, Ubiquity: Why Catastrophes Happen, describing a sand pile that grows by dropping grains of new sand on top. Eventually the pile becomes large and unstable. An added grain may stick and make the pile larger, or it may hit a vein of structural instability that runs through the pile and result in an avalanche of sand. The grain is not the cause of the collapse, it is only the trigger. The weakness was latent within the structure of the pile itself. It is only a matter of time before a grain hits the right place and a collapse occurs. One cannot tell in advance how extensive the avalanche will be. It is based on the characteristics of the vein of instability. The good news is that after an avalanche, that particular instability is removed and more sand may be added.

Currently, it is not really the virus that is causing the economic problem. It is only the trigger that has released the economic sand. Similarly, it is not possible to know in advance where the problem will end and recovery will begin. However, in the case of the economic and market sand pile, each time a government rescue occurs, risk is reduced only temporarily. Valuation risk soon begins to grow again, starting from an ever higher level. The difficulty is that, like a drug dependency, the disease is the medicine itself. Instead of rushing to the rescue with a “Fed put", in the current pandemic terminology it may be better to “flatten the" economic contraction “curve” with as little intervention as necessary to mitigate the damage, until the economic disease plays itself out.

The medicine currently being implemented would never have been considered before the “Fed put". Ben Bernanke called the idea of giving cash to all citizens “helicopter money”, being similar to indiscriminately throwing cash out of a helicopter. Other policies intended to keep workers employed and assure that a viable economy still exists by the time the virus is subdued include other unfunded handouts. Not long ago, the idea of funding government expenses by printing money was considered irresponsible. That constraint is being further removed by the idea of Modern Monetary Theory, also known as the Magic Money Tree. Whether this change in financial restraint is the necessary prescription to save the current political and economic patient is unknown. If so, it must be done, but the cost is likely to be an even more difficult cure next time.

The duration of the pandemic is not currently known. However, if the Fed employment and GDP estimates are anywhere close to reality, expectations of investment performances should be restrained at least until a change in the intermediate trend is seen. Some, including the administration, believe that the economic recovery will be fairly quick and very strong. Others see the likelihood of continued decline.

In the interim, the markets have given a gift to those who can benefit from a discount on stocks. This includes younger investors for whom lower purchase prices will add to their long-term returns. It can also help those who have substantial money trapped in traditional IRAs. They have the opportunity to convert traditional IRA account investments near market lows to a Roth IRA account, and pay no tax on the gains enjoyed as the market recovers, rather than pay ordinary income rates. Similarly, although not as beneficial, if withdrawals from a traditional IRA are made near a market bottom and are reinvested in a regular investment account, their price recovery will be taxed at potentially lower dividend or capital gains rates.

These can be troubling days from both a health and financial perspective. Having a financial plan prepared and operational can help. We suggest creating or updating your plan once the current conditions stabilize. LFM&P is ready to help when you are.