Second Quarter 2020: Recovery

The question we are asked more than any other these days goes something like this: how is it possible that the stock market has recovered so strongly since March while the economic and other news has been so bad? We feel obliged to answer this question, and we will shortly, but before doing so we need to get our hedges in. We simply don't know yet whether the stock market is accurately foretelling a return to normal economic growth or if its recovery is just a temporary, artificially sweetened pop. 

 Here are four big reasons the stock market rebounded so strongly in the second quarter. 

1. The federal fiscal stimulus in response to the coronavirus pandemic was fast and large. On March 27th, the U.S. Congress appropriated more than $2 trillion dollars to be transferred to individuals, businesses, and state and local governments. This is not only much larger than the fiscal stimulus following the 2008/9 financial crisis, it went out much more quickly and more of the money got directly into the hands of people who needed the money right away. Large as it was, this CARES Act stimulus was only part of the federal response, and another large stimulus package looks to be on the way.

2. There has been unprecedented monetary stimulus. The Federal Reserve revived and vastly expanded its playbook of monetary moves from the 2008/9 financial crisis, intervening with more money in more markets. Starting with a balance sheet of less than $1 trillion in 2007, the Federal Reserve added about $1.2 trillion to its balance sheet in the first 18 months of the financial crisis. Then its quantitative easing program gradually expanded the Federal Reserve's balance sheet from $2 trillion to about $4 trillion by 2014, where it stayed until the coronavirus crisis. In the last 6 months, the Federal Reserve has conjured money to purchase a huge array of assets, adding a further $3 trillion to its balance sheet.

Although the Federal Reserve has not yet purchased stocks, its actions no doubt indirectly elevated stock prices. Three trillion is a figure too abstract to understand, but for context it is about 15% of the entire annual output of the U.S. economy and just shy of 10% of the worth of all U.S. stocks. The Fed’s actions kept a broad array of debt markets liquid and functioning and kept many interest rates much lower than they would have been otherwise. Suppressing interest rates toward zero makes stocks look relatively more attractive (see the Broken Bond below). Even income-seeking investors are pulled toward stocks, where the S&P 500 dividend yield of 2% towers over the yield on a 10-year Treasury bond.

3. Prospects improved throughout the quarter for a Covid-19 vaccine, or even multiple vaccines, coming to market in record time. Vaccine development has historically been measured in decades, not months. And, to be clear, there are still serious hurdles for any Covid-19 vaccine candidate to overcome. But it is also fair to say that what once seemed impossible - going from identifying a new virus to successfully designing, testing, and manufacturing an effective vaccine in 12 to 18 months - now does seem possible, maybe even likely. It is way too early to predict victory (and the history of viruses and vaccines suggests victory will only be partial), but suffice it to say that getting an effective vaccine to hundreds of millions of people next year would count as one of the all-time great scientific achievements. Credit goes to governments, scientists, philanthropists and - yes - pharmaceutical companies around the world for their effort. The market has clearly been lifted by near-term prospects for a vaccine.

4. We regularly remind clients that stocks are not pieces of paper or blips on a screen, and this crisis reminds us again that businesses are dynamic, adaptive, and creative organizations with a drive to survive. We read nearly every day, or just see with our own eyes driving around, the sad stories of the many businesses that closed permanently due to the effects of the pandemic. But the larger story, especially among the companies that comprise your portfolio, is that most will survive to thrive again someday. Businesses large and small have pivoted to figure out new ways to serve customers. We've now listened to business updates on many first and second quarter earnings calls and it is remarkable how many businesses have adapted quickly and successfully to the new conditions. While the full effects of the economic downturn are not evident yet - it is important to remember that caveat - most of the businesses that comprise the market and your portfolio have managed surprisingly well so far.

So, yes, it is true that the news flow is relentlessly negative. Virus-related case numbers and deaths are distressingly high. Economic activity is down. Unemployment is historically high. Rightly or wrongly, all that news was outweighed by those four factors to drive stock markets around the world higher in the second quarter.

The Broken Bond

An equally noteworthy development during the second quarter of 2020 was the continued drop in interest rates. The stock market recovery seemed to tell a story in the quarter of an imminent return to economic growth and stronger business conditions. The bond market, partly or mostly due to the Federal Reserve's appetite for buying bonds, painted a murkier picture. During the first quarter of 2020, the 10-year Treasury rate fell from 1.92% to 0.70%, a classic flight to safety but to record low levels for U.S. rates. One might have expected Treasury rates to bounce higher under the same assumptions as the stock market in the second quarter, but in fact they stayed essentially the same and even dropped a little (ending at 0.66%). Today, the purchaser of a $100,000 U.S. 10-year bond will earn just $660 interest each year (for a total of $6,600 over the ten-year life of the bond).

Bonds used to serve two purposes in constructing a portfolio. They generated income in the form of interest payments and they acted as a stabilizer, holding their value when stock prices declined. It is important for savers and investors today to understand that, for the moment, that first role for bonds has essentially disappeared. It is very difficult to find safe sources of much income in the bond market today. The prudent course for that portion of clients' portfolios needed to satisfy spending needs over the next several years is just to be satisfied with principal protection rather than seeking higher income from uncertain sources. The cost of this prudence will be low or no expected returns from bonds in the near term.

Is It Possible the Rest of the World Will Outperform the U.S. Going Forward?

A big anomaly in stock markets over the last ten plus years has been the vast outperformance of U.S. stocks compared to other developed markets (mainly Europe and Japan). We don't know what, if anything, might spark a reversal of fortune on this front. Our common sense tells us that starting from a much cheaper valuation should give a boost to foreign stock performance, but sometimes a catalyst is needed. We wonder if it is possible that the vastly better response to the virus by the rest of the world will generate relatively better economic or market outcomes? Or is it possible that the recently announced European stimulus plan, a markedly different response than their austerity-driven response to the 2008/9 financial crisis, will lead to a stronger fundamental rebound in Europe? Similarly, could a strengthening European Union (contrasted to one that appeared on the verge of disintegrating a decade ago) lead to a stable or appreciating Euro (a major reason non-U.S. stocks underperformed so badly was currency headwinds)? In short, we think it is possible.

On that front, we made some changes to our international developed markets fund lineup during the quarter. We added a new fund, the Vanguard International Dividend Appreciation Fund (VIGI), and increased our weighting in the Vanguard FTSE Developed Markets Fund (VEA). We have been using the U.S. version of the dividend appreciation fund for a while now to balance out our exposure to value stocks. We like these funds because they give us exposure to companies benefiting from long-term secular growth trends without forgoing an emphasis on fundamental underlying value (what we get for what we pay). Companies that regularly pay a growing dividend to investors are also typically among the strongest financially and offer a complement to more cyclical names common in value-oriented portfolios. Both funds are very low cost and passively managed.

Large-Cap Value (LCV) Stocks Review

(Not all clients of Bristlecone are invested in our Large-Cap Value Equity portfolio strategy, depending on the size of the overall portfolio, and the client's objectives and constraints.)

The average LCV portfolio delivered positive returns about midway between the S&P 500 (+20%) and the Morningstar Large Value Index (+11%) during the 2nd quarter. Top performance detractors for the quarter included Berkshire Hathaway, Graham Holdings, Markel, Nutrien, and Wells Fargo. Top performance contributors included Adient, Facebook, HanesBrands, Liberty Media and Polaris.

We were unusually active during the quarter due to the market volatility. We sold two holdings whose businesses we thought were likely to be disproportionately negatively impacted by this recession: Expedia (we discussed the sale of this online travel agent in our 1Q commentary) and Aggreko (a provider of temporary power solutions with exposure to large events, such as the Olympics, and the oil and gas industry.) We also trimmed Pfizer, among our best performers during the downturn.

We used the proceeds to add one new position to the portfolio: Howard Hughes Corporation (HHC). Howard Hughes (the person) was known mostly as a larger-than-life aviator and filmmaker, but he owed much of his business success to real estate investments, including nearly 25,000 acres he acquired just outside of Las Vegas. That development, known as Summerlin now, forms part of the holdings of HHC today.

HHC holds a large, eclectic group of real estate properties, ranging from projects in development to income producing properties, including office towers, master planned residential communities (like Summerlin), and retail. Holdings span from Hawaii to New York, but are concentrated in Las Vegas and Texas.

The coronavirus pandemic is sure to have a large impact on real estate trends and that is no doubt why the stock lost two-thirds of its value in the March downturn. We have actually tracked the company for several years and declined to add it to the portfolio earlier (at much higher prices than we eventually did) because we didn't feel it offered a sufficient margin of safety. The precipitous drop in price changed that risk / reward calculation. We believe a poor near- and intermediate-term outlook for retail and office properties is outweighed by the long-term value potential of its properties, especially the large master planned communities that are likely to benefit greatly from housing trends over the next decade.

We also increased our position in Graham Holdings, a mini-conglomerate we've owned for a long while now. Primary businesses include local broadcast TV stations and the Kaplan education subsidiary. The real value is in a long-term, value-creating, owner-oriented management that has a proven ability to build long-term shareholder value.

We welcome your feedback and questions. More than ever, we wish you good health and peace of mind.