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CPWM Market Update – 3/13/2020

This week has brought historic levels of volatility to public markets. This can be unnerving, even when you have a solid plan backed up by a sound investment philosophy and process.

It is a fundamental principle that markets are designed to handle uncertainty, processing information in real-time as it becomes available. We see this happening when markets decline sharply, as they have recently, as well as when they rise. Such declines can be distressing to any investor, but they are also a demonstration that the market is functioning as we would expect. As markets digest such serious information, as we have seen in recent weeks, we believe it is best to stay disciplined to the long-term investment plan that our advisors have helped every client customize to their needs and time horizons.

Our Advisors and Investment Committee are staying closely tuned to market developments, while maintaining perspective on the history of market cycles. We wanted to share some comments from one of our long-time investment partners, Global Endowment Management (GEM), who have been navigating volatile markets for decades across both public and private investments. What follows is part of a response from the GEM team to an inquiry from our Investment Committee:

“The human impact. This is clearly the piece we know the least about, but the facts seem to be:

  • The virus is probably far more widespread than confirmed cases would indicate
    • The fatality rate is modest compared to other similar outbreaks and it seems to have a greater impact on older people or with pre-existing medical conditions
    • We need to slow the rate of spreading the virus in order to have a chance of protecting those people and avoiding overwhelming the healthcare system
      • “Non-drug interventions,” social distancing, staying home, etc. have been effective in countries that have implemented them severely (South Korea, Singapore, etc.). There’s some evidence that our response in the US has been too slow and too late, so we’re expecting the number of confirmed cases to continue to rise as testing is rolled out, and the frenzy around cancellations and quarantines to continue.

The market impact. We thought investors were whistling past the graveyard making all-time highs even as the virus had clearly jumped to South Korea, but it wasn’t until the outbreak in Italy that people seemed to truly digest the implications. The quickest bear market in history and the flight to safety in Treasury bonds has really been stunning.

Global economy impact. The big question is how the global economy will fare. One original framework for pandemics was something akin to natural disasters — there’s an unexpected supply shock that disrupts production, but once the dust settles demand builds up and things reach equilibrium again. After Fukushima a similar dynamic took place with production data recovering pretty quickly.

With all that said, if we look at corporate value rather than stock price, most corporate value comes from expected cash flows that occur years out. Erasing all S&P 500 cash flow in 2020 is estimated to knock off roughly 4-6% of intrinsic value. The current sell-off so far implies that earnings will be erased for the next few years, or that highly levered companies will not have enough runway to survive. The latter is a possibility, but the former seems unlikely to us.”

Historically, US equity returns following sharp downturns have been positive. A broad market index tracking data since 1926 in the US shows that stocks have generally delivered strong returns over one-year, three-year, and five-year periods following steep declines.

Fama/French Total US Market Research Index Returns

July 1926 – December 2019

Past performance is no guarantee of future results. Periods in which cumulative return from peak is -10%, -15%, or -20% or lower and where a recovery of 10%, 15%, or 20% from trough has not yet occurred are considered downturns. For the 10% threshold, there are 3,442 observations for 1-year look-ahead, 3,396 observations for 3-year look-ahead, and 3,345 observations for 5-year look-ahead. For the 15% threshold, there are 3,175 observations for 1-year look-ahead, 3,167 observations for 3-year look-ahead, and 3,166 observations for 5-year look-ahead. For the 20% threshold, there are 2,561 observations for 1-year look-ahead, 2,560 observations for 3-year look-ahead, and 2,560 observations for 5-year look-ahead. 1-year, 3-year, and 5-year periods are overlapping periods. The bar chart shows the average returns for the 1-, 3-, and 5-year period following market declines. Data provided by Fama/French, available at mba.tuck.dartmouth. edu/pages/faculty/ken.french/data_library.html. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. Short-term performance results should be considered in connection with longer-term performance results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Investing risks include loss of principal and fluctuating value. There is no guarantee an investment strategy will be successful. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

We believe that in order to capture the recovery, you need to stick to your plan. The key in these moments is calm, long-term thinking – avoiding a bad decision that could harm your thoughtful long-term strategy. One of our recent articles on our Blog seems to be even more relevant in light of the volatility and we should all remember to Make “Space” to Improve Your Financial Decision-Making and focus on the long-term plan.

We want to remind all of you that we are here to help and available for any questions anytime.