It is starting to look as if the next Black Swan for the economy and stocks is the new coronavirus making its way around the world. In February the stock market behaved like in the 2007—09 financial crisis. The 10% drop from the peak was about the fastest on record for stocks. As we have been running our portfolios on the low risk side for quite some time, going into this mini-crash we performed relatively well.
The most startling action was actually in bonds. The decline in interest rates that started in late 2018 rapidly accelerated, leaving the U.S. with 10-year government bond yields at around 1%. We've previously discussed the possibility of our bond market heading to European and Japanese interest rate levels. These regions have long had rates of zero percent and below because of low economic growth, among other issues.
This 'How low can you go?' possibility was one reason we continued to own long-term investment grade bond funds. This helped our portfolios to avoid much of the downside last month, but it is now necessary to find alternative options. The upside from these bond funds is now limited, as is their offsetting protection against further stock losses. On the last day of the month we carried out a fairly extensive trade, largely to achieve two goals: to reduce our exposure to longer term bonds, and to shift more of our portfolio abroad — even to China.
This still leaves us with plenty of room to increase our stock allocation if this turns into a 2008 grade event with a 20—50% slide in stocks and a recession. The question remains: why would that be caused by a health event that to date has caused fewer deaths than die from cigarettes in China every day, and far fewer than the number of ordinary flu-related deaths per season? This is where we get into Black Swan territory — the unforeseen event that triggers major problems everywhere.
We are still at a point where all this could cease to be an issue, and the economic disruptions only create stock-buying opportunities — one more 'buy on the dip' moment. But the potential for Covid-19 to trigger something bigger is real. The main problem — which we have discussed before — is that our country is not positioned well to fight a sudden recession. We already have low interest rates, tax cuts, and government spending far in excess of tax revenue. We are in stimulus mode now. It is also not clear how more tax cuts and rate cuts would help.
On March 3 the Fed made an emergency interest rate cut of 0.50% and the market still tanked. It probably didn't help that the President said it was not enough, as so much of this is a matter of confidence. The issue this virus-related economic slowdown event creates is similar to how, when real estate prices started to decline, it exposed how risky real estate loans had become — there was no room for price declines.
Today there are many corporate borrowers who probably couldn't handle a major disruption to their business and still continue to make debt payments. This includes many commodity-related companies, such as popular master limited partnerships (MLPs) that transport energy products (which we used to short until the fund was liquidated for lack of interest). We could see a radical drop in energy consumption, beyond that experienced in the last recession. There are also companies that will be unable to obtain materials with which to make goods to sell. Much of the travel and leisure industry is facing lower volumes than in a recession, if this problem doesn't go away soon. Then there are the unknown liabilities that insurance companies may have; not so much in life insurance, but in business interruption insurance which may or may not include contagion coverage.
The best hope right now is that before businesses start missing debt payments, travel can resume, either because some sort of vaccine appears, or it turns out that the mortality rate for most people is low enough for it to seem flu-like. Until the risk of being quarantined or having your flights canceled is gone, there will be significant economic fallout globally. It would also be nice if we waived all the tariffs added against China and other countries in recent years, at least temporarily. Don't hold your breath.a.php?ticker=DZZ&pg=d">
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It is starting to look as if the next Black Swan for the economy and stocks is the new coronavirus making its way around the world. In February the stock market behaved like in the 2007—09 financial crisis. The 10% drop from the peak was about the fastest on record for stocks. As we have been running our portfolios on the low risk side for quite some time, going into this mini-crash we performed relatively well.
Our Conservative portfolio declined 1.78%. Our Aggressive portfolio declined 3.03%. Benchmark Vanguard funds for February 2020 were as follows: Vanguard 500 Index Fund (VFINX), down 8.24%; Vanguard Total Bond Market Index Fund (VBMFX), up 1.71%; Vanguard Developed Markets Index Fund (VTMGX), down 7.56%; Vanguard Emerging Markets Stock Index (VEIEX), down 3.71%; and Vanguard Star Fund (VGSTX), a total global balanced portfolio, down 3.80%.
The most startling action was actually in bonds. The decline in interest rates that started in late 2018 rapidly accelerated, leaving the U.S. with 10-year government bond yields at around 1%. We've previously discussed the possibility of our bond market heading to European and Japanese interest rate levels. These regions have long had rates of zero percent and below because of low economic growth, among other issues.
This 'How low can you go?' possibility was one reason we continued to own long-term investment grade bond funds. This helped our portfolios to avoid much of the downside last month, but it is now necessary to find alternative options. The upside from these bond funds is now limited, as is their offsetting protection against further stock losses. On the last day of the month we carried out a fairly extensive trade, largely to achieve two goals: to reduce our exposure to longer term bonds, and to shift more of our portfolio abroad — even to China.
You will no longer see them in the performance tables for the month, as we sold them at the end of the month, but the February returns were pretty high for our doom and gloom holdings that we sold: Vanguard Extended Duration Treasury (EDV) up 8.24%, Proshares Ultrashort Russel2000 (TWM) up 17.68%, and PowerShares DB Crude Oil Dble Short (DTO) up 25.61%. The losers of the month include Vanguard Utilities (VPU) down 9.99%, Vanguard Telecom Services ETF (VOX) down 5.63%, iShares MSCI Italy Capped (EWI) down 5.35%, Proshares Ultrashort NASDAQ Biotech (BIS) weirdly down 2.33%, as biotech had seemed like a solution to the outbreak, and Gold Short (DZZ) down 1.4%. These are not our exact returns as we sold these positions during the day on February 28.
This still leaves us with plenty of room to increase our stock allocation if this turns into a 2008 grade event with a 20—50% slide in stocks and a recession. The question remains: why would that be caused by a health event that to date has caused fewer deaths than die from cigarettes in China every day, and far fewer than the number of ordinary flu-related deaths per season? This is where we get into Black Swan territory — the unforeseen event that triggers major problems everywhere.
We are still at a point where all this could cease to be an issue, and the economic disruptions only create stock-buying opportunities — one more 'buy on the dip' moment. But the potential for Covid-19 to trigger something bigger is real. The main problem — which we have discussed before — is that our country is not positioned well to fight a sudden recession. We already have low interest rates, tax cuts, and government spending far in excess of tax revenue. We are in stimulus mode now. It is also not clear how more tax cuts and rate cuts would help.
On March 3 the Fed made an emergency interest rate cut of 0.50% and the market still tanked. It probably didn't help that the President said it was not enough, as so much of this is a matter of confidence. The issue this virus-related economic slowdown event creates is similar to how, when real estate prices started to decline, it exposed how risky real estate loans had become — there was no room for price declines.
Today there are many corporate borrowers who probably couldn't handle a major disruption to their business and still continue to make debt payments. This includes many commodity-related companies, such as popular master limited partnerships (MLPs) that transport energy products (which we used to short until the fund was liquidated for lack of interest). We could see a radical drop in energy consumption, beyond that experienced in the last recession. There are also companies that will be unable to obtain materials with which to make goods to sell. Much of the travel and leisure industry is facing lower volumes than in a recession, if this problem doesn't go away soon. Then there are the unknown liabilities that insurance companies may have; not so much in life insurance, but in business interruption insurance which may or may not include contagion coverage.
The best hope right now is that before businesses start missing debt payments, travel can resume, either because some sort of vaccine appears, or it turns out that the mortality rate for most people is low enough for it to seem flu-like. Until the risk of being quarantined or having your flights canceled is gone, there will be significant economic fallout globally. It would also be nice if we waived all the tariffs added against China and other countries in recent years, at least temporarily. Don't hold your breath.a.php?ticker=DZZ&pg=d">