Before beginning this quarterly review, I want to preface my remarks by framing the quarterly performance statistics with a word about the pandemic that has suddenly changed all of our lives.
A financial professional relies on statistical analysis methods similar to those used by public health authorities to predict hospital utilization and deaths from the Coronavirus.
This chart is from the Institute of Health Metrics and Evaluation, an independent public health research center at the University of Washington. IHME is backed by the Bill and Melinda Gates Foundation and this model is relied on by the White House Coronavirus Task Force. It is used with the permission of IHME.
The grim picture shown here is the projected death toll through the end of the Coronavirus epidemic of 2020. IHME expects 68,841 deaths from COVID-19 in the U.S. on August 4, 2020, at which time the epidemic is projected to end.
IHME's projection, if accurate, would exceed the 58,209 Americans killed in the 14-year Vietnam War and the 54,246 American lives lost in the three-year Korean War.
The sickness, suffering, and grief is incalculable, but, according to IHME, it does come to an end.
For investors, especially those depending on their portfolio for retirement income, stocks losing about a third of their value has been frightful, and fear is likely to return before life returns to normal again, but the forecast from public health experts is that the epidemic will indeed end.
That is the statistic that matters most to investors for the long run.
Reports of the outbreak in Wuhan, China, a city of 12 million, started to appear in popular U.S. media outlets in mid-January. Nonetheless, the Standard & Poor's 500 stock index a key growth component in a diversified portfolio closed at an all-time high on February 19, 2020. From the peak to the bottom on March 23, stocks lost 34%, surging in the last week of the quarter. Despite the surge, the S&P 500 posted a -19.6% loss in the first quarter of 2020, and the worst of the coronavirus bear market may be behind us, though it will ultimately depend on epidemiology and social distancing measures in each of the states.
While the -34% loss in the S&P 500 stock index, the low point of the first quarter of 2020, was slashed in nearly in half in the last days of the quarter, losing -19.6% of value in stocks amid an unprecedented public health crisis with no cure in sight is a new kind of risk.
Risks that blindside investors and change the world are a thing that happens.
In his 2007 book, Nassim Nicholas Taleb called such events "black swans."
According to Wikipedia, "Taleb is a Lebanese-American essayist, scholar, statistician, and former option trader and risk analyst, whose work concerns problems of randomness, probability, and uncertainty.
Until Mr. Taleb came along with his book, random unexpected events were simply unknowns. By defining these unknown random events that change the world, Mr. Taleb made such events known unknowns.
While this may sound like philosophers arguing over how many angels can dance on the head of a pin, seeing the coronavirus in this light adds important new perspective on the nature of investment risk.
These statistics add further perspective on the nature of investment risk; the -19.6 plunge was the end of the longest bull market in modern U.S. history.
The losing quarters in red don't stand out so much amid the past 21 quarters.
Past performance can't be expected to repeat itself, but the pattern shown here since 2015 conforms with the history of stocks since 1926, when the modern era of investing began. It also conforms with the 200-year history of U.S. investing documented in Stocks for the Long Run by Prof. Jeremy Siegel.
This is the quarterly total return on stocks - including dividends as well as price appreciation - as measured by the Standard & Poor's 500 over the past 61 months of the 126-month bull market, the longest bull market ever.
The point is that the long arc of history is not straight up. It's usually two or three steps forward and then one step back.
The quarter's pain is captured in these four next slides. The losses were deep and spanned across market the range of securities investments in the U.S. and across the globe. As with the virus, it seemed like there was no place to hide.
Growth stocks as well as value investments, and both large and small companies, suffered losses in the first quarter of 2020. However, small-cap value stocks suffered the worst losses of the major categories, losing -37.4%. Large growth stocks suffered the least damage, dropping -14.5%.
Energy stocks in the three months lost half of their value. The oil market was flooded by oversupply. With stay-at-home orders mandated by governments across the globe and in the U.S., travel by cars, planes, or trains came to a standstill.
Subway ridership in New York City was down by more than 92%. Airlines reportedly slashed seat capacity by more than 70% since January. Demand for gasoline is down by 50% or more in parts of the country.
While demand for oil was plunging worldwide, two of the world's major oil suppliers, Russia and Saudi Arabia, acted out on the world stage in a race to see who could produce the most oil when the market was glutted.
Even technology stocks, which you might think would benefit from the stay-at-home lifestyle, suffered an -11.9% loss for the quarter, and health care stocks the industry tasked with managing the epidemic even they dropped -12.7% in the coronavirus bear market of 2020.
It's likely, in the weeks ahead, you will hear a lot of talk about which industry sectors are the best to benefit from the coronavirus epidemic. Predictions of a crash in commercial real estate are rampant, as are forecasts of explosive growth in tech and biotech.
Please be skeptical. Every crisis spawns sales pitches and outright frauds. The unprecedented nature of the coronavirus epidemic makes it harder to know what to believe. What we are experiencing is almost surreal.
Financial gurus, Wall Street seers, and outright fraudsters are about to bombard shell-shocked investors with sales pitches about which sectors will prosper most from the epidemic.
This scattergraph shows the history of the Wall Street strategists' sector performance based on their predictions published in Barron's for the past 13 years. If Wall Street strategists had been correct, the black dots would all fall along the red line or cluster around it. The randomness of their picks shows that Wall Street cannot predict the best and worst sectors over a calendar year.
This data was compiled by economist Fritz Meyer, a strategist at one of the world's largest investment companies for over a decade before going independent in 2009. We periodically share Mr. Meyer's updates to this chart, and it's worth repeating amid these surreal times. Fritz has been called a national treasure and I am a big fan of his work.
In this data he has collected since 2007, Fritz shows the folly of investment advisors who tell you they can predict the future and actively manage your stock or mutual fund portfolio, that they know which sectors will profit most in the next 12 months from the epidemic.
If Wall Street strategists' predictions had been correct, if Wall Street really could predict which industry is doomed and which will prosper the most, then the black dots would all fall along the red line.
The randomness of the picks shows that Wall Street's top strategists' picks and pans, as published in Barron's every year since 2009, were usually way off the mark.
Here's the takeaway: Past performance is not indicative of future results, but the COVID-19 epidemic does not suddenly make it easier to predict which industry sector will be best or worst in 2020.
Instead of trying to predict the future, rebalancing into undervalued sectors is a prudent choice. It's not as exciting as the stories spawned by coronavirus financial schemes, but it can provide a sensible, low-expense choice for investors over the long run.
Rebalancing systematically buys securities when they're cheap. It's a way to buy cheap based on history rather than trying to predict the future.
This quarterly snapshot of returns for the first quarter from major stock markets across the world shows that China, where the virus started, suffered the smallest price decline.
The Chinese stock market is influenced by government action. The S&P China Broad Market Index declined -10.3% versus the -24.6% plunge in emerging market stocks and -25.1% drop in value in Europe's stock markets, as measured by the Standard & Poor's indexes.
For diversified investors, the coronavirus bear market losses in stocks were mitigated by fixed-income returns. The 10.3% total return on intermediate term bonds softened stock losses in the quarter. Diversification worked.
Another hedge in portfolios, securities in gold mining, also benefited from the rise in fear in the first quarter.
In the 12 months ended March 31, 2020, the S&P 500 lost -7%. It was a year marked by unprecedented financial events, capped by the COVID-19 outbreak.
U.S. interest rates were being kept artificially low because of low rates in Europe. Germany's central bank was trying to stimulate economic growth and dropped rates to negative territory. That meant investors were being paid to own German bunds.
The upside-down bond market caused the German central bank to embark on a quantitative easing program, which dropped yields on bunds. Low yields on bunds sent bond investors from across the world to U.S. Treasurys, pushing up prices on long-term bonds and depressing bond yields.
Artificially low yields on long-term Treasury bonds caused an inversion of the yield curve. A yield curve inversion preceded every recession in postwar history. It's when 90-day Treasury Bills yield more than 10-year bonds. It's a bad sign and the Fed fought it.
With the economic growth at about a 2% annualized rate from April 2019 and running at about 1.8%, the lowest rate of inflation in many decades, the Fed cut lending rates three times to un-invert the yield curve.
The Fed's policy and continued signs of growth on the horizon pushed the S&P 500 to a new all-time high on February 19, 2020.
Then the coronavirus bear market hit. Stocks lost -33.9% from the all-time high on February 19 to the bottom of the coronavirus bear market of the first quarter of 2020.
Small-value style investors took a drubbing in the 12-month period ended March 31, 2020; Standard & Poor's small-company index plunged -30.6% in value.
We are pleased to say that diversified portfolios fared much better in this one-year period that included the COVID-19 bear market.
Large-cap growth investors lost -2.5% in the same period, and large-cap value investments lost -12.2%, a relative minor loss versus small-cap value and mid-cap value investors.
The 12-month growth stock boom is explained by the returns of the tech sector.
Of the 11 industry sectors in the S&P 500, the tech sector was the only one to show a gain, while the other 10 industry indexes showed losses in the 12 months ended March 31, 2020.
Of course, the tech sector included companies benefitting from the stay-at-home culture of this unique period in modern history. Netflix, Amazon, and other tech giants gained +10.4% in the year ended March 31, 2020.
The U.S. stock market is shown here relative to other major world markets.
After trading sideways in 2015 and most of 2016 hitting two air pockets along the way the stock market broke out of that range after the November 2016 election and rose steadily to an all-time peak on September 20, 2018, whereupon it dove by -20% on fears that an inverted yield curve was imminent.
On January 4, 2019, the Fed signaled rates were on hold, whereupon stocks rallied for most of the remainder of 2019.
In February of 2020, stocks hit a new all-time peak, whereupon the COVID-19 virus put the economy and the stock market into meltdown.
Over the last five years, including dividends, the S&P 500 total return index has gained +39%. That figure was +74% for the five years ended just one quarter ago, at the end of 2020.
The five-year gain of +39%, or +7.8% per year, is substantially less than the stock market's long-term annual total returns of approximately +10% going back 200 years, as described by Wharton professor Jeremy Siegel in his seminal book Stocks for the Long Run, first published in 1994.
In the five years ended March 31, 2020, small-cap value stocks and mid-cap value companies were thrown for losses of -8.1% and -7% respectively, while large growth companies returned +57.3%.
The performance of large-cap growth stocks was largely fueled by the tech giants.
When you have dramatic outperformance of an asset class or style in a portfolio, you can see how your portfolio could become too heavily weighted toward the winning assets.
In the current coronavirus market conditions, investors are being bombarded with sales pitches about how tech stocks will continue to outperform and how you want to concentrate your portfolio on them.
But it is prudent to rely on the basic precepts of modern portfolio theory instead.
The gains in large-cap growth stocks stand out in this chart of U.S. stocks by style and capitalization.
Modern portfolio theory is a large body of financial knowledge based on academic research done over the last 70 years.
This framework for investing is now taught in the world's best business schools and embraced by institutional investors.
The world is too dynamic and not enough statistical history exists to make predictions with certainty about which investments will outperform in the months ahead.
Modern portfolio theory is a framework for managing these risks based on financial, economic, and statistical facts.
Classifying investments based on their distinct statistical characteristics imposes a quantitative discipline for managing assets based on history and fundamental facts about the economy.
Of course, human judgment and an understanding of historical performance is critical in applying modern portfolio theory to an individual's portfolio. And this approach does not guarantee success - nothing can. It's called a theory because your investment results can't be guaranteed.
Applying portfolio theory requires periodically lightening up proportionately on the most-appreciated types of assets and buying more of the types of assets that lagged. The exact amount of each asset is set based on your personal preferences, age, and specific circumstances.
Rather than expecting that the future will look like recent past, and that tech stocks will continue to outperform as they have during this period of stay-at-home orders spawned by the epidemic rebalancing forces a discipline in which one would periodically buy more of the assets that declined in value. It is a long-term approach for investing over the long run.
But applying the rubrics of modern portfolio theory requires judgment from a professional and personal attention because the rules of MPT are changing.
For example, emerging markets and foreign stocks have underperformed for years. Whether you diversify into those asset classes is an important decision, and so-called robo-advisors that automatically invest for you, and that are sold by some of the largest retail investment firms, may not be on top of this change in how modern portfolio theory is applied.
If you have questions about this, please let us know.
Over the five years ended March 31, 2020, the S&P 500, the growth engine of a diversified portfolio, was the winner of the return race despite the fact that a bear market occurred in the final three months of the period.
Even in the shadow of the coronavirus bear market, the five-year period was not terrible for stocks.
Of course, no one can predict the future, and the bear market may resume in the second or third quarter, depending on the success of measures to fight the coronavirus.
We remain optimistic that the nation will adhere to social distancing edicts, and that treatments for COVID-19 will improve and a vaccine will be found to eradicate the disease in mid-2021.