News & Media

Things I Think and Things I Know

Jeremy Hutzel | Mar 21, 2020

I've been asked a lot for my opinion lately. At the risk of sounding like a broken record, here is where I THINK we stand today.

The impact of the coronavirus scare, and the global social distancing and/or quarantine, is going to have a very significant impact on short term demand. Hopefully, this is no greater than a two-month demand shock. But make no doubt about it, it is likely the most significant demand shock in the shortest period of time that we have experienced in our lifetimes.

Why this is problematic? For starters, it is very painful for certain industries: hospitality, travel, retail, restaurants, etc. But for all businesses - particularly small and medium sized businesses without access to credit and commercial paper markets - it's rapidly becoming a top line revenue issue. Accountants make a lot of adjustments to a company's income statement, and CFOs can sometimes delay the recognition of a certain expense or delay starting a project to influence bottom-line earnings. And let’s not forget all non-GAAP disclosures that are found in the footnotes of a modern-day income statement. (Shout-out to my personal favorite: community-adjusted EBITDA, found on WeWork's financials.)

But you can't really fake top line revenue. Revenue is a cash flow story, and cash flow is king for running a business. (No wonder Mr. Buffet likes to focus on it!) How long can these businesses maintain solvency while continuing to have expenses such as lease payments, payroll, insurance, vendors and suppliers, etc. with little or no revenue coming in the door?

So, what I THINK is that we have two possible courses for the recession that I believe we are headed into. It could be a mild one, or it could be a severe one. And which course we take will be largely dependent upon a fiscal policy response from the United States government. To clarify, fiscal policy is not the same as monetary policy enacted by the Federal Reserve. The extraordinary measures announced by the Federal Reserve yesterday target liquidity in our capital markets, and specifically our credit markets. Their actions are designed to keep the system working and to ensure banks have access to ample capital to continue to loan to businesses, individuals, and to other banks. In fact, I wouldn't be surprised if the Fed steps in with another action targeting the commercial paper market, which is where large corporations often access short term credit.

The government needs to step in with some form of fiscal response, and it needs to be targeted at providing cash flow relief to the individuals and businesses in industries most affected. Perhaps some sort of access to bridge financing? We've already seen some of that through the SBA loan expansion, although I'm not sure that given the onerous requirements of an SBA loan that will be timely enough. We also need to see something target the affected employees whose income will be significantly impaired. Other nations around the world have enacted things such as temporary suspension of utility payments and mortgage payments. These are all things that could occur here. Certainly, with the Federal Reserve providing a 0% discount window for banks to borrow from the Federal Reserve, and extending that window for up to 90 days, they've created a better environment in which the federal government could step in and announce mortgage payments are suspended for the next two or three months. And of course the Federal Reserve has also announced they will be $200 billion buyers in the mortgage backed security (MBS) market. So perhaps this is a route we're headed, but it's pure speculation at this point. Regardless, I THINK the severity of a potential recession is largely dependent upon fiscal response.

Secondly, I THINK the duration of said recession will be largely dependent upon our containment, or perhaps better said curtailment, of the spread of the coronavirus. If the social distancing measures we are enacting today are effective in flattening the curve and lowering the stress placed on our health care infrastructure, will this recession be short? (Technically a recession is just two quarters of negative GDP growth).

If curtailment is successful in flattening the curve three or four weeks from now, then I THINK people will feel positive about that outcome. Even if we see a dip in cases over the summer and it actually comes back a little bit in the fall, I still think our consumer confidence (which is 70% of U.S. GDP) will recover. Pent-up demand could act like rocket fuel.

In summary, that's my two cents. Which is about all it's worth right now!

In times like this, it's much better to have had a plan going into a downturn and to stick to that plan, because that plan is built on the things we KNOW.

And here's what I know, I know that on Friday, with markets down over 20% since the recent highs, it was an excellent time to engage in tax loss harvesting in many of our client accounts. That process continues today. I don't know if this was the low point - I doubt it based on my outline above of what I THINK. But I KNOW a good opportunity presented itself and we took advantage of it. And there may be another opportunity to tax loss harvest should the market fall another 20% from the levels seen Friday. That's our disciplined approach: formulate a plan while times are good, step in while times are bad, capture the tax loss, transfer it to your ‘balance sheet' to offset future income, and create a quantifiable impact on your wealth accumulation goals.

I also KNOW that rebalancing, i.e. shifting a portion to equities from fixed income as equities decline, can be very successful for those still in the accumulation phase and with an adequate time horizon. This week we have hit our parameters to rebalance in many client portfolios and we will begin executing today. We set these parameters when times are good, so that we have the discipline to adhere when times are volatile and emotions can override the decision-making process. I KNOW that we're buying at better prices today than we could have just three weeks ago. I don't know if these are the lowest prices we'll be buying at. If markets were to fall another 10% to 15% from this level, it is very likely that our rebalancing parameters will be triggered again. The effect for accumulators of dollar-cost-averaging their purchases into declining equity markets is a very successful long term investment strategy as markets recover.

I also KNOW that many of those with idle cash have been waiting to buy. I've been contacted about putting cash to work. In other words, the “buy-the-dip” mentality has not yet broken. Over the last 11 years the Federal Reserve and central banks around the world strongly influenced this buy-the-dip mentality. In financial markets we had a term for it: the Fed put. Going back to the last true crisis of confidence, the Great Recession, my experience was that when markets were down around 30% to 40% we really saw the buy-the-dip mentality start to break down. At this level, investor's risk tolerance was truly tested. We haven't reached that point yet - and let's hope we don't. But I KNOW that a process for rebalancing enables buying price declines, and therefore we don't need to pick the exact bottom.

Lastly, I KNOW that this too shall pass. The American economy and markets have survived longer lasting, more pervasive shocks than the coronavirus scare: the financial and housing market collapse of the 2008 Great Recession, crippling stagflation of the 1970s, World Wars, etc. The U.S. markets and economy have resiliently rebounded, time and time again.

In summary, as we move forward in this crisis, we will continue to execute our plan of opportunistic tax loss harvesting, opportunistic rebalancing and dollar-cost-averaging for accumulators, and we will monitor for additional opportunities to add value to client portfolios.

For those of our clients that we classify as decumulators - those living off their assets in retirement - this is why we constructed a healthy ‘bond tent'. This is why we ran Monte Carlo analysis on your retirement plans to ensure a high probability of success, accounting for a wide range of market outcomes (over 1000 iterations).

I look forward speaking with each of you further as we navigate this volatile time.

Take care of one another and stay safe out there,

Jeremy Hutzel, CFA, CFP®

Past performance is not indicative of future results.

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