The “ricochet rally” of the stock market in recent weeks has left even the most bullish investors astonished. In the aftermath of a 37% decline in stock indexes that culminated on March 23rd, stocks have rebounded a whopping 30%! That’s an amazing accomplishment within the last six weeks which has led many investors to assume that the COVID-19 virus, accompanying recession and bear market will unfold in a “V” shaped recovery for stocks and the economy validating anyone who bought the last great “dip.” We think that investors may want to question many data points in the realm of stocks and bonds in this strange new world – namely is the recent strength in stock indexes to be trusted? What has caused this rapid rise in stocks and what are the risks that the much hoped for “V” shaped recovery turns into a “W?”

Stocks Rise on Positive Stimulus

Our team can see pretty clearly the reason that stock indexes have rallied from the March lows. The Federal Reserve and US government have done an excellent job of providing significant liquidity, in record time, to the recession at hand. This alone has been encouraging to investors as they calculate the power of providing funding for those most in need (individuals and companies) until the virus recedes and the economy can re-start. The Fed and US government suggest that their ability to continue to do so is endless which has further supported investor’s appetites for stocks. This massive monetary stimulus coupled with certain states re-opening their economy and FDA’s approval of Gilead’s remdesivir, a drug that may better manage the care of serious COVID-19 patients gives hope for us all that “this too shall pass.” Hence the rapid if not unprecedented rise in stocks.

Ugly Math

Some may wonder if stock indexes have fallen 37%, but have rebounded 30%, why we are not closer to the old highs. This reminds us of what we call “ugly math” and the reason that mitigating downside is imperative to increasing your wealth over the long run – something our Active Risk Management accomplished for you recently. A 37% decline requires more than a 37% recovery to break even. In this case a 55% recovery would be required for indexes to achieve their old highs reached in February.

“V” or “W”

The recent report that US gross domestic product (GDP) – a measure of economic strength or weakness – contracted by -4.5% in the first quarter gives us pause in our conviction of a “V” shaped recovery. This along with a general lack of virus testing, continued – albeit at a slower rate – infections and deaths, and the uncertainty of the efficacy of opening the economy back up, support our view of being a bit less invested in stocks at this point. It should be noted that the 4.5% contraction in the first quarter’s economic report was mostly due to the month of March since January and February were largely unaffected by the virus. It is highly likely that second quarter GDP will be more than twice this figure – a possibility investors should consider. We are well aware that stock markets often, if not always, recover before economic figures actually get better, making it the greatest discount mechanism on the planet. However, one should consider that during recessions stock markets usually fall between 35-55% and are often characterized by a mid-bear market rally that recovers 50% of the decline before turning down once again. If this were to occur the current “V” shaped recovery would look more like a “W” and a revisit of further stock market weakness will be upon us. We are hopeful that such is not the case during this recession and bear market, but we are prepared with our risk management tools just in case.

A Tale of Two Markets

This bear market is unlike any that we have witnessed in the past and has been an excellent time for our investment style. Though stock indexes have been volatile, certain sectors of the economy have thrived during this period while others have been decimated. In typical recessions and bear markets all stocks decline except a small variety. During this recession and bear market certain sectors of the economy have experienced significant demand for their products and services – namely consumer staples (paper towels and food companies), healthcare (virus fighters), and technology (wireless, internet, videoconferencing). At the same time a number of sectors have been debilitated from this environment such as companies in the industrial, energy, banking, raw materials and travel and leisure – to name just a few. We feel grateful that our investment style is focused on individual stocks allowing us to avoid the vulnerable areas of the economy and overweight those that are thriving. This sector management and stock selection, along with a bias to be a bit less invested has allowed us to fare much better than most investors during this recession and bear market and should continue to add value should the market and economy take longer than expected to recover.

Individual Bonds NOT Bond Funds

The recent volatility of financial markets has validated our consistent belief that individual bonds are much better for investors than bond funds. During the market volatility many bond funds lost significant value (5-18%). This is related to the fact that many bond funds own securities that are less than investment grade (riskier) and during periods of economic weakness and market panics investors often want to sell – causing these securities to fall in value. The bond market is an investment asset class that is meant to return better than money market funds with little risk – something bond funds struggle to do when most needed. We are pleased to report that our portfolios of individual bonds have held up extraordinarily well throughout this market volatility and should continue to do so.

The Next Economic Expansion & Bull Market

Once the COVID-19 virus recedes and becomes manageable we will enter a new period of economic expansion and a renewed bull market in stocks. We have confidence that we will reach that point in the coming months of this year. Though recessions can be devastating to citizens and companies, the aftermath usually brings about a renewed business cycle and bull market in stocks. As a team we look forward to this new bull market and believe that certain industries and sectors are uniquely positioned to thrive – while others may have difficulty or become irrelevant. The thought of a new bull market is exciting and will play well to our investment style, which can allow us to focus on the sectors and companies that are best suited for the post COVID -19 era. We are busy making a list of these companies as of this writing.

While we continue down this path of attempting to control the virus, the end of the recession, and the unfolding of a “V” versus “W” shaped market recovery, we will be adamant about employing our Active Risk Management process which includes flexibility with your allocation to stocks, sector management and the use of carefully placed stop loss orders.

Many of the themes of today’s market turmoil are echoed in our founder James’ book, The Journey to Wealth. If you would like a copy to give to a family member or colleague, feel free to let us know and we would be happy to send one along.

In the meantime we wish you, your families and colleagues good health and safety. Together we will get through this and experience many better days and years ahead!

Your Team at Main Street Research