Q1 2020 Client Letter - April 2020
It’s been a very long time since I had to begin a quarterly letter with so little good news, so I will start with the hope and prayers that everyone stays safe and healthy.
We all know we are experiencing once-in-a-century health and financial crises, and there’s no need to repeat those obvious superlatives that have been everywhere. Our resiliency helps us to adapt to the new normal in work, play, and investing. If we can keep in perspective that we had great equity returns last year (ironically our last quarterly letter was “2019: The Year of the Unexpected Rally”) and several years prior, that can soften the blow of this devastating and historic Q1.
As we are prudent investors it’s good to remember we have known for quite some time that every positive quarter could be the last one before a correction, and we positioned our portfolios to have a little more in cash than fully invested. It wasn’t much because we don’t practice market timing and we didn’t want to miss what was left of the very long expansion and rally, but it was enough to leave us room to buy at little, a smidge at a time.
These past few weeks I have focused on when it would be prudent to start buying, knowing we will never call the bottom but can appreciate gradually increasing our equity allocation at prices that should look very attractive in hindsight. It’s not easy to decide when to buy amidst this extraordinary volatility, but it’s my recommendation that it’s prudent to begin inching in a little at a time. I hope to buy around the unexpectedly large upswings in this market that appear to be driven, again, by the leveraged institutions. I think we will have adequate opportunities as we should see continued volatility as news about the virus, the economy, the deficit spending, and politics hit the tape. I also think the smaller business loan program is underfunded and will require more assets. The chart below is intriguing: 83% of our economy is driven by small and medium sized businesses. The disappearance of share buybacks won’t help either, so we have to resist being too optimistic. We expect that some of these incremental purchases will invariably be at lower levels, but that shouldn’t stop us from buying. One of the biggest initial downward shocks has likely cleared; the leveraged players, who drove the market to what many view as oversold, appear to be closer to neutral, no longer forced by spiking volatility to unwind for risk management and other systematic strategies. The Fed’s actions have appeared to soften the effects of severe liquidity disruptions but it’s frustrating that even the best-connected investors didn’t know just how levered these traders were, investing probably an average of 2 times their capital, and some up to 10x. That is the nature of markets in this era and we will likely see record volatility until the news on everything becomes less urgent.
It’s worth recalling that while these risk-on, risk-off traders can dominate the markets in the short term as they scramble for performance, so many of these funds have failed there’s a name for the industry data caveats: Survivor Bias. You can’t trust hedge fund return statistics because all the spectacular failures disappear from the data tables. Just as you know that for every TV screen sporting a face of an alternative investment superstar, there is a plethora of old media with faces that have long fled the industry.
Even some of the better-known fund managers who made their billions in a matter of weeks this quarter were catching up after years of underperformance vs. the S&P 500, selling because they bought just before the drawdown, losing on their shorted stocks, or all of the above. We earn our competitive performance one quarter at a time; they swing for the fences, lose quite often, then have the occasional astoundingly good calls that catapult them right onto our TV screens. In the end, we do as well as or better than most of those funds that take excessive risks we avoid.
Another risk, cherry picking individual stocks in these markets, has gotten plenty of chatter but it remains to be seen if that will work this time as it rarely does. If it’s a sustained successful strategy it will show up in the mutual fund performance data I track, and we would be delighted to buy actively managed funds that can deliver sustained outperformance. I remain dubious but I am always on the lookout anyway.
We will be pretty much ignoring economic data for the next several months but that doesn’t mean it won’t affect market pricing. The fallout from oil price shocks will continue to add to the volatility. We are hopeful that the trillions in historic and massive Fiscal and Monetary Stimulus packages help those who need it and return us to normal activity as quickly as possible.
We will get through this as we have other crises, and our portfolios will recover as they always do. Hang in there...