Spring Cleaning

Thank you for joining me this morning. I have been looking forward to this extra strong, much needed, cup of coffee as there are a number of items we will chat about following the extreme volatility that occurred in the financial markets. As you probably know, the global markets experienced one of the fastest “corrections” on record with the S&P 500 declining 12.75% in a mere 7 days thus erasing the liquidity-driven rally that commenced in October 2019. The tragic Coronavirus that has claimed approximately 2,870 lives has been listed as the main culprit that spooked investors and induced panic selling. While we do believe the Coronavirus is an important development to monitor and does pose a risk to global growth, we believe that this narrative is merely the straw that broke the camel’s back. As our readers know, we’ve been highly skeptical and vocal about the liquidity-driven rally that commenced in October of last year and that the baton handoff from a slowing environment to an acceleration in leading economic indicators is typically met with heightened volatility.

While drawdowns are never comfortable, no matter an investor’s risk tolerance, they are a necessary cleanse for excess complacency and overcrowding. This is no different than the natural Spring Cleaning we all conduct in aim to remove excess items from our lives. Over coffee today, I will provide some perspective around the financial market selloff, Coronavirus, and a quick update on our investment outlook and portfolio positioning.

For the high-speed espresso drinkers, here is a quick bullet point synopsis:

  • Financial markets saw record sell-off with the S&P 500 selling off 12.75% in 7 days
  • Coronavirus is the straw that broke the camel’s back
  • We have been skeptical of the Fed-induced liquidity rally that began October 2019
  • Volatility events more often than not occur during inflections of leading economic data
  • While Coronavirus is a dangerous and tragic situation, the rate of infection has moderated substantially
  • We believe a reflection in economic prospects is still on the table

As mentioned above, and discussed in our latest Quarterly Reflection  we were highly skeptical of the incredible performance the S&P 500 produced following the liquidity injection from the Federal Reserve beginning October 2019. For some context, the return for the S&P 500 for the last quarter of 2019 was 8.53% which represented almost 30% of the annual 2019 price return. To further this, the return from the lows of October 2019 to the peak in February 2020 represented an 18.82% return which is 57.28% return on an annualized basis. The returns being produced by the financial markets during this timeframe were some of the strongest returns we’ve seen on record. Now to be clear, strong returns don’t in of itself mean they’re unjustified but it is important to discern if they are warranted. At DelosCA, we remained highly skeptical of this type of momentous return as leading economic data continued to collapse and the aggregate stock market produced zero earnings growth. A rise in stock markets with the absence of earnings growth leads to what is known as multiple expansion. In simplicity, the most common multiple used is the Price to Earnings Ratio (P/E) to value the aggregate level of the stock market. 2019 was driven purely by the rise in P (Price) where the E (Earnings) were negative thus leading us to very expensive market valuation. This type of rally, which was fueled by liquidity injections, can be highly unsustainable as we’ve seen over the last 7 trading days.

One of the most important concepts we’ve discussed over the last quarter is that inflections from decelerating to accelerating leading economic data are typically met with volatility events. As we’ve discussed, we anticipated a reflection in leading economic data to commence at the end of Q1 2020 based on our DCA PIIL (Policy, Inflation, Interest Rates, and Liquidity) model. The reason we always expect volatility episodes at these inflections boils down to two main reasons; (a) inflections from deceleration to acceleration are never exact and nor do they occur in one period (ie. It takes a couple of reports to show a durable inflection), and (b) when leading economic data accelerates from deceleration, most investment practitioners focus on coincident and lagging economic data which exhibit negative numbers thus causing them to sell. While some investment practitioners pontificate the uselessness of PMIs (leading economic indicator), we believe that is widely misguided as history shows that the turns (inflections) in the PMIs are almost always met with volatility as investors begin to rotate assets or focus on the continued deceleration in coincident and lagging economic data.

From time to time, financial markets are keen on pinpointing a specific narrative as the culprit for a market correction. While we believe the latest market drawdown is more of a reflection of asset prices recoupling to the tail end of deceleration in economic data, it is important to still maintain awareness of the seriousness of the Coronavirus. Now to be clear, assessing the impact or final outcome of such an event is near impossible but what we can at least try to understand is the rate of infection and the impact transmitted to economic stress and consumer confidence. What we know is this, the infection rates, on a daily basis are slowing dramatically alongside confirmed deaths. We’ve learned that mortality rates are tilted more towards elderly individuals with pre-existing conditions. The global financial markets have used Coronavirus to reprice assets and we believe the fear amongst the general public has more to do with the new infections outside of China. We believe that governments and health organizations are working to contain the spreading of the virus, which seems to be working based on the reduction in net new confirmed cases per day. In the interim, we are watching consumer confidence and initial jobless claims closely as they will provide quick clues if the virus is impacting expectations and labor markets.

While it is likely the Coronavirus could impact global growth, we still maintain that a re-acceleration in economic data will commence at the end of Q1 as the stimulus of lower interest rates and inflation manifest through the economy. We still remain skeptical that this year will produce outsized returns but we have begun to see a reflection in leading economic data that warrants a shift in portfolio positioning to cyclicality and high-quality investments. During these transitions, we still maintain defensive positions such as low beta/vol, classical defensive equity sectors, and long duration treasuries alongside clients Risk Control allocations as we anticipated volatility during this inflection. With the latest market correction, we believe the cleansing of complacency and market euphoria will present a better risk-adjusted backdrop for investors.
Please feel free to reach out with any questions, topic suggestions, or if you want to chat!
Sincerely,

ANDREW H. SMITH
Chief Investment Strategist
andrew@delosca.com
asmith971@bloomberg.net