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Market-Based Stress Receding

Over the past six weeks, markets have been on a recovery rally and market-based stress is receding, but the reality of the uncertainty of the economic impact still lingers. If we could turn the calendar back to January 2020, one would never envision the impact of a global pandemic, requiring the shutdown of the economy for physical distancing, and the speed of government stimulus packages being rolled out. The stock market’s reaction as it returns to near-previous values is almost as if the pandemic never occurred.

My Three-Phase Market Recovery Overview

To review some of our previous thoughts in the first four memos, I still see a three-phase recovery, and we are still in the second phase. The three phases are:

Three Phases of Market Recovery
In phase two, I previously suggested a risk of a second wave. My prediction today is that a second wave will occur, and we will remain in phase two until a vaccine is approved and available to the global population. I see a vaccine by this year-end, but mass distribution occurring next Spring. We continue to see governments without long-term considerations of debt extending their fiscal and monetary stimulus, which in my view, averts the fall back from a market perspective to previous lows.
Any second wave will not be as severe. We have become somewhat acclimatized to physical distancing, the number of daily tests we can do is multiple times greater, and the initial concern about overwhelming the emergency rooms has been mitigated by better preparedness. This further supports my view that we will not retest the previous low. Ultimately, the size and severity of the second wave will depend on individual behaviour and my concern is that people are not mentally prepared for another full shut down, if required and mandated.
When we enter the third phase and get back to fundamentals, this is where a company that can consistently produce a dollar of profits has a determinable enterprise value. Markets, being forward-thinking, are starting to anticipate the proximity to business as usual, and while we are still in phase two, markets are anticipating the third phase.

Economically Speaking

There is a huge disconnect between current markets and the economy. I have read many academic research papers spanning my time at university up to now, concluding that markets do not equal the economy and the economy does not equal the markets. This thesis is proving true through this period.
Looking at economic data in a silo, most people would draw the conclusion that things are not good. The US initial jobless claims rose to over 6.6 million in March this year. In comparison, during the last recession in 2007–2008, this number never exceeded 700,0001. This is an unprecedented employment collapse. This alone justifies governments’ provision of fiscal and monetary stimulus, paying forward with debt to keep short-term issues in check. People riot for many reasons, but not being able to feed your family would be seen by many as a justification for stealing and looting, so governments will continue to roll out stimulus.

Government Intervention at Lightning Speed

From the market high of February 10 to the market low of March 23, we had 31 trading days. The Nasdaq hit a record high on June 10, only 52 trading days later. In the financial crisis of 2007–2008, the same Nasdaq index was high in October 2007, bottomed 16 months later in February 2009, and passed its previous high two years later in February 20112. That is 83 trading days in contrast to 40 months!
Typically, governments will intervene in a crisis, with stimulus provided by cutting interest rates. From September 2007 to October 2008 during the financial crisis, the US Federal Reserve cut interest rates four times over 14 months, for a total period reduction of 175 basis points. The same US Federal Reserve cut rates twice by 150 basis points over just 12 days, from March 3 to March 153. This has been done at rocket speed. The US government is repurchasing bonds to keep liquidity in the markets. The current amount of stimulus added by the US government to the economy is 44% of the GDP. This is almost $10 trillion worth of stimulus.4
The snapback of the markets through the first and second phases of our recovery model is assisted by the unbelievable speed of governments to come to the rescue. People needed help, and speed was essential for many reasons, but primarily for humanitarian reasons and to minimize the risk of unrest.

Forward Thoughts

Again, in my view a second wave is inevitable, but we will be better prepared medically for this. It will be interesting to see how individuals react to the second wave. Ultimately, this reaction will determine the effects on markets.
Normalization will not be evident until next summer after a vaccine is available for everyone. We hear often of a new normal, and while adjustments from previous patterns will be evident, I do believe we will return close to previous daily patterns. We have seen the peak of COVID-19, and economies are now slowly reopening.

What is important in our view, as discussed in my first memo on March 2nd, is that we remain and act as owners of the businesses we invest in.

Our investor-based discipline kept us invested in great businesses, and for the most part, we are back near our portfolio values at the beginning of the year. Our discipline to not react emotionally has been the best decision, and I truly cannot believe the speed of recovery.

Our investor focus needs to be on the next five to ten years. If we hyper-focus on daily news, we will experience unnecessary stress and potentially create an improper response. We need to be prepared to be WRONG in the next three to six months, as there is absolutely no ability to predict the short-term future with the uncertainty of the items discussed above.
It is imperative in my view to remain engaged as an investor. I am convinced that our investment philosophy of owning great businesses that grow their dividends is a core essential. I expect that we will see at least 50% of our companies that we monitor daily, give us a dividend raise by year-end. We continue to focus on mission-critical businesses. For example, the utility companies we own still need to supply hydro services to residential and commercial properties, and we as consumers need to pay their bill. The same logic applies to rails, banks, pipelines, technology, health care, etc. Remember, the market does not equal the economy and the economy does not equal the market. We need to be owners of businesses offering essential services that can pass on any requirement for price increases to their consumers. We call these companies internally price makers.
Expect markets to be more volatile for the next year as some investors hyper-react to the daily news. Take comfort in the current recovery and the quality of companies you own.
At the same time, I encourage clients to plan their cash-flow needs for the next year. It would be strategic to speak with us in this regard and look to taking some recovered funds out of the markets to protect this anticipated withdrawal. For clients needing more certainty and less stress, this cash-flow requirement could be pushed out to two or three years of anticipation.
I have received multiple requests from clients to share my memos with their friends and family as they have received no communication from their own advisor. I encourage everyone to share my views as often as they desire.
Todd Campbell
President, RBA

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