Investing

Markets Not Yet Normalized or Behaving Rationally

April 13, 2020

Since my last memo, I have been intently pondering what to write. My concern was not to send another memo about “buy and hold for the long term.” Instead, I will shed light on some evolving personal viewpoints.

Market Overview

Since the lows of March 23 (my son turned 27) up to Wednesday’s last week, the TSX has rebounded 24% or is 40% back off the low toward the high of February 20. In the US, the S&P 500 Index is up 23% and 45% off the low to the high. The Dow and S&P 500 had their best week since 1974. While this is encouraging, I am not yet calling the markets normalized or behaving rationally.

In my previous memo, I expressed concerns about the market being too efficient in trading models through the use of exchange-traded funds (ETFs) and computer trading on risk modelling. Major amounts of money were moved out of markets in nanoseconds by individuals and computer modelling, creating a liquidity burden in the system, and prices fell greater than they should have.

This leads me to a few forward conclusions:

The sell-off was indiscriminate, everything got sold regardless of quality. Equity diversification across industries added little utility value of risk management as everything was sold.
The Chinese index only suffered a pullback from top to bottom of 18%. I believe the number is lower than in North America because of fewer financial derivatives being traded. The TSX was off 37% and after today 22%. I believe the overselling by ETFs and model trading has now for the most part worked its way back out the market and is the main reason for the quick rebound. From here forward, I predict the recovery will take a more normalized approach that is based on the fundamentals of the underlying companies.
Quality companies, being principally defined as companies that have resilient cashflows in their business models, sold off in a similar fashion. My conclusion is these companies will lead us to new highs as they will rebound faster due to being oversold. These are the companies that we model every day, whether from a mutual fund or individual stock.

Policy-Maker Actions

The actions taken by governments to stimulate or protect the economy are unprecedented. It has been an “at any cost” attitude. This stimulus will be well galvanized into the system and be one of the contributing factors to markets establishing new highs. This comes with a degree of caution, as we the taxpayers must someday repay these programs. My concern about deferral actions is that this eventually creates more financial stress and that stress leads us back to a bank. In 2007–2008 it was stress on the banking sector that led us into a financial crisis. I am a little concerned that banks become the ultimate end loser in the chain of events.

As policy-makers change rules about rent, landlords have less cash flow to pay service providers. Those service providers cannot pay for their supplies and employees, and that leads all parties to higher amounts of borrowed money that the banks need to ultimately collect from the extended credit lines. The other initiative of mortgage deferrals leads us again back to the banks accepting that higher risk into their loan portfolio. I do not see this as a risk today, but I am putting it on my agenda as something requiring monitoring. If banks are stressed, the recovery period lengthens.

A new economic cycle will ultimately emerge with this policy support. We are still very much in the early innings in terms of economic impact. Irrational markets and volatility will continue and possibly retest the lows of March 23, and it will take time for more rationally based volatility. Lowering interest rates will not cure the pandemic, and it will take a “puck to drop” for markets to truly reset their path upward.

Policy-makers are making good decisions in the short term for the most part and will keep any recession mild and away from a full-on depression.

COVID-19 Situation Today

There appear to be pockets of hope around the globe for a levelling effect. It is certainly not in aggregate and the process continues to evolve. The medical community deserves a gold medal, from front-line workers to the policy-makers. We advance daily toward rapid testing and vaccine control, and this is the light at the end of the tunnel.

From Here Forward

As stated above, I believe the immediate first stage of the recovery is close to complete. To move forward will take fundamental re-strengthening of the financial system. This will require people to be reengaged in the economy. This will be when the “puck drops” in reference to my previous memo. It will take some time to get greater clarity on the situation.

Client Liquidity Needs: Situation Review

It is foremost we all stay as safe as possible and give praise to our essential workers, independently keeping this country functioning daily.

On the financial side, I would like you to reflect on the next 6 to 12 months of your cash-flow requirements.

Keep access to emergency funds in the event the puck does not drop near term and more restrictions are put in place, restricting your ability to earn a paycheque or to assist a child who is temporarily classified as non-essential.
If you are drawing money, or plan to withdraw money from your portfolio for a planned need in the short term, I would at an extreme minimum advise having any liquidity needs in the next 6 months be in cash. With the recent 10 days of good markets, we could discuss taking some money out of the market to assist with these immediate cash-flow needs. Please call me to discuss options or clarity of your account if you are uncertain of how much liquidity you have.
Try not to take any of the deferral arrangements being offered in terms of rent or mortgages. These payments will ultimately still have to be paid in the future, with interest accruals. Talk to your children, keep current with their payments, and assist where you can.
Assist your community, friends and neighbours where you can. It does not always need to be financial but assisting with grocery shopping and prescription pickups can be invaluable.

The RBA Team

The team at RBA continues to work as a listed essential service. We have made a few internal decisions to reduce personal risk exposure for ourselves and our clients.

Our door is locked to all public access. We are reachable by phone or email, and physical delivery of documents can be done through our mail slot 24 hours a day.
Kevin Smith, our internal analysis and licensed advisor has been working from home for the last three weeks.
I am trying as much as possible to work from home for activities in reading and research.
All my associate staff members are in the office daily for regular hours doing administrative functions as normal.

In Summary

This letter was intended to put forward my current thoughts. As I read this, I was concerned it had too many negative overtures. That is not my intent but wanting to share my current thoughts and uncertainties.

In summary, I see a three-phase recovery of the markets.

Phase 1 is near complete, to replace the extreme overselling created by ETF and computer trading models. Should the ETF and risk models swing back negative in sentiment, this would be the rationale to retrench the gains of the last 10 days.

Phase 2 will centre around medical news and, in the short term, this news will create anxiety and market volatility on a daily basis as the globe attaches itself to the concept of levelling and the potential for a second wave of the virus.

Phase 3 will be driven by the fundamentals of the market, needing corporations to return to business as normal and realizing normalized cash flows and earnings from strong balance sheets. This phase will take markets back to all-time highs given the amount of economic stimulus in the system.

Timelines on these phases are not calculable, but each phase must complete for the next to start.

I have a positive outlook for the markets going forward. The markets are still trading at a significant discount due to the uncertainty. As the uncertainty erodes, I suspect we may have another 10 days like the last 10. What we do know is we have to be in the market every day, investing in great companies for the long term to realize the recovery of their full intrinsic value.

Todd Campbell
President, RBA

Disclaimer