The current economic and domestic environment is one that has not been seen by anyone in the last three generations! Only stories from the past, told by grandmothers and grandfathers about the “hard times” in the early 20th century come to mind. The unusually sharp turnaround in prices has caught everyone off guard. Exhibit 1 shows investment returns of various popular market measurements for the first quarter of this year ending March 31, 2020.
The Shortest Time Ever
On February 19, 2020, the stock market hit its historic all-time high. Then, a mere 35 days later people were spellbound by the losses that had occurred. Historically, most bull markets, after peaking, take much longer to turn into a bearish market trend. Exhibit 2 shows the length of past negative markets. Notice in particular the length in the middle column. The fastest prior drop in time was three months. With this latest sharp one-month decline, investors became shell-shocked and reacted quickly. Add to that high frequency and algorithms piling on with more selling, and this is what happens. A long negative market of 12 months or more at least gives an investor time to adjust portfolios and get more defensive.
One of the biggest problems is the large amount of exchange-traded funds (ETFs) that are controlled by financial advisors who have no idea what they own and depend completely on the ETF. When they all sell at once, there’s no place to go with so many stocks. We’ve said for a number of years that the 11-year bull market put many people into the money-management business who really had no business being there. When businesses are too good for too long you always end up with a lot of people who don’t understand the business. So it was the current group of so-called “wealth advisors” who buy only ETFs. Most could tell you very little about the individual stocks in those vehicles.
Credit Quality – A Maior Concern
Wall Street, with the help of the Federal Reserve, has created a huge bubble in debt over the last 10 years. In the 1990s, there were over 60 U.S. companies with AAA credit ratings. Today only two, Microsoft and Johnson and Johnson have that high of a rating. There is
over $66 trillion of corporate debt in the world. Corporations have continued to borrow and buy bbback their own stock. Exhibit 3 shows the high percentage of bonds rated BBB. This rating is the lowest rating not classified as junk bonds.
The current problem is that as much as 25%-33% of these bonds can and probably will get downgraded. When that happens all the mutual funds and ETFs that they own will have to be sold because they are no longer investment grade. Unfortunately, the average investor doesn’t realize that a lot of these lower grade funds will come under price pressure. In addition, presently the credit markets are extremely illiquid. What that is doing is causing upward pressure on the interest rates of low-quality rated paper. Notice Exhibit 4 showing the current interest rate on these kinds of bonds.
The problem this creates for investors is that there’s a very large number of investments currently held in these areas. Many of these funds have leverage (borrowing), and that will exacerbate the volatility or loss. In our opinion, of all of the problems the investment community faces, none is bigger than the credit problem. Most every product that has been produced by Wall Street was based on getting more yield via leverage. We would be willing to bet that the aftermath of all of this will be “leverage” being a dirty word. There is too much debt, and too much borrowing everywhere. The Federal Reserve is to be blamed for this 25-year span of lowering rates to support the stock market and hence the economy.
But it only helped the top 10% who own the bulk of such assets. They created the worst income inequality and completely beat down the middle class. In addition, it created this useless habit of “stock buybacks” instead of growing the company, paying dividends and paying workers more. When normal business cycles needed to be put in place, they let Congress shirk their duty to create good fiscal policy.
If oil is underperforming, then that is a sign for the economy. Oil prices usually tell us what is going on in the economy. Those prices don’t forecast, but they do tell you that the market is sick. Here we have both a weak stock market and weak oil demand with too much supply. Exhibit 5 shows the current oil price. At Oxbow, we wouldn’t be surprised to see oil selling below $15 a barrel due to the economy.
During these turbulent times, we believe it’s important to know our investment processes. Oxbow has four basic strategies. They range from very conservative to full stock accounts. Here’s a basic explanation of those processes.
Conservative Fixed Income: This is the least volatile of all strategies. In fact, there has never been a down year in its history. This doesn’t mean it will never happen. Here is the process. This strategy owns a combination of very short-term U.S. treasuries, CDs and municipal bonds. We also can own government national mortgage bonds (U.S. guaranteed). At times, we put portions of the portfolio (as much as 35%) in longer maturities. As inflation returns, however, we’ll have less and less in longer maturities.
High Income: This strategy was developed over 20 years ago to provide higher levels of income than our conservative strategy. With higher income comes higher volatility. We try to mitigate that by having a diverse portfolio. Holdings include corporate bonds, preferred stocks, convertible preferreds, convertible bonds, specific municipal bonds, real estate investment trusts, MLPs (master limited partnerships), closed-end funds and
high-yielding common stocks. This has been our most challenging strategy this year due to the almost instant need for liquidity from cash-strapped funds and investor selling. In addition, the instant “Mach 1” drop in oil prices from $60 to $20 a barrel in just two months was devastating to MLPs and the majority of oil-related common stocks. Most income items are not designed to have instant liquidity, which shows up in panic selling. The same thing happened in 2008, but the rebound in 2009 was the biggest ever. We’re certainly not saying that this time, but we do have the highest liquidity and will be upgrading investment quality in portfolios.
Equity: Oxbow has two primary stock strategies, Long Term Growth and Dividend Growth. There are thousands of publicly traded companies to choose from when investing in stocks. We think it’s important to reduce that universe to a list of candidates that fits our clear investment philosophy. Our list features around 200 companies that exhibit the following criteria: (1) a long-term competitive advantage over its competition, (2) an ability to consistently grow cash flow through the ups and downs of an economic cycle, (3) a competent CEO leading the company and ( 4) a low or reasonable amount of debt that won’t jeopardize the company’s future during a poor economic environment. Note that #4 is the most important criterion right now while economic activity is being disrupted around the world. We develop financial forecasts and continually read about these 200 businesses and their industries. We have a set price for each company at which we’ll buy shares. Then it’s just a matter of waiting until a company’s share price falls below that targeted buy price before we act. This strategy has been very successful this year. It also holds some cash reserves that will be deployed at certain prices.
What to Do Now
Presently we have no economic visibility, which makes everything more speculative when investing. In 2008 all we needed was to have the banks get straightened out. Today all three areas-demand, supply, and consumers-have stopped. This economy had gotten increasingly more dependent on financial leverage to replace organic growth, which in turn has made everything more volatile. What we need now is to have the government stimulus package be put in place and distributed as quickly as possible. This situation is dependent on the duration of the drop. If it goes too long, things get difficult.
Case in point: President Barack Obama signed the $800 billion American Recovery and Reinvestment Act in February 2009. But by September 2009, only $114 billion had been placed. We can’t do that this time! Speed is of the utmost importance if we are to return to normal economic conditions. What investors should do now is upgrade quality.
At Oxbow, we’re doing that in every strategy. We are upgrading quality and in some cases taking losses where things don’t measure up. Certain investments may have been great in normal times but this situation changed the landscape for them. If you don’t have money managers who can do that, then you just keep on suffering with the market. Our managers are working almost around the clock to upgrade quality. Activity may pick up, but be assured it is for the better. Oxbow is dedicated to your investment health and welfare. Thank you for believing in us. Hopefully, by the next market letter in 90 days, things will have improved. In the meantime, know that we are ever vigilant.
With positive thoughts, we will all get through this current uncertainty. We wish you all the very best as we enter spring and summer.