Out of the Blue – COVID-19 Pandemic PerspectiveMarch 24th, 2020
We as a firm, had an excellent 2019 in absolute returns, making up for a downturn in the fourth quarter of 2018 caused by the premature Fed tightening and an evolving trade war with China. 2020 began with gains in the U.S. markets supported by the expectation of domestic growth fueled by almost record employment and strong consumers buttressed by low interest rates and low inflation. Corporate earnings were projected to increase modestly over 2019. Domestic GDP growth projections for 2020 and 2021 were between 1.8% and 2.2%. Stocks looked reasonably attractive to us especially when compared to low-yielding bonds. However, this level of valuation was attractive only if the projected earnings growth materialized.
Reality interfered with our plans when “out of the blue,” a vicious virus emanated out of Wuhan, China in December 2019. It is believed the Chinese delayed disclosing the true nature of this coronavirus and the critically important fact that the virus was spreading from human to human – community spread. This element gave rise to what would become a global pandemic as Chinese nationals and visitors to and from China became lethal carriers of the virus. Unsuspecting nations including the U.S. and all European countries became victims, both victims of disease and the ensuing economic contraction necessary to stem the tide of the growth of this heinous virus. Social distancing and “shelter in place,” both prescriptions for killing the virus as well as killing the economy, have become part of the norm!
What is now occurring is a two-pronged war. The first is a medical war against the virus. Our soldiers are healthcare forces made up of frontline doctors, nurses, physician assistants, and all others on the front lines in all medical facilities. They are battling day and night with the beginnings of a surge of patients as testing for the virus ramps up. The virus remains highly contagious and some carriers have no symptoms. Unprecedented amounts of testing are now being undertaken, but at a slower pace than required. The best prescription to stem the tide of disease spread is social distancing which has become the cause of our second war, the economic one.
Social distancing has required the shutdown of an unprecedented amount of commerce. Cruise lines, airlines, hotels, casinos, all professional sports, and live events (including concerts) began the economic contraction. Now given the disease spread, government at both the Federal and state levels have created guidelines limiting groups to no more than ten or even worse “sheltering at home.” Businesses have had to adapt to having employees primarily working remotely. Virtually all restaurants, bars, and clubs throughout the country have temporarily closed. Tens of thousands of workers are being let go or furloughed on a daily basis. Most automobile production facilities have closed. Schools, kindergarten through twelfth grade, across the country as well as many universities have sent students home indefinitely.
This unprecedented dislocation of our way of life appears to be necessary to limit the spread of the disease and keep the fatality level down by spacing out hospital admissions in an attempt to deal with the capacity of our hospitals. Additionally, this disease is particularly severe for seniors and people with preexisting health conditions. There is really no way to adequately describe this challenge although it is one we believe that we as a nation will beat in time.
Clearly, this “out of the blue” global pandemic has already brought an end to our 11-year bull market and will cause a recession. A recession that a month ago seemed very unlikely to us. It has also brought incredibly rapid government action along with decisive and bold Fed action lowering interest rates and using the Fed balance sheet in many developing ways. It is expected that well in excess of a trillion dollars will be earmarked for afflicted workers, small businesses, and certain major industries. Hopefully our elected officials can come together in the next few days and leave behind partisan politics.
As we write this, the S&P 500 Index has declined 30.4% year-to-date and declined 33.8% from its high in mid-February. With so many industries and companies, big and small, curtailed or closed for an unknown period of time, corporate earnings and GDP will substantially decline. Thus we are undoubtedly in recession and the stock market is declining. High-quality bonds have performed better than high-yield, low quality bonds. Real estate values will likely decline as commercial tenants defer or renege on rents. Shopping centers are closed as stores have been forced to close, waiting out the hoped-for decline in disease spread.
In addition to this debacle, our economy also is digesting an oil war resulting from the failure of OPEC countries to reach agreement on limiting supply, primarily between the Russians and OPEC countries led by the Saudis. The good news for now (for consumers and businesses) are lower oil and gasoline prices. The bad news is the impact of collapsing prices on America’s oil and oil shale businesses. This could also impact debt arrangements with many domestic banks.
Looking Across the Valley
As long-term investors, we have experienced other periods when unexpected events led to substantial market declines. October 1987, the dotcom crash of 2000-2002, and the financial crisis of 2008-2009 were other periods where we faced dramatic market routs. Our advice then was the same as it is now: stay the course in high-quality companies, bonds, and real estate. Valuations have become quite attractive assuming that the companies we invest in will at some point in the not too distant future return to “normalized earnings.” Some companies that we invest in might even benefit in the short- and long-term from this crisis including Amazon.com, Facebook, and Alphabet (Google’s parent company). Additionally, other companies that we have an interest in will ultimately benefit from new 5G technology like QUALCOMM, or the continued move towards cloud computing such as Adobe and Microsoft. We believe there is a certain inevitability of a return to normal where great companies will prevail. Look to 2021 for more normal earnings and economic conditions.
However, for the time being the equity markets are falling quickly. To make matters worse, high-quality companies are falling along with lower-quality ones. Future earnings and dividends do not seem to matter in the short term but our experience tells us that they will matter in time. Vitally needed pharmaceutical companies are trading at what we believe will be viewed as bargain prices with many paying high dividends based on the reduced share prices of these companies. Banks that are well capitalized are also in free fall despite rock solid balance sheets. Technology companies, as mentioned above, with great prospects also have fallen victim to the panic selling. Every sector of the S&P 500 is down at least 20% with more than half of them down more than 25%. There appears to be a disregard for a future that is brighter than the gloom and uncertainty of today.
As we have often said, we own interests in real companies that have assets and almost always make a profit. In today’s world, that does not seem to matter, but it will. We believe many of these companies are cheap and deserve to be held for the long term.
The consumer, who is the backbone of our domestic economy, has suffered a vicious gut punch. A punch that has temporarily stopped many from working, shopping, eating at restaurants, and participating in activities that were always taken for granted. Unemployment will soar in the weeks to come. Many smaller businesses will close. This is war. We need the Federal government to come to the aid of the consumer, worker, and business. We expect that to happen shortly. This will make a difference and the sooner the better.
How to Invest
Our adherence to a prudent asset allocation has worked for us to a degree. Many of our defensive and traditional equity strategies are outperforming their benchmarks despite being sharply down. Quality will ultimately prevail. Diversification in having some bonds and defensive strategies is keeping our clients in the battle.
We do not know where the bottom is as we have no crystal ball. However, we believe we know good prices for solid companies, and those of today seem like good prices for many. However, they could get even better. That said, if one has additional liquid assets (beyond what is needed to either live on or sleep at night) we would consider deploying in stages to what we believe is an exceptional long-term opportunity for the future.
Hold on and let’s beat this invisible enemy, the coronavirus. Once we as a society and government do that, you can count on America as consumers and businesses to come back. We always do.
Thank you for your confidence in us and the kind words many of you have said to us as we have reached out to you during this surreal period of time. Please do not hesitate to call.
Stay safe and practice social distancing and good hygiene.
In good health,
Robert D. Rosenthal, Chairman, CEO, and Chief Investment Officer
Ralph F. Palleschi, President and Chief Operating Officer
*The forecast provided above is based on the reasonable beliefs of First Long Island Investors, LLC and is not a guarantee of future performance. Actual results may differ materially. Past performance statistics may not be indicative of future results. Partnership returns are estimated and are subject to change without notice. Performance information for Dividend Growth, FLI Core and AB Concentrated US Growth strategies represent the performance of their respective composites. FLI average performance figures are dollar weighted based on assets.
The views expressed are the views of Robert D. Rosenthal through the period ending March 23, 2020, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such.
References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Content may not be reproduced, distributed, or transmitted, in whole or in portion, by any means, without written permission from First Long Island Investors, LLC. Copyright © 2020 by First Long Island Investors, LLC. All rights reserved.