By John Nicola, CFP, CIM, CHFC
Chairman & CEO
It is important to remember that above finances, the COVID-19 outbreak is a human tragedy, affecting hundreds of thousands of people around the world and, in doing so, is having a growing impact on both the global economy and daily life. This letter is intended to provide Nicola Wealth clients with our perspective on the evolving economic situation, the impact on the markets, and implications for their financial plans.
This newsletter reflects our perspective as of March 12, 2020. The current situation is changing quickly, and some of these written perspectives may fall out of date.
On March 9th equity markets went into a freefall that saw many of them drop 10% in one day. The S&P 500 experienced its 7th largest decline in 70 years. The next day (March 10th) markets recovered significantly, but not completely, and had all of the earmarks of the proverbial dead cat bounce (my apologies to pet lovers). On the 12th many markets had trading halted at the open as stocks fell the maximum allowed. As of the end of the trading day, the TSX, S&P 500, NASDAQ, all European exchanges and the Nikkei were in bear market territory (a drop of more than 20% from the last peak). Notably, the Dow Jones had its worst day in three decades.
In the meantime, investors are being asked to remain calm and stay the course. This reminds me of an old adage told to many of us years ago
When you’re up to your neck in alligators, it’s hard to remember that your initial objective was to drain the swamp.
You may be wondering, how much more will equity prices fall? What does this mean for the economy? Is all of this the result of Coronavirus?
As we strive for trust and transparency, we will lay out the facts and give you our interpretation of them. Most importantly, we will end with the actions we believe all of our clients should follow during this particular crisis.
This newsletter is written in three sections:
- Our current situation
- Looking at where we are in context
- Strategies and tactics we believe will perform best and that worked very well in during the last major crisis (the Great Recession of 2008/2009)
As noted above, as of March 12th almost all equity markets are down more than 20% off their peaks. The TSX is down 30% since early February and the S&P 500 25%. Commodity prices have fallen precipitously as global trade, tourism, and travel have been sharply curtailed as a result of many countries’ Coronavirus responses. Oil, in particular, has fallen about 60% from its 2019 high of $75/barrel to just over $30. Coronavirus infections now exceed 133,000 with more than 4900 deaths and 124 countries experiencing cases.
Interest rates have in some cases dropped to record lows. U.S. and Canadian 10-year bond rates are just over 0.6%, down from almost 2% 15 months ago. Swiss 10-year government bond rates are close to -.8%, which means that if one buys 10-year Swiss bonds today there is no interest paid for ten years and when the bond matures the investor receives just over 90% of their original investment. Other interest-paying vehicles such as high yield bonds and preferred shares have seen their prices fall (and correspondingly their yields rise) as capital moves in a flight to safety.
Canada’s dollar is now just over 72 cents USD as a result of a combination of being seen as an oil/commodity currency and a desire by investors to own USD. 2020 growth rates for all countries have been reduced and many economists now expect this to be a recession year as a result of the impact of Coronavirus on the global economy.
One would not be criticized for seeing our current situation as glass half empty, especially considering we are likely to see more bad news before this crisis ends.
However, all of the above should also be looked at in context of other similar periods. As we know, fear and greed drive public markets in particular. So before we look at our current situation in context, let’s consider the following question investors are asking themselves and their advisors.
Would it be better to get out of stocks in this environment and wait until this crisis is over?
My initial response to that question is:
- Do you intend to stay out of stocks forever? If not, when would you buy back in? What would the signals need to be?
- In ten years’ time which asset class will perform better? Bonds or equities?
- What impact has this current market had on your wealth? What has the impact been on the cash flow your portfolio generates? What impact will there be on the security of your retirement and other important legacies?
It seems to me that at the very least investors should be able to answer all of these questions before making a decision to sell their current assets invested in equities.
For those investors who want to liquidate all equities now and buy back in at a lower price in the future, they need to consider the facts from 2009. When the market bottomed in March 2009, the economy was in the middle of a great recession. Unemployment was 8.7% in the US and 8% in Canada. It would continue to deteriorate and reach 10% in the US and almost 9% in Canada by November of 2009.
Investors need to ask themselves if they honestly would buy back into equities with both hands under these conditions. However, if they waited until the recession was officially over and unemployment peaked they would have missed out on the S&P500 recovering to 1100 (almost 70%). Market timing is for the young and the restless who would rather speculate and gamble than building wealth.
The Context & Comparison
It was almost 12 years ago that I wrote a series of newsletters, similar to this one, in the middle of the 2008 financial crisis that eventually came to be known as The Great Recession, a time when the S&P 500 had a peak to trough drop of 57% from November 2007 to March 2009. Through this period, nearly all U.S. banks required government funding, major companies accepted bailouts and U.S. unemployment increased to 10%. The damage was done and the U.S. GDP took three years to recover to the level achieved in 2007.
In the 21st Century, there have been two major bear markets. The first was the so-called “Dot Com Crash” when over two years between 2000 and 2002 the S&P 500 dropped almost 50% while the NASDAQ was down almost 80%. The financial fallout of the 2008/2009 Great Recession has been covered above. Our current equity markets peaked in early February 2020. As of now, we are barely a month into it.
It appears obvious that the cause of our current market conditions and any future recession we may experience is the Coronavirus crisis; however, we also have to remember that as of December 2019 the S&P 500 was at its highest valuation level since March 2000 (using the Case Shiller model of measuring PE ratios using ten years’ earnings) and second highest in history (more than 1929 and 2007). In addition to that, the US has not had a recession in more than 11 years. At some point, both a major market correction and a recession were inevitable. Coronavirus may have been a trigger, but is unlikely the sole cause if even the major one.
When investors experience markets such as this, their focus is almost exclusively on price as opposed to cash flow. Our focus has always been cash flow from dividends, interest, and rents. If these grow consistently over time, then prices tend to take care of themselves. As of now the yields of the S&P 500 and TSX have risen by as much as the market has fallen (25% and 30% respectively). What is happening is the cash flow being generated is the same as it was a month ago but since prices have fallen by 25-30%, it takes that much less capital to acquire the same cash flow as a month ago and this is the reason the yield on both indices have risen. While it is true that some companies may have to reduce their dividends during 2020, there are also many other companies with very strong balance sheets that will maintain their distributions.
Some typically solid financial stocks have fallen by more than 35-40%, we can buy $1 of dividend income for 35-40% less with a number of Canadian banks and Lifecos than we could just a few weeks ago. The chart below shows a number of Canadian and U.S. companies, how their prices have fallen, and, as a result, the impact on their current dividend yields. All of these companies have very strong balance sheets and should be able to support their current dividends comfortably.
As a group, these companies have fallen, on average, more than 25% and now payout dividends equal to a yield of just over 4.3%. As of March 11th that was about 7x the yield on 10-year government bonds in Canada and the U.S.
As noted above, in the middle of the 2008 Financial Crisis we wrote two newsletters asking the question “How Bad Is It?” A more relevant question might be “How did our clients’ portfolios perform during 2008/2009?” Our average client experienced a net drop in account value of 6.5% for 2008 and a positive return of 14.8% in 2009, resulting in virtually no change in the annual cash flow that the portfolio generated. By comparison, a 60% equity (Canadian/Global) and 40% bond (Canadian/Global) portfolio would have earned a return of -1.5%/year (assuming total fees of 1% annually). That is approximately 11% less return over those two years. How was this possible? Follow along below for Strategies and Tactics.
Strategies and Tactics
So that brings us to what should we do now. What about our strategy for building wealth and a successful financial plan and what does that mean for our short-to-medium-term tactics?
First I’d like to state my opinion (and it is just that) of where we are now. I expect things to get worse. I believe a long-term resolution to the impact of Coronavirus is many months off and that it will create significant fallout in the real economy globally. Those impacts are already being felt in tourism, transportation, supply chains, and capital investment, just to name a few. When we combine that with the fact that equity markets were very expensive at the end of 2019, we need to be prepared for high volatility in asset prices, especially in public markets.
That caveat notwithstanding, we believe our approach should be as follows:
- Every investment strategy should have a financial plan bespoke for the individual or family who owns the assets. Now is the time to review that plan and reinforce the key objectives it is trying to achieve.
- In these markets, the focus on building cash flow is more critical than ever. This is a crisis that is also an opportunity to buy more income for considerably less money.
- Record-low interest rates provide an opportunity to refinance existing debt and perhaps lock in some or all of it for longer terms (5-year personal residence rates are approaching 2% from some lenders). We are reviewing all mortgages we have on our U.S. and Canadian real estate to determine where we can best apply these low rates. On an $80-million asset with a $40-million mortgage the impact of reducing a mortgage rate by 1% over 10 years is almost $4 million and would improve our return on equity by 1% annually for those 10 years.
- Market timing works for those who are lucky and then rarely consistently. The best way to take advantage of bear markets in any asset class is to rebalance on a regular and disciplined basis. Our average client had 32% of their portfolio in long-only equities (typical advisor recommendations are for 60-80% exposure to stocks).
As a result as of this week our Nicola Core Portfolio Fund is down about 3% net of fees on a YTD basis vs. more than 25% for many equity markets. Our objective is to systematically purchase equities and to do so even if markets continue to fall. The math worked in 2008/2009 and it will work in this environment.
When I wrote those 2008 newsletters, I wanted to build a special model to test our own belief that a truly diversified model should own real estate, private assets, public equities, and fixed income, not just 60/40 stocks and bonds. We used a hypothetical couple (Jonathan and Martha Kent and their baby named Clark) with a portfolio designed to resemble our own Nicola Core Portfolio Fund.
At the beginning of 1929 they invest a $100,000 inheritance and try to live off the income they hope it will generate from that point forward. We tracked their results during the entire 10 years of The Great Depression and six years of World War II (a much bigger crisis and challenging environment in which to invest than anything we have seen since then).
They survived the 16-year period with no significant impairment in their income or their capital and ended up with an after-inflation return of almost 5% annually throughout that very difficult investing period. The bottom line is that their portfolio was truly balanced and diversified; therefore, they were generating a significant portion of their return from cash flow.
Those principles of good investing and wealth building have not changed and they will be very effective, in our opinion.
This too shall pass. And from our point of view, the glass is half full.
This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.