March 6, 2020
Dow Fights Its Way to Weekly Gain
It was another volatile week for investors as coronavirus virus fears continued to grip Wall Street and Main Street. The Dow Jones Industrial Average appeared to be on the rebound through Wednesday’s market close, up 6.62% for the week. The Federal Reserve’s 0.50% rate cut and a strong showing by former Vice President Joe Biden in Super Tuesday contests for the Democratic Presidential nomination gave markets an early bump. By week’s end, the enthusiasm had faded as the U.S. saw a jump in coronavirus cases from 64 a week ago to 260 across more than 20 states as of Friday afternoon. In response to the spread, businesses in hardest hit regions have begun to implement contingency plans to help contain the spread of the virus and maintain normal business operations. In Washington state, which leads the nation with 70+ cases, tech giants Microsoft and Amazon are asking employees to stay home to help contain the outbreak. With coronavirus dominating the headlines, current fundamentals have been tossed aside with investors summarily dismissing the first crop of post-coronavirus outbreak economic reports. Nonfarm payrolls crushed estimates, while the services industry posted continued gains. The manufacturing sector notched its second month of expansion despite coronavirus shuttering Chinese factories. Despite the week’s roller coaster ride, the positives managed to outweigh the negatives as the Dow Jones Industrial Average fought its way to a 1.80% gain for the week.
Jobs Friday Smashes Estimates
The coronavirus may have started its march west in February, but that did not deter businesses from hiring. February nonfarm payrolls rose by 237,000, beating estimates of 175,000. As a result, the unemployment rate fell to 3.50%, matching its lowest level in more than 50 years. Job growth was widespread, with healthcare leading the way with 57,000 new jobs. Strong housing demand continued to fuel demand for construction jobs, up 42,000 for the month. Professional and business services also saw gains during the month with 41,000 new jobs. As an added boost to the consumer spending picture, wages rose 3.00% from a year ago. Rounding out the good news for the jobs market was a 243,000 upward revision to December and January’s payroll figures. The jobs market still looks incredibly strong. Yet, with businesses operating in uncharted waters with the coronavirus outbreak, it is too early to tell how it will impact hiring as we look further out.
Services Expand While Manufacturing Holds on For Back-to-Back Growth
The services sector accelerated to a one-year high in February, signaling continued strength in the economy. The ISM Services Index rose to 57.3 in February, its highest level since February 2019, and up from 55.5 in January. Numbers above 50 indicate expansion while numbers below 50 indicate contraction. The rise in the services figure is reassuring for the economy as it represents more than two-thirds of U.S. economic activity. The index reported that businesses remained positive on the economic outlook, noting continued business demand.
The manufacturing sector, fresh off a U.S.-China Phase I trade deal, posted its second consecutive monthly expansion. The ISM Manufacturing Index hit 50.1 in February, down slightly from January’s 50.6 reading. Lifting the index higher was continued growth in new export orders, supplier deliveries, and production. However, imports took a hit in February, falling 8.7 points as coronavirus shuttered Chinese factories. The manufacturing sector appeared to be on the verge of a comeback as the U.S. and China were on the way to mending their trade rift, but the global spread of the coronavirus has wreaked havoc on global supply chains. For the time being, it appears the continued rebound in the manufacturing sector will be placed on hold.
Markets this week remained squarely focused on coronavirus figures and lost in the fog was the Atlanta Fed’s GDPNow forecast revision that has now bumped Q1 2020 GDP growth to 3.10% from 2.60% a week ago. The latest figures indicate the economy has managed to build some momentum against a drop in demand in the last month of Q1. Unfortunately, with headlines continuing to read like a sci-fi horror film, it is going to take some time for traders to get desensitized. Until then, the bumpy ride is likely to continue.
The Week Ahead
Coronavirus concerns are sure to dominate headlines once again as U.S. economic data will be light with reports on consumer and producer prices being the highlights of the week. In overseas news, the European Central Bank meets.
Mind Over Money: Important Reminders in Times of Volatility
As noted above, it’s been a roller coaster of a week. CNN Business’ Fear and Greed Index remained in “extreme fear” territory, and the VIX Volatility Index hit its highest level since exactly 11 years ago today — March 6, 2009. In our weekly commentary last week, we examined — in the context of coronavirus — the impact of past epidemics on the market to provide historical perspective in response to investor concerns. As coronavirus fears continue to dominate headlines, we thought it would be helpful to provide further perspective.
An old Wall Street adage states that financial markets are driven by two emotions: fear and greed. Investors tend to experience greed during the good times and fear in the bad. This was particularly true in 2019. The U.S. stock market concluded 2019 on a remarkable high with the S&P 500 posting a gain of 28.9% for the year. It was the best annual performance since 2013, yet lessons can be learned by contrasting how the year ended relative to how it began.
In late 2018, markets fell precipitously on concerns over interest rates, slowing growth, corporate debt, and a Chinese trade war. These fears knocked nearly -18% off the S&P 500’s value from September 2018 to December 2018, negatively shaping investors’ forecast for 2019. Very few saw 2019 breaking records, while some feared a recession was on the horizon. Following such a volatile period, even long-term investors may have questioned whether it was time to get out of the market.
This highlights the first investment lesson: We are all subject to “recency bias,” meaning that recent events have a disproportionate impact on our predictions for the future. This tendency can cause investors to alter their investment strategy in response to short-term market movements, potentially resulting in a profound and negative impact on their portfolios. Investors may attempt to time the market or to buy or sell based on the sense that current trends will persist. More often than not, periods of volatility contain very little new information that fundamentally affects the intrinsic value of portfolio holdings.
The second investment lesson: Investment gains are made tiny bits at a time. Sure, we may remember the big up or down days, but using the S&P 500 as the market proxy, the average daily return for the market over the last 25 years has been just 0.045% for a cumulative return of 1009% over this same period. Small differences compound over time, which illustrates that it is one’s time in the market that counts — not timing of the market.
Most of us are aware of these lessons, and anyone who has been invested during this 10-plus-year bull market can attest to just how volatile and unpredictable the market can be. Temporary market declines happen quite regularly, even during periods when stocks are mostly rising. Since investors abhor losses even more than they love gains, the natural tendency is to attempt to manage downside volatility. When the going gets rough, the instinct to do “something” — anything — is hard to resist. The question for us as long-term investors becomes what is the true value of doing “something” in a real world application. How much do you gain or lose over time if you are lucky enough to avoid large market declines, but incur taxes and miss recoveries in the process?
To demonstrate this scenario, we analyzed the impact of an investor with a $100,000 portfolio invested in the S&P 500 Index. We equipped this investor with perfect predictability, meaning that he or she was able to accurately foresee the worst daily performance for the S&P 500 each year, selling their entire portfolio a full day before the worst day of the year and buying back into the S&P 500 a full day after. In total, the investor is out of the market for three days each year (the day before the worst day of the year, the worst day of the year and the day after the worst day of the year) but otherwise remained fully invested. This investor was incredibly successful in avoiding the worst day of the year for 25 consecutive years, a period from January 1, 1995, to December 31, 2019, being invested for 6,219 days of 6,294 trading days, missing 75 days, 25 days which happened to be that year’s worst. Along the way, we applied a short-term tax rate of 37% and a long-term tax rate of 20% as the investor bought and sold. We then compared this to a buy-and-hold portfolio for the same period. In both scenarios, we liquidated the portfolios on December 31, 2019, to compare the net, after-tax portfolio values.
The results were surprising. The buy-and-hold, net after-tax value was $869,202.60, while the “successful” investor’s portfolio only grew to $815,297.16, despite having avoided the worst days in the market. There are a couple of reasons for this. The primary factor is taxes. Investors who sell securities held less than one year are subject to short-term capital gains, which are taxed as ordinary income. Whereas securities sold that were held for greater than a year benefit from the lower long-term capital gains rate. In our “successful” investor’s scenario, the gap between worst days in each calendar year were less than 365 days apart 56% of the time, meaning that our “successful” investor significantly impaired their portfolio by paying the higher tax rate relative to having held the positions longer.
Another downside in trying to time the market is the risk of incurring an opportunity cost by being out of the market and missing out on any subsequent gains. Big down days are often followed by big up days. In our model, we felt that because we gave our “successful” investor the trait of perfect clairvoyance, we needed to place some reasonable buffer around that successful prediction. We decided to require the investor to exit and re-enter after one full day on either side of the worst, calendar-day return. In doing so, we were still quite generous to the “successful” investor, since it is highly unlikely anyone has anywhere near that level of consistency or accuracy. That small period of time being out of the market is significant enough, however, to negatively impact performance. What we find when we start expanding the buffer window in subsequent models is that the “successful” investor’s annualized return decays very quickly as we start adding additional days to the buffer. The cost of being out of the market quickly overtakes any benefit from avoiding the downside volatility — putting an exclamation point on the idea that it really is time in the market that matters most to successful investing.
Assumptions: 1) Buy & Hold Investor taxed at the long-term rate of 23.8%. 2) Source data is from Yahoo Finance. 3) Using Adjusted Close price for the SPY ETF. 4) Using a static tax rate. 5) Re-invest portfolio at the adjusted cost-basis. 6) Both portfolios exit the market on 12/31/2019.