Collateral Damage: Global Trading, Global Virus, Failed OPEC Agreement, and Surprise Rate-Cut Collide

Chris Perras returns to talk in depth about the current market conditions, the Corona Virus, OPEC and what all this has meant for institutional players in the market.

Chris Perras: Good morning. My name is Chris Perras. I’m the chief investment officer at Oak Harvest Financial Group here in Houston, Texas. Welcome to the Friday, March 13th edition or weekly Stock Talk podcast: Keeping You Connected to Your Money. First off, there is no denying that the headlines, fear, and rhetoric surrounding the Coronavirus have become the primary driver of investment performance the last several weeks.

While the duration and volume of the COVID-19 virus related news is yet to be determined, we continue to counsel our clients and prospects to control what they can control. Investors should be mindful that perspective matters. In investing, time horizon always matters. The longer the holding period, the lower the volatility, and the higher one’s expected returns. At all times, we advise clients to try to remain calm and rational in their decisions. However, particularly in times of high volatility, like the ones we’ve seen for the past four weeks, we advise investors to remain poised and patient in their decision-making and to trust the investment process and their financial plan.

This podcast is a hybrid for my listeners. I’m going to combine the last four weeks current events with some rarely talked about behind the scenes dynamics that we’ve been seeing play out the last four weeks. This podcast is going to be entitled Collateral Damage. When leveraged trading meets a global virus, a failed OPEC agreement, and a surprise rate cut by the federal reserve, long-term investors feel short-term pain but are given long-term opportunity. As of this recording we were sitting near 2,575 on the S&P 500.

From the February 19th high of about 3,385 on the S&P 500, we have fallen about 24% from our all-time high in four weeks as volatility has spiked historically fast and markets have fallen at a speed not seen since October of 1987. I do remind listeners that the rapid October 1987 sell-off was the low point for the next 10 years of a 20-year-plus secular bull market. Historically, rapid -20% and higher declines often and do happen during ongoing secular bull markets.

This rapid decline comes on the back of dramatic selling and increased volatility in not only equity markets, but perhaps more importantly, also commodity, currency, and bond markets, including even the safest US treasury bonds. Even though the spread of the virus throughout China, its origin, and Korea have peaked, its sudden ramp in Northern Italy, the third largest economy in Europe and the eighth largest in the world has heightened concerned of its spread throughout the rest of Europe.

More recently its spread in Seattle and New York has brought the fear of the virus to our home shores and has caused a rapid slow down and shut down entirely. Think of events like the Houston stock show, South by Southwest in Austin, and the NBA basketball season. In some cases of US economic activity, which our listeners know is over 70% a service-based economy.

The COVID-19 virus and its effect on global growth supply chains and consumer demand was already sending economic shockwave through the global markets. On Tuesday, March 3rd, the federal reserve slashed interest rates by a half-point in an attempt to give the US economy a jolt in the face of concerns about the virus outbreak. It was also the first unscheduled emergency rate cuts since 2008, and also marks biggest one-time cut since then. Unfortunately, it seems to have had the reverse effect as investors have piled more money into treasuries and pulled money out of stocks and bond markets equally.

Then, the final out of left field move happened mid-last weekend when OPEC and Russia, during their oil production meeting, the world’s two largest oil producers met to agree on production cuts in order to help stabilize pricing due to an anticipated slowdown in the demand caused by the slowdown in Asia and the rest of the world from the virus. Saudi Arabia pushed for steeper and longer production cuts in Russia instead of acquiescing, walked away from the table in a deal probably to put a squeeze on the US shale operators.

Saudi Arabia responded with a shock and awe campaign seemingly intended to remind Russia just how much economic pain they can impose on other oil producers. That night, Saudi Arabia slashed its crude prices to China for the next few months and promised to ramp oil output by 2 million barrels a day even as demand is declining. When oil markets opened Sunday evening, prices plummeted to half of what they’d been in early January of this year, they dropped by 20% to 30% overnight. The move down in oil price has ripped through global stock and credit markets, when markets opened last Sunday morning, as many investors chose to sell first and ask questions later. That, and many large leveraged financial players were forced to sell assets to de-leverage.

This is where my weekly Stock Talk podcast title comes from, Collateral Damage. The investment team at Oak Harvest builds investment models and allocation for our clients to help try to achieve your long-term financial objectives. I repeat, your long-term financial objectives. Our financial planning is based on the core four pillars of asset diversification. These include a combination of low-risk insured tools, fixed income, income-yielding public real estate, mutual funds, ETFs, and dividend-paying stocks for some of our clients. Some of these asset classes, like equities, and ETFs, and mutual funds that own equities are inherently volatile.

Other things that fall into pillar one that we use for clients if appropriate for their situation, like insurance tools are inherently non-volatile. The fixed insurance tools that we use as part of pillar one are, in fact, principal-protected. That means clients who have taken our advice and allocated money to these tools have not lost a single dollar, a principal, in those fixed insurance products during this market turndown.

Meanwhile, some of these products still provide the potential for double-digit growth in good market years depending on the contract terms. We do not leverage client assets with debt. We do not borrow money to enhance returns of our clients. However, there are many investors, including hedge funds, risk parody funds, and others that do borrow money to invest in markets, including public equities and public debt instruments.

Many of our competitors actually use leveraged ETFs in their model portfolios. We do not. These investors have much different goals and objectives than our clients and use much different structures to try to reach their goals. The main thing that they all have in common with each other, but not us, is they all use leverage. They almost all use an underlying asset as collateral to borrow money, to buy more assets, to leverage their return.

Almost every investor understands the use of leverage in buying a home and borrowing money in the form of a mortgage. Most first time home buyers are required to put down at least 20% down payment to buy a house. If you want to buy a house, say a $500,000 house, you must put down $100,000 in cash. They must pony up $100,000 in collateral. Then, the bank goes ahead and lends you the other $400,000 to buy the house.

However, if you should have to turn around and sell your house before you pay off your mortgage, say maybe three or four years from now, when you have to move or maybe there’s an economic downturn, and say you only get $450,000 when you sell the house, who takes the economic loss on the house? You, the homeowner, does. The $50,000 loss comes out of your $100,000 in equity. It comes out of your $100,000 in collateral.

While the overall market value of the house price decline was only 10%, dropping from $500,000 to $450,000, you, the homeowner, just lost 50% of your investment. That is called leverage. In this example, it is negative leverage, and it is what is going on in the markets currently, which leads us to much of what has transpired the last four weeks in the market. The speed and veracity of the decline that has transpired since mid-February has been magnified by those investors who are leveraged and on margin.

Unlike a homeowner who might look into the market once in a five-year period to value their house for a sale, these investors have their house price at least at the end of every day. Many of them have their houses priced in real-time throughout the day or over their collateral, which unlike the homeowner situation, which is almost always a cash downpayment, these leveraged investors almost always use another public market security as collateral. As the value of their collateral becomes increasingly volatile, these players must sell assets out of necessity.

Trying to predict the final timing events, like what has transpired the last four weeks, is impossible. The markets and the economy are being hit by what is similar to a 9/11 type event, one that is literally transpired out of nowhere, triggered by a one-off shock. This time, a pandemic spread of a new virus that causes economic growth to drop for a few quarters, which is technically a recession.

According to Goldman Sachs, historically, those economic and stock downturns have lasted on average 7 to 12 months, and the S&P has fallen between 26% and 29% from its highs, which as of Thursday’s market lows, was almost exactly the draw down from our all-time highs only four weeks ago. The speed of the decline has been historically rapid. It’s been out of left field, and therefore very unnerving, but it isn’t the time to make a long-term asset allocation change decision.

The time to make a long-term asset allocation decision is when volatility is low and you are thinking with little emotion. It is why we, as a team, stood in front of our clients in mid-January and said to them, if you are uncomfortable with market volatility, now is the time to meet with your advisor and make a change in your allocation, when stocks are near all-time high and volatility is low, not when stocks are down and volatility is high.

On January 17th, after almost four months of a linear up move in the market with the S&P, if you’re nearing 3,350, the team at Oak Harvest previewed our concerns for the first quarter pullback in the market. This podcast was entitled It’s Rotation Nation Time, Goodbye Old Friends, It’s Been a Good Ride. Listeners can review that podcast by heading to our website at oakharvestfg.com and searching the investment management tab for our podcasts. In that podcast, we outline how the team was allocating our client’s exposure to small-cap growth stocks out of their accounts due to the huge run that they’d had the prior nine months.

In addition to selling these assets when they were up and extended, we also sold some consumer discretionary stocks, harvesting losses for our clients. That being said, the breadth, speed, and magnitude of the current market decline is beyond what we expected to see during the first quarter. Events like the virus outbreak, 1987 stock events, and terrorist attacks are 100% unpredictable. They’re indiscriminate in their scope. Their teams see this event or its outcome happening in advance of it. No, not at all. However, we were making some tactical changes in advance of it because our discipline says to sell or trim when we see things get too extended, others are too optimistic or just too enthusiastic as we saw in mid-January pre-virus fears taking hold.

Had the last four weeks been fun? Certainly not. These are the events that bring increased anxiety to savers, investors, and our communities in general. Listeners, please remember, your highest compounding returns come from buying equities during economic downturns, regardless of their causes, and event-driven downturns like this has historically rebounded relatively quickly due to pent-up demand on the other side of the event. At Oak Harvest, we pride ourselves on being comprehensive long-term financial planners. What this means is that as our client, you and your financial advisor should have a financial plan that is independent of stock market volatility.

It is currently too early and too unpredictable in its nature to assess the final impact of the virus on economic activity and corporate earnings. The sooner the virus is confidently contained in the United States, which statistics in China and Korea already point to it being controlled there. Just this morning, Disney reopened its park in China, and Apple reopened about 50 stores in China. The quicker the stock markets and bond markets can recover, and economic activity will pick up.

For now investors should maintain a balanced approach to asset allocation given the uncertain nature of the outbreak. Anxiety and risk aversion is likely to continue in the weeks and months ahead, as our country implements measures to fight the spread of the virus here in the States, which undoubtedly, will cause short-term negative growth early this year. We continue to expect a sharp and sustained rebound, both the economy and the markets the second half of 2020. If you’re retired or in the process of retiring, give us a call at 281-822-1350. We are here to help you plan your financial future and help smooth the financial path you had into and through your retirement years with a customized retirement planning. Many blessings. This is Chris Perras with Oak Harvest Financial Group.

Operator: The preceding content expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable and created, but any cited data statistics and sources are not guaranteed. Content, ideas, and strategies discussed may not be right for your personal situation. It should not be considered as personalized investment, tax or legal advice, or an offer or solicitation to buy or sell securities. Investing involves the risk of loss, and past performance does not guarantee future results.