Monday was a notable day in the financial markets. Following a break down in oil supply talks between the OPEC countries and Russia, the Saudi’s announced that they would be dramatically increasing their output of oil beginning April 1. The Saudi’s are the low-cost producer and can still make sizable profits at much lower oil prices then other countries. This announcement was very unexpected. As recently as Friday oil had rallied on expectations of a cut in OPEC supply to offset demand weakness from the coronavirus. Oil was down 20-30 percent yesterday, an unprecedented move that lead to a sell off in all equity markets. Why? The answer is varied. First, the market hates surprises and market participants reaction to news that they can’t calculate a value for is to sell first ask questions later. Next, the United States had a flood of capital into its energy markets over the last several years as investors rushed to take advantage of the newly discovered shale oil fields. However, shale oil is expensive to get out of the ground. When oil was $70-80 per/bbl that didn’t matter when it is sub $30-40 it’s a problem for producers who aren’t profitable at those levels and have a lot of debt. This dramatic down move in oil brought the potential for eventual defaults by oil companies front and center. The market was forced to deal with what had been “potential” uncertainly as an “actual” uncertainly. This, while the market is still dealing with the uncertainty of the coronavirus.
How does the market react to uncertainly? With large trading ranges, moving in large percentage amounts up and down. Why does it react this way? Because every seller needs a buyer and when there is uncertainty it is difficult to find buyers of the assets that are for sale. Wall Street is the only store where when items go on sale the buyers flee! The good news is, that although the short term is uncertain the long term is much more certain and those willing to take advantage of this are well positioned to profit.
This is especially true of companies without high debt relative to their revenues. A good analogy might be two landlords. One owns his rental property outright, the other owes the bank $1000 per month and is reliant on the tenants $1500 rent to cover his debt payments. If his tenant loses his job and can’t pay, then the landlord can’t afford his debt payments and he will lose his property. The other landlord, who owns the house outright, can wait until he finds a new tenant with a job without worrying about losing his property. This is the same in corporate America. Companies with little debt can wait for revenues to turn around those with large debts sometimes can’t. Warren Buffet says, “When the tide goes out you see who is swimming naked.” Right now, the market isn’t differentiating between who is and isn’t wearing trunks and there is opportunity to add high quality, low debt companies to your portfolio at excellent prices.
You should not think that this uncertainty is over, however, though it might be. The truth is, no matter what they say on TV, it is impossible to predict when the markets reaction to the uncertainty will end. Interestingly, yesterday, March 9th marked the 11-year anniversary of the bottom of the 2008/2009 bear market. Even in hindsight it is impossible to point to any tangible reason. There was no bell, no government announcement just an end to the selling and eventually a more certain future. What do we do in this environment? We make small incremental purchases of individual securities or indexes with strong companies, on the way down. For us, with a long view, the lower prices get the better the expected future returns and thus the better the opportunity.
The one area where we do have some certainty is that the future returns of government bonds will be VERY low. As recently as yesterday a 10 Yr. US Government bond was trading at ½% per year. People are so nervous about the future that they are willing to accept a ½% p/yr. return for 10 years! Individuals can’t support their retirement on these types of returns. We have been anticipating lower for longer rates which is why we have been proponents of alternatives and other sources of returns unconnected to stock and bond markets. These instruments have served us well in this environment, with some having big upside moves. We continue to uncover new uncorrelated instruments and they are going to be important parts of client portfolios with interest rates so low.
Finally, we’d like to say something about our business and our clients. Periods like this are when financial advisers earn their stripes. Often, our services seem ancillary when the stock market is up 15 or 20%. However, we are always trying to calculate and mitigate risk for our clients. In recent years we have done that by expanding our menu of alternatives and that is serving us well in this period. We will continue to do this as interest rates stay low. In volatile periods we also provide important separation between our clients and their money helping to limit actions based on emotion. Over the two and half decades that we have been in business we have seen many draw-downs, bear markets and even a crash or two and know how to come out the other side stronger. As a firm we are very proud of the sanguine way our clients have reacted to the volatility. We also believe that periods like this can be a good time to refer a friend or relative struggling with the volatility or making rash decisions to a financial adviser.
Can we be sure that the next weeks or month will be better for the markets then the last? Unfortunately, not. But, can we be certain that the economy and markets will again be good? Absolutely