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If you’ve been paying attention to the news, you know the markets have endured a topsy-turvy month of January. As a result, the S&P 500 and Dow Jones are both on the verge of what analysts call a market correction.¹ (Something the NASDAQ already entered last week.¹)  Should this volatility continue, you’re likely to see that term a lot in the days ahead.

Headlines proclaiming a market correction can often look very scary. That’s a problem because fear is every investor’s worst enemy.  It’s what drives investors to make irrational and shortsighted decisions instead of sticking to their long-term strategy. So, in this letter I’m going to give you a few simple steps for dealing with the market correction that will never go out of date.

Step 1: Know What a Correction Is

Quick refresher in case you’ve forgotten or are unfamiliar with the term: A market correction is defined as a decline of 10% or more from the most recent peak.

It’s important to know this so you understand why corrections are not the end of the world. For example, it’s hypothetically possible for a stock to drop 10% and still be higher than it was a week ago. And while corrections can sometimes worsen into bear markets — defined as a drop of 20% or more — they usually don’t. In fact, on average, corrections last only around three to four months.²

Step 2: Remember That Corrections Are Common

Unlike bear markets, market corrections are also surprisingly common.  Prior to this month, we’ve had ten since the turn of the century alone…of which three turned into bear markets.³ You see, “a drop from a recent peak” doesn’t mean the sky is falling. It simply means that, for whatever reason, investors are feeling pessimistic and have decided it’s time to lock in the gains and sell, or move their money to less volatile investments like bonds. Invest for long enough and you’ll live through dozens of corrections in your lifetime.  They’re like getting a stomach bug: Unpleasant and unavoidable, but usually short-lived.

Step 3: Understand Why This Correction Is Happening

So why are investors retreating? Well, there are two main drivers of the current correction. The first is an old story, one we’ve been dealing with for over a year now. The second is newer, at least to those of us living on this side of the Atlantic.

I’m referring, of course, to inflation and Ukraine.

Let’s start with inflation. As you know, the ongoing pandemic has wreaked havoc on global supply chains.  This has caused prices to rise on everything from cars to food to toiletries.  At the same time, the economy has expanded, partially due to the Fed keeping interest rates at historic lows. The result? Skyrocketing inflation.

Early in the recovery, the Fed hoped that inflation would be transitory, meaning temporary and short-lived. But inflation has proven stubbornly persistent.  After all, COVID-19 has not gone away, choosing to spit out new variants instead.

For months, investors have been expecting the Fed to raise interest rates to combat inflation. (Higher interest rates slows the economy by encouraging consumers and businesses to save rather than borrow or spend. This, in turn, leads producers to lower prices to attract new business.) Now, in 2022, many analysts anticipate the Fed will raise interest rates several times this year. And it could happen as early as this week. The Fed is gathering for a two-day meeting on January 25, and investors are waiting with bated breath to see whether they’ll announce an interest rate hike.

Why do stock investors fear the prospect of higher interest rates?  Well, low interest rates mean that many securities, like bonds, simply don’t provide the same return on investment as they would in a high-interest-rate environment.  That drives more into the stock market to get the returns they need.  Higher interest rates could potentially reverse this trend, leading to money flowing out of the stock market and into other areas.  When that happens, stock prices typically fall.

As we have discussed, when attempting to reduce risk by switching to bonds in response to stock market volatility, you often trade one risk for another risk. When you switch to bonds you are vulnerable to purchasing power risk. Purchasing power risk is when inflation is growing faster than your money.

For these reasons, the interest rate/inflation story is unlikely to go away anytime soon. But now, the markets have a new question to deal with: The prospect of Russia invading Ukraine.

Now, this is hardly the place to dive into the long and controversial history of the Russian-Ukrainian relations. So, let’s just cover the basics. In recent weeks, Russia has moved over 100,000 troops near the Ukrainian border.⁴ This has NATO — of which the US is a leading member — understandably concerned. (Remember, Russia forcibly annexed Crimea from Ukraine back in 2014.) All the major nations in the region are currently engaged in diplomatic talks, but the situation is growing so serious that the U.S. has ordered all family members of embassy personnel in Kiev to leave Ukraine.

Compared to inflation, it may be hard to see why this story has any effect on the markets at all. The reason can be boiled down to a single word: uncertainty. Will Russia really invade Ukraine? No one’s certain. What would happen if Russia did?  No one’s certain.  What will the US and other Western countries do about it? No one’s certain. If, theoretically, the US were to levy sanctions against Russia, or prevent Russian banks from doing business with the US financial system, what would that do to global trade? No one’s certain.

The markets hate uncertainty.  When investors encounter it, they tend to draw the curtains, head for the hills, and circle the wagons.  So, when you see a broad selloff after news like this, keep in mind that it’s not because investors know what will happen.  It’s because they don’t.

The good news is that geopolitical events tend to have a very short-lived effect on the markets.  That’s because, as the situation clarifies and uncertainty is replaced by understanding, the markets will settle down and go back to focusing on more domestic concerns.  However, my team and I will keep a close eye on this.  If the Russia-Ukraine crisis continues to impact the markets over the coming weeks, I will cover the subject in greater depth in a future message.

Step 4: Determine Whether a Correction Is Likely to Affect Any Short-Term Needs

Now that you know what a correction is and why this one is happening, the next step is to determine whether we need to do anything about it. For most long-term investors, the answer is usually no. However, if you have a major life event coming up, or feel you may need access to your money in the coming weeks, it’s possible your answer will be different. Should this be the case, please reach out to me as soon as possible so we can plan accordingly.

If that’s not the case, then proceed to…

Step 5: Keep the Long View

You knew this was coming, didn’t you?  But this fifth and final step always bears repeating, because it’s so important.

Think back on everything we just covered: Corrections are common.  Historically, corrections are short-lived.  Most investors will experience many corrections in their lifetime.  Corrections occur because investors want to lock in gains or reduce their personal volatility.  Investors do this not because they know what the future holds, but because they don’t.

Put it all together, and it becomes clear: Corrections really aren’t worth overreacting to, are they?

That’s why keeping the long view is so crucial.  Generally speaking, it’s not the markets that determine whether we reach our financial goals or not.  It’s our own decisions.  Which, in some respects, can be a bit of a struggle, because it means we must stay disciplined all the time.  But it’s also an enormous comfort, because it means the power to control our financial future is always in our hands.

So, there you have it,  your guide to dealing with market corrections.  Simple, right?  Of course, simple doesn’t always mean easy.  So, if you have any questions or concerns that I didn’t address in this message, please feel free to contact me.  I’m always happy to speak with you!

In the meantime, always remember that my team and I are here for you.  From inflation to Ukraine and everything in between, we’ll keep monitoring the situation, so you don’t have to…and inform you immediately if there’s ever anything else you need to know.

¹ “Dow, S&P 500 and Nasdaq all in ‘correction’ territory as inflation and geopolitical tensions flare,” CBS News, January 24, 2022.  https://www.cbsnews.com/news/stocks-s-p-500-dow-nasdaq-correction-inflation-russia-ukraine-2022-01-24/

² “Correction,” Investopedia, updated January 24, 2022.  https://www.investopedia.com/terms/c/correction.asp

³ “What is a stock market correction?” The NY Times, January 24, 2022.  https://www.nytimes.com/article/stock-market-correction.html

⁴ “How Russia’s Military is Positioned to Threaten Ukraine,” The NY Times, January 7, 2022.  https://www.nytimes.com/interactive/2022/01/07/world/europe/ukraine-maps.html

One year.  It seems incredible, but it has been one year since COVID-19 struck our shores.  One year since the World Health Organization declared a pandemic.  One year since the markets crashed and the schools closed, and we realized just how much we take toilet paper for granted. Since then, the markets have recovered and risen to new heights.  The economy, meanwhile, has recovered more slowly.  Now, a quarter of the way through 2021, we have a new president, several new vaccines, and a completely different world than the one we knew before all this started. We have also seen some renewed volatility in recent weeks.  This has many of my clients asking, “Where are the markets going next?  What should we expect for the rest of 2021?”  We’ll address those questions in this letter.

As you know, there are two types of long-term market situations: Bull markets and bear markets.  But the whole “bull vs bear” concept can also be used to describe two types of investor sentiment.  Bulls are investors who have a positive, or “bullish”, view of where the markets are headed.  Bears, meanwhile, generally have negative, or “bearish” expectations.  So, in this letter, I’m going to let both animals debate each other, each presenting their case for why the markets will have a positive year or a negative one. We’ll start with the Bull, move onto the Bear, and then give the Bull a chance for a short rebuttal.  Finally, as your financial professionals, We’ll give you our view.

The Bullish View

Last year’s market crash was sudden, swift, and deep.  But in the grand scheme of things, it didn’t last very long.  In fact, it took only six months for the markets to recover.  (By contrast, it took the markets almost six years to recover after the Great Recession.)  Since then, the markets have risen to new highs.  Three things propelled the markets to this remarkable turnaround: Low interest rates, federal stimulus, and the expectation of a major economic recovery.  Let’s start with the first one.  To help juice up the economy, the Federal Reserve lowered interest rates to a historic degree.  Low interest rates promote more borrowing and spending, two pillars our economy is based on.  They also help people buy homes and encourage businesses to invest more in themselves.  (Including hiring more workers.)

Congress, meanwhile, has passed three major stimulus packages in the last year.  The most recent bill was signed by President Biden on March 11.  The America Rescue Plan Act of 2021, as it’s called, provides $1.9 trillion in aid for both businesses and consumers.¹  Among other things, the Act extends COVID unemployment benefits through Labor Day, provides $1,400 direct payments to individuals, expands certain tax credits, and grants billions to small businesses to help meet payroll and retain workers.¹ The first two stimulus packages had a positive impact on things like retail sales and consumer spending, and it’s widely expected that this one will, too.

This combination of low interest rates and government stimulus have helped the economy tread water while we deal with the virus.  But much of the market’s rise is due to something else: Expectation.  Specifically, expectation that the pandemic will end, and the economy will hit the accelerator. As more people are vaccinated and case numbers fall, the thinking goes, more and more of society will re-open, releasing a flood of pent-up demand.  Demand to travel, to eat out, to catch a movie in theaters, you name it.  Add the latest round of stimulus to the mix, and suddenly Americans have both extra money in their pocket and the means to spend it.  In other words, all the ingredients are there for a major economic comeback, the likes of which we haven’t seen in decades.

Now, we seem closer than ever to that expectation becoming reality.  As of this writing, there are three approved vaccines in the U.S., with more than 115 million doses administered.²   (40 million people are currently considered fully vaccinated, approximately 12.3% of the total population. ²)  Currently, our nation is averaging over 2 million shots each day.²  It's no surprise, then, that cases in the U.S. have been falling for weeks.  In fact, as of March 19, cases are down over 14% over the last two weeks.³  We’re not out of the woods yet, not by a long shot.  Masks and social distancing will continue to be a part of our lives for some time yet, and of course there are relatively new variants of the coronavirus to deal with.  But if we can maintain this trajectory, increasing the number of people vaccinated and reducing the number of people sick, that could do wonders for our economy.  It could lead to more of society re-opening, leading in turn to more jobs, more consumer spending, and greater company earnings.  Greater earnings, of course, usually lead to higher stock prices.

The Bearish View

So, in light of all this, how can anyone have a negative view of where the markets are headed?  It all comes down to a single word:  Inflation.

Inflation.  It’s a scary-sounding word that conjures up images of German children stacking useless money in the 1920s, or gas rationing in the 1970s.  For decades, economists have monitored it relentlessly. The Federal Reserve considers managing inflation to be a core aspect of its mission.  That’s partly why our nation’s inflation rate has been relatively stable over the last twenty years.  But recently, some analysts and investors have begun stressing over inflation again.  They don’t deny that the economy is poised to grow.  They just worry that it will grow too much, too fast.  There’s a word for this, too.  Economists call it overheating. When an economy overheats, it essentially no longer has the capacity to meet all the demand it faces from consumers.  Some producers will simply not be able to supply all the goods their customers want.  Other producers, to keep up with that demand, will be forced to raise prices.  It’s a classic example of the Law of Supply and Demand.  (When the demand for something outpaces its supply, the price goes up.)  For example, if everyone suddenly decides to fly to that vacation spot they’ve been putting off for a year, the cost of air travel would skyrocket.

If the economy were to grow too quickly, prices would rise across the board – and the value of our currency would drop.  This, essentially, is inflation: When the general price level rises, a dollar simply pays for less than it used to.  That makes it much harder for people to buy the goods and services they need.  Or to pay off their debts.  It makes it harder for businesses to hire new workers or pay the workers they already have.  The upshot?  When inflation gets too high, consumer spending plummets, unemployment jumps, and economic booms turn into economic busts. Some experts worry this is what’s in store in 2021.  They see the economy as a garden hose that’s been tied up into a knot.  Untie the knot – or re-open the economy too quickly – and the water will burst out with sudden, savage force.

So, here’s what this has to do with the stock market.  Normally, the Federal Reserve combats inflation by raising interest rates.  Higher interest rates tend to cool off the economy, because they prompt people to save their money instead of spending or borrowing it.  A cooler economy decreases inflation, and gradually things go back to normal.  The problem is the stock market has become accustomed to the Fed’s low interest, “easy money” policies.  Low interest rates mean that many types of investments, most notably bonds, simply don’t provide the same return on investment as they would in a high-interest rate environment.  That drives more and more investors into the stock market to get the returns they need.  But what happens when interest rates go up?  Consumers and businesses could cut back on spending, which in turn could cause earnings to fall and stock prices to drop.

Fear of inflation, and fear of higher interest rates.  That’s the bearish view in a nutshell.

Rebuttal

We promised the Bull would have the opportunity for a short rebuttal, so here it is.  There are two main reasons for thinking this fear of high interest rates are overblown.  The first is that, even if inflation does go up – which it likely will – we have a lot of room to work with before it becomes a problem.  In 2020, the inflation rate was only 1.2%.⁴  That’s well below the 2% mark the Fed generally aims for, and nowhere close to the mindboggling numbers we saw in the late 70s and early 80s.  (In 1979, for example, the inflation rate was 13.3%.⁴)

The other reason is that there’s no reason to assume the Federal Reserve will automatically raise interest rates just because inflation goes up.  Why?  Because the Fed itself has said that it won’t!⁵  Currently, the Fed sees stimulating the economy and boosting employment to be far bigger priorities than tamping down on inflation, and recently, the Fed Chairman suggested interest rates would remain low at least until 2022.

Our View

Now that we have told you what the Bulls and Bears think.  So, here’s what we think.  Go watch a video on YouTube and then read the comments.  Ever notice how many people like to say “First”?  In my experience, a lot of investors – be they Bulls or Bears – are like that.  They stress over “getting ahead” or “being first”, and as a result, they overreact to the slightest provocations.

Here at Vaughan & Co. Securities, Inc., we don't worry about being first. We only care about moving forward.  That’s why we focus on one thing: Investing for the long term without trying to guess whether the Bulls or the Bears will dominate.  That means positioning ourselves to take advantage of bull markets while being prepared – mentally and financially – for bears.Historically, an improving economy leads to a stronger stock market.  If that happens in 2021, wonderful!  But if interest rate fears worsen and volatility goes up, experience has taught us not to overreact.  Remember, we’re not investing for next week, or next month, or next quarter.  We’re investing for years.  Any general rise in prices is likely to be temporary, just as any bouts of volatility are temporary, too.

It’s been a year since the pandemic began.  A year since some of the worst market turmoil in a long time.  We got through that by being disciplined and patient, and we’ve been rewarded.  So, that’s what we’ll continue to do.  Other investors can worry about being a Bull, or a Bear, or “first”.  We’ll just continue being disciplined and patient.

 

SOURCES:

¹ “The American Rescue Plan Act Greatly Expands Benefits through the Tax Code in 2021,” Tax Foundation, March 12, 2021.  https://taxfoundation.org/american-rescue-plan-covid-relief/

² “How is the COVID-19 Vaccination Campaign Going In Your State?” NPR, March 19, 2021.  https://www.npr.org/sections/health-shots/2021/01/28/960901166/how-is-the-covid-19-vaccination-campaign-going-in-your-state

³ “How Severe is Your State’s Coronavirus Outbreak?” NPR, March 19, 2021.  https://www.npr.org/sections/health-shots/2020/09/01/816707182/map-tracking-the-spread-of-the-coronavirus-in-the-u-s

⁴ “US Inflation Rate by Year,” The Balance, March 1, 2021. https://www.thebalance.com/u-s-inflation-rate-history-by-year-and-forecast-3306093

⁵ “Powell Confirms Fed to Maintain Easy Money Policies, The Wall Street Journal, March 4, 2021.  https://www.wsj.com/articles/feds-powell-to-take-questions-on-job-market-interest-rates-bond-yields-11614872817

If you have any questions or concerns about the market, please feel free to contact me.  In the meantime, enjoy the upcoming spring season!

 

Every year around this time, parents, grandparents, and guardians prepare for Back to School season.  This year is no different – except how they prepare may be very different indeed.  Due to the pandemic, parents now have some difficult choices to make.  Do they send their children back to school?  Do they choose online learning?  Should they homeschool for a year?  It’s a difficult question with no easy answer because there are so many factors to consider.  How many cases are in the area?  What options does the school actually provide?  What is the child’s health like?  What about the health of other family members?  How do parents balance their child’s education, social needs, and health with their other responsibilities?

Since the headline at the top of this letter says, “Summer Market Update,” you’re probably wondering why I’m talking about going back to school.  The reason is simple.  As you know, COVID-19 has completely upended our daily lives.  It has disrupted almost everything we used to think was “normal.”  And the problem is, there’s no playbook for how to adapt!  No cheat sheet that contains all the answers.  That’s certainly true for parents.

It's also true for investors.

I’ve been thinking about this a lot as I’ve studied the markets over the past few months.  There’s simply no cheat sheet – or even a roadmap – for how to invest in a period like this.  Think about it.  Even during “normal” times, it’s hard enough for institutions to know what to do.  But asking an investor who’s simply trying to save for retirement to navigate the markets during a recession and a health crisis?  Talk about dealing with uncertainty – the one thing investors hate most!

Just as parents have multiple options to consider, so do investors.  Be aggressive?  Be conservative?  Stay the course?  Get out of the markets altogether?  And again, there are so many factors and variables to consider – or at least, that’s what media pundits would have you believe.  So many, in fact, that trying to parse what matters and what doesn’t can feel like the world’s worst word search.

Those words are earnings, interest rates, COVID, second wave, vaccines, stimulus, China, oil, and elections if you don’t want to bother searching – and who could blame you?  If you believe the talking heads in the media, each of those words could signal either a glorious market recovery or a gloomy market pullback.  As a result, interpreting the markets can feel like looking at a blurry photograph and trying to guess what it shows.  That just leads to less clarity and more confusion.  Is the economy recovering, or is it still in decline?  Are the markets on solid ground, or the edge of a cliff?

The proof of all this can be found in how the markets have behaved over the past two months.  March’s bear market led to a sharp recovery, but since the beginning of June, the markets have been largely flat.  For example, on June 8^th, the S&P 500 closed at 3,232.  On July 30, it closed at 3,246.¹  There have been plenty of little bumps and shallow dips since then, but overall?  Flat.  And that’s with many investors staying out of the stock market altogether, with “nearly $5 trillion parked in money markets” as CNBC reported back in June.²

In school, we learned that for every action, there is an equal and opposite reaction.  That’s Newton’s Third Law of Motion, and when he wrote it, he was talking about physics.  But lately, it can also describe the physics of the markets.  For example, here’s a short list of what’s been driving the markets lately:

Event	Market Action/Reaction
Good news about vaccine development!	↑
But a rising number of COVID cases…	↓
Unemployment claims fall!	↑
But unemployment is still high…	↓
Consumer spending is up!	↑
But the stimulus that drove it is all used up	↓
Federal Reserve keeps interest rates near zero!	↑
Congress can’t agree on more stimulus	↓

You get the idea.  For every bit of good news, there’s news that’s equally troubling.  For every action, there is a reaction.

In short, there is still a lot of uncertainty out there about what type of economic recovery we’re actually experiencing, and where the markets will go next?  When you talk to investors and analysts, there’s a sense that most of them are just waiting for a sign, a development, for something that’s infallible, incontrovertible, unmistakable.  Something that helps them feel certain about what to do.  Essentially, investors are tired of trying to read tea leaves and want road signs.

But even during normal times – there’s that word “normal” again – the road to growth is rarely straight.  There is, and will continue to be, major uncertainty in the months ahead.  We don’t know what the coronavirus will do.  We don’t know when a vaccine will be available.  We don’t know whether the economy is recovering or stalling.  We don’t know who the next U.S. president will be.  We can have educated expectations, but we don’t know. 

So, what do we do?

We remember the most important things.

I have good news, We don’t need to know all those things.

I say this all the time when dealing with a client who is nervous about the future (which is very rarely.)  Those who worry about what the markets do day-to-day, week-to-week, or month-to-month, are traders and short-term investors trying to make short-term money.  It’s a thrilling way to invest.  As a result, the media largely caters to that crowd, because that’s where the drama is.

What we must remember is that we are long-term investors.  That means we can deal with uncertainty better than anyone else by not trying to make decisions we don’t have to.  As the saying goes, it’s not timing the market, but time in the market that matters to us.  What happens over a month, a quarter, or even a year, is less important than what happens over a decade.

Here’s one way to think about it.  Imagine you were blowing bubbles into a glass of water.  If you looked at it up close under a magnifying glass, the bubbles would look like huge waves.  Take a step back, and they’re mere blips.  The same is true for the markets.  Waves in the short-term look like ripples in the long.  So, what’s the point in overreacting to each one?

When it comes to investing during this climate, we also must remember that, just as there’s no cheat sheet, there’s also no one right answer.  Just as parents must make the best decision for their situation, the same is true for us.  When it comes to our investment strategy, making sense of the word search above is simply not as important as asking ourselves: How much risk can we afford to take on?  What kind of return do your personal goals require?  How close are you to retirement?  Do we prioritize growing your money, or preserving it?  We’ll continue to let your answers dictate the decisions we do make, not how many COVID cases there are or when a vaccine will come.  That way, even when the market is flat, we’ll keep moving forward – secure in the knowledge that we’re doing what’s best for you. 

In the meantime, the markets will continue to act and react.  But we won’t.  There will be good weeks and bad days.  But we’ll continue to think in terms of years.  That’s why, when it comes to interpreting the markets, we don’t have to worry about being cleverer than everyone else.  We just need to worry about being more disciplined.

We hope you found this letter informative.  As always, please let us know if you have any questions or concerns.  We always love to speak with you.  Have a great rest of your summer!

The 30-year US Treasury Bond yields about 1.4% (Yield is calculated by dividing the annual interest paid by the bond by the price of the bond.)  The Federal Reserve (The central bank of the United States, which sets monetary policy.) has a long-held, clearly stated policy of inflating US currency by 2% per year.  Should the Federal Reserve succeed with this policy, the 30-year bond would provide a real yield (interest paid minus inflation) of -.6% each year.

 

However, 1.4% per year is taxable as current income.  To make my math easier, we will assume that you are in the 30% federal income tax bracket.  You would then pay about .4% per year in federal income taxes.  Combined with the .6% per year currency depreciation from inflation, the negative annual return is about 1% per year.  If the 30-year bond is held to maturity, then about 30% of the purchasing power of your money is lost.

 

If you are not planning to hold your 30-year Treasury bond until maturity - maybe you are just parking your money until markets settle down - you may find that interest rates have risen.  Since prices of existing bonds fall as interest rates rise, you may sustain a capital loss in what was supposed to be a risk-less asset.

 

Of course, you can decrease or eliminate the potential capital loss with shorter-term bonds. The 10-year US Treasury yields .9%, and money market funds are at .25%.  Essentially nothing.  To substitute Municipal bonds in this analysis, use a yield of about 2.27% per year (ETF: MUB).

Inflation reduces your return by 2% per year to .27% per year.  No adjustments have been made for the credit risk that some municipal bonds may not be paid in full.

 

Based on the stated policy of The Federal Reserve to generate 2% per year of inflation, the bond market promises negligible to negative returns per year.

 

What are your alternatives? If the bond holdings are part of the savings portions of your portfolio, we will recommend money market funds as a lower-risk alternative.

If the bonds are part of the wealth-building portion of your portfolio, we will recommend an increase in your allocation to quality common stocks.

 

As always, your comments are welcome.

 

What will the economic recovery look like?  It’s the million-dollar question.

Will it be V-shaped, with the economy bouncing back as swiftly as it fell?  Or will it be more like the Nike swoosh – a swift drop, with a long but straight road back to the top?  Or maybe it will be like a rollercoaster, with plenty of stops, starts, hills, and valleys before the ride comes to a stop?  As we continue battling the coronavirus, the answer will influence how soon life returns to normal – and what normal actually is.

Economists often use recession shapes to characterize recessions and their recoveries.  These shapes commonly take the form of letters in the alphabet, like V, U, W, and L.  Modern history provides many examples of each type of recovery.  Currently, there are good arguments to be made for each scenario.  That’s why, for the next several months at least, economists, investors, and analysts will all be looking anxiously at every bit of data they can find to determine which letter the recovery will resemble.

As part of my ongoing efforts to keep you up-to-date on how the coronavirus is affecting your investments, I thought it would be good to briefly cover each scenario.  We’ll look at why each shape may or may not happen and how each could impact us.   Before we begin, though, there’s one thing to remember.  As long-term investors, the long-term health of the economy plays a role in how we plan for the future.  Despite this, we must always remember that the economy and the markets are not the same.  They are related, but they don’t move in lockstep.  More often, the markets move ahead of the economy.  Investors are always looking towards the future, trying to gauge where the economy will go as opposed to where it is now.  That’s why, despite the spate of bad economic news lately, the markets have been fairly stable.  So, even if the economic recovery resembles a specific letter, that doesn’t mean the markets will look the same.

With that said, let’s begin with the most optimistic of letters:

The V-Shaped Recovery

V for victory, right?  In this case, victory over the pandemic’s effects on the economy.

Think of a V-shaped recovery like dropping a fully inflated basketball.  The fall will be swift and steep – but the ball will bounce back just as quickly.  In this case, the ball is the economy.  The pandemic caused a brutal drop in employment, stock prices, and GDP, but the recovery will be equally fast.  It’s probably the most optimistic scenario we can hope for.

The case for a V

There are three basic arguments for a V-shaped recovery.  First is that the U.S. economy was fairly strong before the pandemic.  Since the current recession was caused by external factors (like a virus) and not structural ones (like a change in fiscal policy or a credit crisis), the thinking is that the recovery will be equally strong.

The second argument is based on history.  V-shaped recoveries have happened before, with sharp drops often leading to equally sharp ascents.  One example is the recession of 1953.  America’s soaring post-war economy plummeted to earth thanks to skyrocketing interest rates.  Within a year, though, the economy recovered, with the country’s GDP returning near pre-recession levels.

The final argument for a V is the stock market.  On February 19, the S&P 500 was at 3,386.¹  Roughly a month later, it had dropped over a thousand points to 2,237.²  That’s one of the fastest bear markets in history.  But by June, just over three months later, the S&P had risen 800 points.²  It’s not quite a V, but it’s close.  So, if the stock market can do it, why not the overall economy?

The case against a V

Unfortunately, the letter V also stands for “virus.”  So long as the virus continues to affect our daily lives, so too will it affect the economy.  That’s why many experts consider a V-shaped recovery to be overly optimistic.

Besides infecting over 1.5 million people³, let’s look at what the coronavirus has done in the United States.  Since March, over 38.6 million people have filed unemployment claims.⁴  The jobless rate has floated just under 15%, the highest since the Great Depression.⁵  Oil prices crashed due to plummeting demand.  Entire industries have seen business drop to drastic levels.

These kinds of effects don’t just get reversed overnight.

Again, the markets and the economy are not the same.  The markets have stabilized largely based on government stimulus, hope for a vaccine, and because all this economic pain has already been priced in.  Of these factors, only the first – government intervention – has any effect on the economy right now.  Most experts believe a widescale vaccine is still at least a year away.  And while government stimulus has helped, it’s only bandaging the wound, not healing it.

A V-shaped recovery would be wonderful, and it’s still a real possibility.  In fact, in May, the unemployment rate actually dropped to 13.3 percent!⁶  But even though the U.S. is starting to open back up, returning to normal could still take much longer.

The U-Shaped Recovery

Ah, the letter U.  Visually similar to the letter V, but more rounded, less dramatic.  That’s a perfect way to think of a U-shaped recovery.  Think of it like a V, except the recovery takes longer.  In this case, the nation’s GDP would shrink for 2-3 quarters in a row, and then slowly return to normal.  A good example of a U-shaped recovery occurred back in 1973.  After contracting sharply, the U.S. economy remained in the doldrums for roughly two years before rebounding to pre-recession levels.

A quick note about GDP

You probably learned about GDP in high school or college, but here’s a quick refresher in case you find it helpful.  A country’s gross domestic product, or GDP, is a measure of the total value of all goods and services produced in a specific time period.  Consumer spending, government spending, business investment, and national exports are all components of GDP.  While it has limitations, GDP is important, because it serves as a useful vital sign of our economy’s health.  Higher GDP signals both higher wages and more jobs, as businesses need more production to meet growing demand.  A declining GDP reflects layoffs, falling revenue, and lower consumer spending.

The case for a U

In a recent survey, nearly 45% of the economists who participated predicted the U.S. recovery would be U-shaped.⁷  It makes sense.  Remember above, when I said that so long as the virus affects our daily lives, it will affect our economy?  The U-shaped recovery reflects that.  Back in April, the World Health Organization warned that the coronavirus would likely “be with us for a long time.”⁸ Some experts think it will only go away once we have a widely available vaccine that helps us achieve herd immunity. So, in this scenario, the recovery will be slow and gradual. Only when we have a vaccine will it accelerate.

The case against a U

Economists and epidemiologists will both be hoping for the same thing here: No major surge of cases, especially in the winter.  If social distancing measures and increased testing are enough for businesses to reopen and bring back furloughed workers, a U is likely. But if the country reopens too fast, too soon or if the virus resurges with a vengeance in the winter, there may be no choice but to bring back stricter quarantine measures.  If that happens, the single-U recovery will likely devolve into…

The W-Shaped Recovery

The letter W – it looks more like a double-V than a double-U, doesn’t it?  And there lies the insidious nature of this type of recovery.  It’s essentially two recoveries…for two recessions.

Most of my clients probably remember the recession of the early 1980s.  In many ways, it was two recessions in one.  A weak economy devolved into a bad one.  Then, the recovery started – only for the economy to plummet again.  This is why a W-shaped recovery is also known as a “double-dip recession.”  What initially looks like a quick turnaround turns into something much longer.  Just when you thought it was safe to go back into the water…

The case for a W

It’s simple.  If we are hit with a second, or even third wave of infections, all our efforts to flatten the curve will be undone.  Should that happen, more lockdown measures will likely have to be enacted.  The result?  More economic pain, as our country rides a rollercoaster of good quarters and bad.

The case against a W

The good news is that W-shaped recoveries are relatively rare.  By some estimates, we’ve only had two in modern history: in the late ‘30s and early ‘80s.⁹  Both of these cases occurred largely due to internal factors.  Careful management of both our economy and our epidemiology should hopefully prevent a W from happening.

The L-Shaped Recovery

You have to tilt your head to see the L in this scenario, but in any case, it’s the least ideal letter.

In a sense, an L-shaped recovery is no recovery at all.  Because here, the economy takes years, sometimes even decades, to return to pre-recession levels.  Instead, a new normal sets in, and the economy’s baseline becomes lower than it used to be.  Certain jobs that were lost never come back. Certain spending habits never resume. Business investment is irrevocably altered.  In other words, the pandemic’s effect on our nation’s GDP is enduring, not temporary.

One of the most famous L’s in modern history occurred in Japan.  This was the so-called “lost decade” of the 1990s – and some economists think it was really two decades!  Closer to home, the United States experienced an L-shaped recovery of sorts after the financial crisis.  While the Great Recession is generally thought to have ended in 2009, it took over six years for the unemployment rate to drop below 5%.  (The GDP growth rate, meanwhile, is still lower than what it used to be.)

The case for an L

As of this writing, few economists seem to be forecasting an L-shaped recovery.  But it’s worth noting that a paper released by the National Bureau of Economic Research takes a gloomier view.  According to their data, a high unemployment rate is likely to stick around for some time.  That’s partially because some industries have been hit particularly hard, and likely won’t recover until the pandemic has ended.  (The travel and hospitality industries are good examples.)  Should that happen, the paper estimates that 35% of workers who have been laid off will not be recalled to their jobs.¹⁰  Such a large percentage of permanently unemployed workers would have a big impact on consumer spending, which accounts for roughly 67% of our nation’s GDP.¹¹

The case against an L

Forecasts for an L-shaped recovery are definitely in the minority right now.  It’s certainly possible, but it assumes that the coronavirus spreads completely unchecked for years to come, without cure or even containment.  Remember, the government and the Federal Reserve have been working hard to shore up the economy.  Furthermore, an unprecedented amount of money and brainpower is being poured into the race to find treatments for the virus.  Finally, current economic data suggests that, while unemployment is still rising, weekly jobless claims may have peaked.  That means the worst would be behind us.

For these reasons, the consensus among economists seems to be that a U-shaped recovery is more likely.  Let’s keep our fingers crossed!

So, what does all this mean for the markets?

You’ve probably noticed it already, but each of these letters has something in common: They all start by plunging down.

Right now, our economy is in a recession.  Whichever letter the recovery ends up looking like, we’re currently on the downward side.  That’s why, over the last few weeks, many clients have asked me:

“How are the markets going up when unemployment and the economy are so bad?”

“Should I even trust the numbers I’m seeing in the markets right now?” 

“What if the markets drop again?  Should I start adding funds to my portfolio or should I wait?”

“What should I be doing as an investor right now?”   

The first question, at least, is fairly easy to answer.  I alluded to it earlier, but let’s quickly review how the markets work compared to the economy.

The economy moves based on activity, like production, consumption, and trade. The markets, on the other hand, move largely on anticipation. When investors expect something will happen, they make decisions based off that expectation. So, when the markets plummeted in March, it was based on the expectation that unemployment would rise, consumer spending would fall, and the economy would contract.  In other words, the markets fell because investors saw the downward slope coming a mile away.  Whether the recovery ends up resembling a V, a U, a W, or an L, they knew that economic pain would come before economic gain.

Well, that pain has happened.  So why haven’t the markets continued to slide?  Because that pain has already been “priced in.”  The massive swings we saw in March were based on what is happening right now.  By the same token, the markets have stabilized because of what investors expect in the future – that the economy will make like a V or a U and rise again.

Unfortunately, the other questions don’t have easy answers.  As we’ve already covered, there are cases to be made for and against each letter.  In fact, different industries will experience different letters.  Some industries may enjoy V-shaped recoveries.  Others may have to endure L’s.  Accordingly, different sectors of the markets may sink or swim.

As time passes, more economic data will come out.  So, at some point, we’ll be able to tell the shape of the recovery.  But again, what looks like a V could end up really being a W.  The letter U could actually be the beginning of a sideways-L.  There’s really no way to know ahead of time.

The economist John Kenneth Galbraith once said that “the only function of economic forecasting is to make astrology look respectable.”  That’s why we don’t make decisions based on economic predictions.  In the end, that’s just a type of gambling, and here at Vaughan & Co. Securities, Inc., we don’t gamble with your money.

With that in mind, let’s return to the last – and most important – question my clients have been asking lately:

What should I be doing as an investor right now?

There are three basic things everyone should be doing right now.

First is to remember why we invest.  We invest because you have long-term goals you want to accomplish.  There are things you want to do and places you want to go.  There are dreams you want to achieve and people you want to protect.  We invest so you will have financial means to live the life you’ve worked so hard for.

Second is to remember how we invest.  Because we invest for your (as in, nobody else’s) long-term goals (as in, the things you care about most) we don’t make decisions based on predicting whether we’ll have a V recovery or a W or any other letter.  Make no mistake, the type of recovery we see will have an impact on the markets – and by extension, on your portfolio.  So, as your financial advisor, I do track the economy closely, so we can prepare for what the future holds.  But how we invest – that’s based on determining what kind of risk and what kind of return you need to reach your goals.  That’s why you’ll never hear me say, “You should put more money in the markets because I think the economy is going to do better next month.”  Or, “You should take money out of the markets because I think the economy will do worse.”

Instead, I make recommendations based on what you need to achieve your goals, as well as what level of risk you can afford to take on.  That’s why some investors should consider adding funds while others just maintain their current portfolio.  There’s no “one size fits all” approach.

The third thing investors should do, then, is take this opportunity to assess whether their goals and needs have changed.  Imagine, for a moment, that you do know which type of economic recovery we’ll experience.  How would a U-type recovery, or a W-type recovery, be likely to affect your income?  Your expenses?  Your insurance coverage?  Your retirement date?  Your loved ones?  How would a long-term pandemic affect your goals?  Will some (like travel) need to be pushed back?  Can others (like landscaping your yard or contributing to charity) be moved up as a result?

The answers to these questions go a long way to determining whether we should maintain or adjust our current investment strategy.  When it comes to your personal finances, factoring the answers into our plan is more important than looking at the markets every day, or predicting what the economy will do.

So, here’s what I want you to do, «Salutation».  Take a few minutes to think about everything you just read.  Think about your long-term goals and your short-term needs.  Has anything changed?  Does anything need to change?  If so, let’s talk.  We can meet over the phone or online to update your investment strategy or financial plan.  We can review your goals, adding and modifying as needed.  We can also review your financial needs, including your income, risk tolerance, and more.  In other words, we can lay out a new plan to make your personal economic recovery look however you want!

In the meantime, I hope you found this information interesting and helpful.  Please let me know if there is ever anything I can do for you.  Here’s to a great recovery!

Sources

¹ “S&P 500 and Nasdaq jump to record highs, Dow climbs more than 100 points,” CNBC, February 19, 2020.  https://www.cnbc.com/2020/02/19/stock-market-wall-street-in-focus-amid-coronavirus-outbreak.html

² “S&P 500 Historical Prices,” The Wall Street Journal, https://www.wsj.com/market-data/quotes/index/SPX/historical-prices

³ “Coronavirus Cases in the United States,” Google News, https://news.google.com/covid19/map?hl=en-US&mid=/m/09c7w0&gl=US&ceid=US:en

⁴ “38.6 Million Have Filed For Unemployment Since March,” NPR, https://www.npr.org/sections/coronavirus-live-updates/2020/05/21/859836248/38-6-million-have-filed-for-unemployment-since-march

⁵ “US unemployment rate soars to 14.7 percent,” The Washington Post, May 8, 2020.  https://www.washingtonpost.com/business/2020/05/08/april-2020-jobs-report/

⁶ “U.S. Unemployment Rate Fell to 13.3% in May,” The Wall Street Journal, June 5, 2020.  https://www.wsj.com/articles/may-jobs-report-coronavirus-2020-11591310177

⁷ “U.S. economy likely set for U-shaped recovery after deep rut,” Reuters, April 21, 2020.  https://www.reuters.com/article/us-usa-economy-poll/u-s-economy-likely-set-for-u-shaped-recovery-after-deep-rut-reuters-poll-idUSKCN2231V6

⁸ “World Health Organization warns: Coronavirus remains ‘extremely dangerous’ and will be with us for a long time,” CNBC, April 22, 2020. https://www.cnbc.com/2020/04/22/world-health-organzation-warns-coronavirus-will-be-with-us-for-a-long-time.html

⁹ “Double-Dip Recession: Previous Experience and Current Prospect,” Congressional Research Service, June 19, 2012.  https://fas.org/sgp/crs/misc/R41444.pdf

¹⁰ “Pandemic Recession: L or V-Shaped?” National Bureau of Economic Research, May 2020.  https://www.nber.org/papers/w27105.pdf

¹¹ “Shares of gross domestic product: Personal consumption expenditures,” Federal Reserve Bank of St. Louis, updated May 28, 2020.https://fred.stlouisfed.org/series/DPCERE1Q156NBEA

How can something cost less than $0?

That’s the question many people have been asking this week.  It all started on Monday, April 20, when headlines like this dominated the news:

U.S. Oil Prices Fall Below Zero For the First Time in History¹

That same day, plummeting oil took the stock market down with it – the Dow, for example, slid nearly 600 points.²  And while oil prices have risen since Monday, they are still in historically low territory.  The questions, then, are obvious: why are oil prices crashing?  How can they be less than $0?  What does that mean for the stock market?  And what does that mean for us at the pump?

I’ll answer those questions now.

Q: Why has the price of oil dropped so much lately?

First, let’s define what it is we’re actually talking about here. 

Generally speaking, when you hear about oil prices in the media, you’re hearing about the price of crude oil.  Crude oil is raw, unrefined petroleum extracted from the earth.  After extraction, it can then be refined into various products – gasoline being the most well-known.

Historically, oil prices are tied to two different benchmarks: Brent Crude, and West Texas Intermediate (WTI).  Brent is extracted from the North Sea in Europe; WTI from – you guessed it – western Texas.  There are many types of crude oil, but their prices usually follow the price of Brent and WTI, simply because that makes it easier for buyers and sellers to do business.  That means as these two benchmarks go, so goes the rest of the oil industry.

The price of both Brent and WTI have dropped dramatically in recent months, although the news about oil falling below zero is specific to WTI.  (We’ll get to that in a minute.)

There are many reasons why oil prices fluctuate, but they all come back to one: The Law of Supply and Demand.  When the demand for oil is greater than the supply, the price rises.  Conversely, when the supply of oil is greater than the demand for it, the price drops.  This is essentially what’s happening now.  Due to the coronavirus, the world’s appetite for oil is at an all-time low.  Right now, planes aren’t flying, because people aren’t traveling.  Cars aren’t driving as much, because more people are staying home.  Fewer goods are being transported, which means fewer factories are operating.

In short, the world has more of the black stuff than it needs right now.

Sometimes, nations can influence the price of oil by either increasing or decreasing the production of oil.  For example, earlier in April, countries like Saudi Arabia and Russia pledged to cut production by 9.7 million barrels per day. ³  The hope is that by decreasing supply, prices will stabilize.  And they did.  Briefly.

There are two problems here.  The first problem is that the world’s demand for oil is still far, far below that.  In fact, some experts calculate that demand has fallen by 25-35 million barrels per day.³  Think about that number for a moment.  It’s staggering.  So, despite the production cuts, supply will still outpace demand – by a lot.

For the second problem, let’s move on to the next question:

Q: How can oil prices drop below $0? 

Chances are, you have never gone into a store and seen something worth negative dollars.  Just typing the phrase “negative dollars” seems only slightly less crazy than if I had typed, “the sun rose in the west today.”  Nevertheless, the price of West Texas Intermediate did drop below $0 a barrel.  Now, I’ll tell you why.  Bear with me, though, because this is where things get a little tricky.

When it comes to selling oil, there are actually two different markets: the physical market, and the futures market.  The physical market is similar to the way most of us buy and sell things.  A producer, say, Exxon Mobil, sells its oil – usually via an intermediary – to a buyer, like a refinery.  They agree upon a price, the oil is shipped, and that’s that.  This mostly takes place out of the public eye, and it’s not what we’re talking about here.

When you hear the media talk about oil prices, they’re usually discussing the futures market.  This is where futures contracts are traded between brokers, banks, and other entities.  An oil futures contract is for 1,000 barrels of crude, set to be delivered for a specific price at a specific date in the future.  Both buyers and sellers find them handy because the contracts enable them to lock in current prices.

For example, let’s say Bob wants to buy oil from Betty.  If Bob purchases a futures contract at $20 per barrel, and oil prices rise to $21 between the time he bought the contract and when the oil is delivered, he just saved money.  ($1,000, in fact, as that $1 change is multiplied by 1,000 barrels.)  On the other hand, if oil prices fall, then Betty, the seller, will receive more money than if she had sold later.  Either way, producers use future contracts to guarantee they can sell their crude at a later date, no matter what happens.  Buyers who need crude for their own business – like refineries, for example – use them to ensure they have adequate supplies in the future, at a price they can afford.

Make sense?  Good.  Now, let’s throw in a slight twist in the form of speculators. 

Many traders in the oil futures market are speculators.  These traders have no desire to physically own oil any more than you do.  Instead, they make money by betting – speculating – on whether oil prices will go up or down.  (To do this, they simply close their positions before the contract expires by swapping contracts with buyers who actually need it.)

So, now that you understand how things work, here’s what happened.  The contracts for WTI crude set for delivery in May expired on Tuesday, April 20.  (That means Tuesday was the last day these May contracts could be traded.)  Normally, traders who don’t want to take possession of oil treat the last few days as a chance to swap contracts with buyers who do.  In the meantime, crude set for final delivery in May is stored at facilities in Cushing, Oklahoma, and the entire process is usually neat and orderly.

But this was when traders ran into the second problem I alluded to above.  Thanks to overwhelming supply and underwhelming demand, oil prices had already plummeted.  But now there was a new problem: storage.  Simply put, the world is running out of space to store all this excess oil – and Cushing is projected to be at 100% capacity in mid-May!⁴  As a result, all these traders with May contracts faced the proposition of taking possession of millions of barrels of crude –with no ability to actually store it.  That led to a fire sale of historic proportions.  With most of the usual buyers not buying, traders with neither the desire nor the ability to actually take the oil had no choice but to pay others to take the barrels off their hands.  The result?  WTI prices fell below zero for the first time in history – because the sellers weren’t actually selling.  They were paying others as much as $37.63 a barrel to take the oil for them.⁵

Whew!  We’ve covered a lot of ground.  Congratulations, because you’ve just completed a crash course in the byzantine world of oil prices.  Let’s end by quickly covering two simpler questions:

Q: How will this affect gas prices?   

The answer: probably not as much as you’d think.

Oil prices and gasoline prices are related but not identical.  Gasoline is made from distilled petroleum, usually with a number of special additives.  It’s sold by different companies than those that extracted the petroleum in the first place.  Gasoline futures are an entirely different type of contract governed by a different set of factors.  Transportation, marketing, and refining costs all contribute to the price.  So do federal and state taxes, the latter of which can vary widely.  And of course, different gas stations can set different prices.  There’s no governing body or set of regulations to follow.

Still, falling oil prices do tend to lead to falling gas prices.  As of Tuesday, April 21, the average price per gallon in the United States was $1.81.⁶  That’s 36 cents lower than a month ago, and more than a dollar cheaper than this time last year.  So, you can expect to pay less at the pump for the time being.  Just don’t expect it to get anywhere near zero!

Q: So how does this affect the stock market? 

Still reeling from the pandemic, oil volatility is the last thing the stock market needs right now.  That’s because falling oil prices make life harder for energy companies.  It can lead to significant layoffs, at a time when unemployment is already skyrocketing.  Nations that are particularly dependent on oil production – Canada comes to mind – may feel the effects even more.  That said, oil prices have been turbulent all year long, so moving forward, much of the economic pain may already be priced into the stock markets.  And with dozens of countries pledging to cut production or prop up the industry, we may see prices stabilize soon.

That said, this is not a problem that’s going to end anytime soon.  (The price of June WTI contracts has fallen recently, too.)  It will likely be months, at best, before demand overtakes supply again.  Storage space is increasingly scarce.  So, this is definitely something we will keep an eye on moving forward.  We will scrutinize your portfolio for any possible weaknesses, and let you know if we feel a change is needed.

We hope you found this analysis interesting.  At the very least, now you can impress your family with your knowledge of how oil futures work!  (I know they’re all just dying to learn.)  In the meantime, let me know if you have any questions.  As this pandemic goes on, always remember that my team and I are here for you.  We are constantly working to keep you on track to your financial goals.