The current scene of volatility in the markets is one that we do not take lightly or underestimate the degree to which financial markets can work themselves into a panic. We understand that the current selloff this past week is difficult to endure. Based on our financial planning and investment management approach our client portfolios have been designed for every possible environment, good or bad. Fortunately, our portfolios are designed to prepare for such circumstances as we are currently experiencing. You have a financial plan that has incorporated an emergency fund of cash representing 6-12 months of cash needs so that you would not be forced to sell assets at the wrong time. Our yield bias of dividend paying stocks provides ongoing cash flow support and our focus on large capitalized proven enterprises has proved to be protective in these environments as well. Our total avoidance of international and emerging market funds has also served to protect our client’s assets.
Under these circumstances, it is important to keep things in perspective. An over accommodating Federal Reserve has given us 10 years of rising markets without much volatility. The market typically falls by 5% or more three times a year. It falls 10% or more about once a year. And it falls 20% or more about once every seven years. We are just not used to this volatility. This increased risk and uncertainty, however, is why the equity market over long periods of time return almost double that of the bond market which has much more predictability. This market selloff has been abrupt which raises concern and makes it psychologically more damaging but still the worst thing you can do in the middle of a selloff like this is to panic and let your emotions dictate investment strategy.
When you look over long periods of time like in the chart below you clearly see we have these 10% corrections at some regular intervals. What is important to notice is that they happen fast, and they are followed by longer bull markets. Looking at the chart, the worst thing to do is sell when we are in these red bear markets.
While we cannot predict what will happen in the near future, we do believe the current Coronavirus will run its course (for better or worse) and a couple of years from now, it will be mostly forgotten. The selloff we are seeing this week is the realization that it can (and did) spread beyond China and now investors are adjusting to the possibility that economic growth will significantly decline, along with corporate profits. Stock prices change continuously to reflect the most up to date information about the future growth prospects of a company. When a viral outbreak happens that can temporarily reduce the amount of goods and services that a company sells, it is assumed this will reduce future earnings. In fact, we have seen companies lower their earnings projections for this quarter. At the beginning of the year, analysts were projecting earnings grow around 8-10%. These numbers will be revised to reflect the current impact from the virus but will be much lower.
Every twelve months the companies in the S&P 500 generate about 4% of their market value in cash earnings, which is referred to as free cash flow yield. So in theory if the companies in the S&P 500 did not produce a single cent of cash earnings in 2020 because of a slowdown caused by the virus outbreak, but in 2021 resumed earnings production at the same amount as if Coronavirus had not occurred then the value of the market should theoretically drop by roughly 4%. Of course, this is not how investors think during times of panic. What matters is whether by the end of 2020 the virus begins to fade in the same timeframe that every other past virus outbreak has and economic activity spikes to make up for lost production, or if this outbreak is somehow totally different and the global economy grinds to a halt for a protracted period of time.
We do not think now is the proper time to sell assets given that we would be selling into a correction. We believe the worst of the selloff is most likely behind us but also realize we do not want to try to catch a falling knife. To put things into perspective no American citizen on U.S. soil has died from the virus yet. We would not be surprised that if, or when, the first domestic death occurs, or a high-profile U.S. citizen becomes infected the market will overreact and take a leg lower. Those are both scenarios that we are watching closely and if they were to occur would create an opportunity to buy.
In the coming weeks you will most likely see increased activity in your account. The recent sell off has given us the opportunity to not only add to existing positions that we believe have dropped below their fair value but also add some new names that we have been keeping on our watchlist for the case of a market sell off. We came into the year slightly overweight cash in many client portfolios because of some tax loss selling at the end of 2019 as well as the exit of a few positions at the beginning of 2020 unrelated to the virus. This cash will come in handy now that we can purchase assets at more attractive prices.
As for our current holdings, we continuously assess their financial and operating strength as well as valuation. The average age of a company in our portfolios is over 80 years old. They have dealt with issues more significant than the current Coronavirus. Our companies have excellent management teams that make us confident they will be able to maintain their supply chain operations through this event. Many of these management teams have already been reducing their supply chain exposure to China in the last few years on account of the trade war. All our companies are highly profitable, produce strong cash flows, have exceptional management teams, and do not need to rely on the market for capital to operate.
Our bond and cash positions have also protected us from the downside. One of the most important things to keep in mind for our clients is that we do not own any pockets of the market that are most affected by the outbreak of the Coronavirus. These include Airlines, Cruise lines, Travel Aggregators, Casinos, Commodities, Pure-Play International companies or Emerging Market Funds, Transports, etc. This does not mean that some of our companies will not suffer earnings pressure because of recent events. The two industries that come to mind right away are energy companies that are highly leveraged to the price of oil, and insurance companies and banks that are put under pressure from falling treasury yields. We were already underweight both sectors coming into the year but might look to redistribute into some of the new/existing positions we are eyeing that look particularly attractive. We may also look to consolidate some of our holdings into those that we believe have the best forward potential return.
In summary, you’ve been prepared for this market environment and we intend to remain steadfast in our proven financial planning and conservative investment management approach. We’ll continue to monitor the current market situation and keep you updated as circumstances dictate. We’ll take action when we feel that it is in your best interest to do so, keeping in mind your personal circumstances. In all likelihood, the economic impact of the coronavirus will fade over time just as it did for every one of the virus outbreaks of the past. We encourage you to maintain a long-term perspective as we navigate the challenging economic landscape before us.
Patrick R. Wallace
Disclaimer: The information contained in this commentary has been compiled by Covington Investment Advisors, Inc. from sources believed to be reliable, but no representation or warranty, express or implied, is made by Covington Investment Advisors, Inc., its affiliates or any other person as to its accuracy, completeness or correctness.
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