Stranger Things

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The Netflix mini-series Stranger Things has nothing on reality. To recap the year so far, we are battling through a global pandemic unlike any in the past 100 years. The novel coronavirus is highly contagious and extremely dangerous, particularly to the elderly, those with pre-existing health conditions, and those without easy access to our healthcare system. To counter this deadly virus, all fifty states issued some form of stay-at-home order creating a self-induced economic coma. In just the past quarter, we’ve seen negative oil prices (see Free Oil, by Michael Molitor on our website), an increase in the number of countries issuing debt with negative interest rates, massive anti-racist protests throughout the country including one in which a six square block section of a city was taken over by protestors, hand-to-hand combat on the border between China and India, and North Korea antagonizing South Korea by blowing up a building. Also in the category of “strange,” Hertz, a company in bankruptcy, rallied 400%, and then decided to try to issue new stock because of the rally. To be fair, its disclosure statement did say it is highly likely this new equity would be worthless (caveat emptor to the extreme). The stock market responded to all this news by rebounding with a vengeance. The most common question we have received over the last couple of months is, “How is that possible given all of the uncertainties (and oddities) we’re facing today?”

The very short, simplified answer is the shear financial power of our government. The speed with which the pandemic hit our markets was matched by the speed with which our government responded (as shocking as that might sound). Congress passed numerous stimulus bills costing several trillion dollars and the Federal Reserve pumped in several trillion dollars more. It used every trick ever learned from past financial crises and added a few new ones. The dollar amount of the stimulus projected through the end of the year will end up totaling approximately 20% of our nation’s Gross Domestic Product (GDP), a staggering amount with most of that money literally created out of thin air.

This aided the stock market on several fronts. First, this money went directly to those most affected by the pandemic. Unlike during the Great Recession when the stimulus money went through the banking system, this money went directly to taxpayers and business owners with the goal of keeping wage earners afloat. The government incentivized business owners to hold onto their employees. Despite this, there were massive layoffs and furloughs as the economy came to a screeching halt. The government also approved more unemployment benefits (with a bonus $600/week) than in past recessions. 75% of those who applied received benefits. Normally, only about 25% get them. This allowed most people to continue to pay their bills and minimized damage to businesses (companies in the stock market).

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One other possible reason for the surprising rebound during a pandemic is a bit more troublesome. Schwab reported that during the first quarter, they opened a record 609,000 new retail client accounts. Relative newcomer, Robinhood, signed over 3 million new clients. The combination of no commissions, a stimulus check, no sports to bet on, and a lot of free time has perhaps contributed to a retail investor boom in the stock market. The total effect of this is difficult to gauge, but the Hertz example mentioned above highlights why this might be dangerous if this is indeed a major contributor to the rally. Contacts in the brokerage industry have mentioned that a lot of these accounts are starting with $1,200 or $2,400 values, the exact amount of the stimulus checks received early in the quarter.

 

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Secondly, the Fed provided a great deal of liquidity to markets that were not functioning well during the initial panic from the first quarter. They propped up prices by buying the bonds of companies. This kept companies’ borrowing costs down and prevented marketplace panic forcing unnecessary bankruptcies. Thirdly, the Fed cut interest rates on short-term bonds to near zero. Long-term bonds followed suit with the 30-year bond dropping below 1% at one point. This has an indirect effect on the stock market. Treasury bonds represent the risk-free investment option. When the expected rate of return drops to essentially nothing, investors look elsewhere. Many of those dollars flowed back into the stock market, thus forming some semblance of equilibrium between these two markets.

So now what? An extremely wide range of possible outcomes exists for the next 18 months. We use scenario analysis to help us position portfolios in times like these. As you might expect, the progression of the virus and our government’s response to it will drive all these scenarios. Our base case suggests the virus will not be under control until a vaccine comes out. The fastest this could happen, with enough of us vaccinated to have a meaningful effect, is some time in mid- to late 2021. Past experience with pandemics predicts a second wave is highly likely by the end of this year. We are already seeing cases rise now that most states have reopened to some degree. What will happen in the fall when children possibly return to school and colder temperatures drive people indoors?

In this base case, our economy stays in recession, or at best a near zero-growth environment for a couple of years. Earnings don’t top 2019 levels until at least 2022. Many companies with high debt levels and a high dependence on travel or hospitality will fail. Stay-at-home workers discover they do not need to go to the office as often, and this becomes a more permanent part of how our economy functions. This affects commercial buildings negatively but does have some positive side effects (lower pollution, more efficient workspaces, etc.). Our government will continue to add stimulus to the economy in an effort to keep things from completely unraveling.

A more positive scenario would involve new therapeutics coming to market. While this wouldn’t end the pandemic, it may allow more people to feel safe enough to venture back out to restaurants and travel. We have already seen improvements in patient care and outcomes, but the risk of death is still too high – especially for the most vulnerable groups. If this risk could be diminished down to a level similar to that of the flu, the worst would be behind us.

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A more negative scenario develops if the vaccines prove ineffective or dangerous. There are over 150 trials right now. We have attacked this challenge with all that modern science has to offer. This makes this scenario somewhat remote, but not impossible. This scenario would cause a great deal of financial setbacks and a prolonged recession as governments do not have an endless supply of resources.

In consideration of all of these possible scenarios, we have positioned portfolios with a higher cash balance, more gold, fewer cyclically sensitive stocks, more growth names somewhat insulated from the effects of another quarantine, and a few stronger value names that would perform well if a positive scenario develops. As the United States seems to be an epicenter of the virus, we have continued to add to our international exposure. At some point, it will make sense to add some of the riskier, badly beaten down stocks to the portfolio. Now is a bit early to implement this tactic.

Survival is paramount in this moment. This is true of your portfolio, but of even more importance is your health. Please take care of yourself and your loved ones and follow the CDC guidelines: wear a mask in public, stay six feet apart from others, and remain home as much as possible. As we try to do with your portfolio…avoid unnecessary risks. One long-time client succumbed to this disease; we grieve along with her family. Know that you are all in our thoughts and prayers during this very difficult time.

Sincerely,

Anthony J. DiGiovanni, CFA

Free Oil

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Headlines from news sources across the financial industry rushed to proclaim “Oil Trading at Negative Prices” yesterday as the May contract for WTI (West Texas Intermediate) Crude Oil traded in negative territory.  How can oil, a commodity with versatile uses, trade at negative prices?  Would a company really pay to have its product taken away?  It’s complicated.

The oil market is large and only one small part of it went negative.  Oil commodities consist of the spot market (current market prices) and the futures market (prices for a future date).  Yesterday’s negative price was only in the futures market.  There are two main types of oil:  WTI and Brent Crude.  Only WTI went negative.  Finally, futures extend far into the future.  Only the May 2020 contract went negative.  Let’s take a closer look at why.

A futures contract is a legally binding contract between a buyer and a seller to transact at an agreed upon price on a set date.  A buyer who still owns a contract at the expiration date (which was yesterday for the May contract) is contractually obligated to buy the oil at the agreed price and take delivery of it.  A buyer who does not do so is in default of the contract; the seller of the oil can sue.

In the futures market, most traders unwind their positions (sell if previously bought and buy if previously sold) prior to expiration because most participants don’t have the ability to take physical possession of large numbers of barrels of oil. Usually though, there are some oil companies who can take delivery and will buy if the price gets too low.  That did not happen yesterday.  With few people flying or driving, oil reserves are full.  Nobody had the capacity to take the physical oil, so traders were forced to close out their positions at any price, even a negative price to avoid defaulting.  It’s kind of like having an estate sale when moving.  It would be better to get $100 for your dining room table, but if no buyer comes along, it still needs to go, and you might end up paying someone $50 to take it away.

How did this happen?  In a properly functioning market, oil prices should not be negative because oil has use not only as a fuel but also as a key ingredient for countless products.  There are two main types of crude prices: WTI and Brent Crude.  Brent represents more of a worldwide price of crude since it is produced near a seaport and can be easily distributed globally.  WTI is a landlocked crude, produced in the middle of America, and can only be delivered to Cushing, Oklahoma.  Buyers of WTI must take possession of it in Cushing and then either store it or have a way to immediately ship it.  This is where the breakdown occurred.

Financial markets are constantly rebalancing themselves and engaging in price discovery.  When prices get too high, people sell, and the increased selling brings the price back to equilibrium.  The same process happens in reverse when prices fall deeply below the economic value; buyers step in and bring the price back to its proper value.  But when WTI prices fell yesterday, buyers did not step in.  It seems like it would have been a perfect opportunity to make a significant amount of money by buying at negative prices and selling the next month at positive prices.  However, to restate the key points, futures contracts are legally binding and delivery must be taken in Cushing, Oklahoma.  If there is no available storage in the area, and no transport system in place, then nobody can buy.  If nobody is buying, the sellers become desperate even to such a degree that they are willing to pay others to take the contract off their hands.  That is what we saw yesterday in the May WTI Crude futures.

The other type of oil, Brent Crude, is still trading in the $20 range, and even WTI Crude futures for June is still $15 per barrel.  The price for future WTI one year out is in the $30 range (see chart below).  So, the negative price was an aberration in the current contract that expired with too many sellers and not enough storage capacity for the buyers.  We joked about buying some oil yesterday and storing it at our vacant White Pine offices.  Unfortunately, we couldn’t figure out how to transport the 1,000 barrels one futures contract represents up to our offices, and we’re not sure all the barrels would fit.

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Last month, Russia and Saudi Arabia indicated there would be no slowdown in oil production, thus exacerbating the excess supply caused by the coronavirus pandemic halting the great majority of air travel, automobile use, cruise trips, and other economic activities that typically use oil.  As always happens with a large supply and a dearth of demand, prices dropped.  It is unlikely the world-wide Brent Crude price will go negative as there are still some places in the world to store the excess supply.  However, if demand doesn’t pick up soon, it is possible we will see a repeat of this issue when the June futures contract expires.

 

While the impact to the overall equity market is minimal, this event does provide some insight into the health of the global economy.  Oil prices and the economy often go hand in hand as oil is one of the main fuels used to generate energy.  The low prices indicate the severe lack of demand both in the US and the world.  This unusual phenomenon is a symptom of the severe disruptions we are all feeling in our daily lives.  The futures curve may indicate how long the market thinks this lack of demand will last and when the economy can begin to return to normal; the graph indicates the price of oil returns to a more typical $30 price by the end of the year.  We will continue to monitor this situation and how it affects our positions.  Meanwhile, we’ll work on reconfiguring our desks to accommodate 1,000 barrels of oil.

Navigating the Impact of COVID-19

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Lessons from History

This was a difficult quarter from an emotional standpoint even more than from a market return perspective.

In the middle of the quarter, the market collectively decided to take notice of COVID-19 that had been spreading for several months prior. The first case in the US wasn’t the spark. It was the combination of the outbreak spreading to Italy and Iran and the first case in the US that wasn’t easily associated with someone traveling abroad that were the final straws. For the rest of the quarter, the market moved in giant 3%+ increments, both up and down daily. This extreme volatility brought back echoes of 2008 adding to the market’s angst. Times like these remind us of philosopher George Santayana’s sentiment, “Those who cannot remember the past are condemned to repeat it.” I have been in this business for a little over thirty years now and have found value in looking back to learn from history. The fact that no two downdrafts are ever the same makes my profession both interesting and challenging, and it brings a measure of caution to the exercise of looking back. With that caveat, here is a quick review of the major events throughout my career and how they might provide insight to today’s world.

The first major financial market disruption of my lifetime occurred while I was still in college.

1987

The largest single day drop by percentage happened my junior year in 1987. Interestingly, the “crash of 1929” commonly thought to have been worse, developed over four days, making the 22.6% drop in 1987 the worst one-day calamity. I was too young to feel much empathy for what that event meant for my future clients. I remember having the TV on all day and watching it like a sporting event. 200 points after lunch, 300 by my third class, and 500 by the end of the day (and yes, it took only 500 Dow points to account for a 23% drop). To me, it was entertaining and not the financial devastation it truly was for many.  We studied the event in school and learned that the culprit was a financial product called “portfolio insurance” created by some quant in a backroom. Everyone was using it. The concept was to use stop-loss sells when the market started to fall to help investors get out. It became its own self-fulfilling prophecy as all the sell signals kicked in with nobody there to buy. The only thing ensured were guaranteed losses in the market. Not exactly what was advertised. My takeaway was a career-long suspicion of any product that becomes wildly popular, especially if driven by computer algorithms that don’t consider human nature. The damage in the markets did not lead to a financial crisis and did not spread to the real economy as the 1929 crash did. The drop was short lived, and the stock markets were actually up for the full year.

A recession didn’t materialize then but would a few years later near the beginning of my career.

First Recession

The 1991 Desert Storm recession is the only recession that left me unemployed. The company I worked for went from about 40 people to six by the time I was let go. I didn’t have a good sense about how long the recession would last, so I studied for the GMAT to prepare for a return to school. The time off helped, and I scored well enough to know I’d make it back to the Michigan Business School. Before I even completed my application, I found myself employed again with the economy well on its way to recovery.  It was a very mild recession. My new employer encouraged me to enroll in the CFA (Chartered Financial Analyst) program. I couldn’t choose, so I did all three, working during the day, attending night school, and studying for the CFA on weekends and every other spare moment I could find. I was also newly married, and, by the time I completed the MBA and CFA, we had three young children. Though that period made me think recessions weren’t so bad, my wife had a different perspective.

The 90s were an incredible time for investing.

Roaring 90s

My biggest frustration was being too young to have money to invest. We tell our youthful clients that they should actually root for bad stock markets. The bulk of their investing dollars will then be put to use at great prices. To our younger clients’ credit, several have called eager to invest during this downdraft.  We started this decade with the first real, functional personal computers that cost $12,000 yet were barely more powerful than today’s calculators. They were loosely connected to an archaic Novell Network that nobody understood. We had one computer hooked up with a “rocket fast” 2400 baud modem which was our only link to the internet. The clean starting page of a then barely known start-up company named Google was enticing because it didn’t take five minutes to load, and the search results were pretty good. Research on this new medium was sparse at best. Most of our research came from the big brokerage firms that had no problem charging us commissions of $50 or more for access to their printed material.

There were several key lessons from this period. A lot of money chased a lot of ideas. That formula lead to tremendous growth and spectacular failures. Even some of the failures, though, benefited the rest of us. For example, there was a big push to wire the world. Crazy money flowed into the infrastructure we get to enjoy today with fast internet speeds and a ubiquitous, global network. However, investors in WorldCom and Global Crossing lost everything. Nearly every idea or company that had a dot associated with it got funded. To use my Italian grandmother’s analogy, we were just throwing the pasta at the wall to see what would stick.

The ideas that worked turned into some of the most powerful companies this planet has ever seen: Microsoft, Cisco, AOL, Intel, Qualcomm, Lucent Technologies, and Nokia. Despite their power, only Microsoft has since eclipsed its 2000 peak level. AOL used its power to acquire Time Warner which is probably the only reason it still exists today. Lucent eventually found its way into a merger with Nokia after a series of prior mergers; the combined companies are worth approximately 10% of what they were worth in 1999. The other big companies have continued to thrive financially, finally inching back to market levels from twenty years ago.There were several intense competitive battles outside of those top names. Remember Netscape? It was going to take on Microsoft by using the browser environment to reduce the power of the Microsoft operating system. Microsoft then incorporated Explorer into its operating system, and Netscape disappeared. Competing search engines included Google, Yahoo, Excite, AOL, Ask Jeeves, Altavista, and MSN. Only one is relevant today. Google was not in that previous list because it wasn’t public yet, but clearly it gained incredible power as a private company. Now as a public company, it has exceled even more.

There were fantastic ideas that turned into great investment ideas, though frequently not with the company that came up with the idea in the first place. Napster changed how we listen to music. This led to the rise of Spotify and Apple’s iTunes. Though Napster still exists in Latin America (under the name Rhapsody), Apple clearly won this battle. In social networking, it took a few iterations; CompuServe led to Prodigy, which was overwhelmed by AOL and MySpace, and then destroyed by Facebook. In other words, great ideas didn’t necessarily lead to great investments.

The market climbed over 20% every year for five straight years. Earnings did not keep up causing valuations to become extremely stretched. We all knew things were crazy. I remember an analyst following Qualcomm upping her new price target for the company to $1,000/share because it just kept going up. The Chair of the Federal Reserve Alan Greenspan even coined the phrase “irrational exuberance” during this time period. Ironically, Greenspan was three years early. This highlights how long the markets can be irrational. As a side note, even after two 50% bear markets in the following decade, the market never got as low as it was when he called the market irrational. Maybe he just didn’t understand the market as well as everyone thought he did at the time. Also, ironically, Qualcomm briefly hit that $1,000/share price target.

All good things eventually do come to an end

Second Recession

It didn’t end abruptly. Rather, things kind of just lost momentum. It started with the pure speculative stocks. Remember the sock puppet Super Bowl ad for pets.com? That company didn’t make it. It turned out, earning money does matter to investors. Eventually, it hit all companies. Even the companies with staying power, like Microsoft, fell 50% or more. The stock market fallout, at first, didn’t trickle down to the real economy. There were layoffs, for sure, in the smaller startups. However, most companies continued to chug along without much of a hiccup. In fact, many used all this new technology to become stronger and more efficient in their operations. Then, out of the blue, terrorists took down the Twin Towers. Everything changed. The travel industry was hit hard. We couldn’t look at a low flying plane the same way. People would stand and stare at the sky. The word of the era was cocooning. Everyone stayed home. We had the misfortune of having to sell our home during this period. I could count the number of walk-throughs we had at that time on one hand.

This did affect the real economy and put us into recession. It, like the early 90s recession, was relatively tame in terms of economic damage. Investors certainly felt the pain as the stock market fell over 50%. What made it particularly difficult from an investor standpoint was how slow the march down took: three years! There weren’t a lot of volatile downdrafts other than the week after 9/11. Instead, it just ground slowly down, down, down. Our newsletters became a bit redundant. In many ways, though, this was about as orderly a correction to reasonable valuation levels as possible. The weak companies disappeared, and the strong companies consolidated power. In the category of “If I Knew Then What I Know Now,” I would have invested in Amazon when it traded down to $6/share. Of course, it was just an online bookstore then.

The Federal Reserve took decisive action and aggressively cut interest rates to help pull us out of the economic slump. Eventually, the market began to recover. This bear market ended without bells and whistles. One day, the market just stopped going down. Even after we realized the market had bottomed, it was difficult to believe. Years of conditioning ourselves to the daily grind of lower market prices made it tough to go all in on this new recovery.

Eventually, we did embrace the new bull market

Third Time's a Charm or Something Like That

Over the next four years, the market climbed all the way back to the peaks seen in 2000. However, investors diversified their portfolios by moving into real estate. With the Feds’ easy money policy (that lasted a bit too long) and no restrictions on loans, flipping houses became the new way to make a quick buck. Leverage at banks climbed ever higher, and new financial instruments were created in the backrooms of these investment banks. (Remember my 1987 period takeaway? This is never a good thing.)

Stocks peaked in 2007, but it wasn’t until Bear Stearns collapsed in March of 2008 that things really worsened. Bear Stearns topped out at over $170 per share in 2007, and analysts were still bullish with price targets in the $180 range. It started writing down bad debt in December of 2007. By January, the stock was at $70/share, and even in early March, it closed at $60/share. Over one weekend, an emergency buyout was arranged, and the company was sold for $2/share. I was stunned. How could an efficient market, with all the relevant information available to investors, not see this? This was viewed by the very same market participants as an isolated incident, and so the market did not follow. In fact, it continued to climb all the way until September when Lehman Brothers and AIG both got into trouble.

Three percent moves a day were common as the Fed and our government tried to figure out which companies to save and which to let go. Lehman went bankrupt. AIG stayed solvent, but barely and not without tremendous government support. Closer to home, GM and Chrysler didn’t survive; but Ford, thanks to the fortuitous timing of a large bond offering, was able to ride out the storm. GM and Chrysler got a government-brokered, expedited bankruptcy, but the original shareholders were completely wiped out. This recession was deep in both the stock market and the real economy. Unlike the first two recessions of my career, this one was caused by a near collapse of our financial system. Our banks were careless, and our investment banks downright reckless. All of the financial regulation meant to keep our banks boring and safe was eliminated leading up to this collapse. Fears of and comparisons to the Great Depression were valid and disconcerting. Unemployment skyrocketed. Most everyone was affected in some way or another by the impacts of this recession.

Fortunately, our Fed was swift in its reactions and flooded the market with liquidity. Congress too acted relatively quickly and added its own $1.0 trillion stimulus package. Despite these efforts in late 2008, the market continued its dive through the first two months and two weeks of the new year, falling an additional 30%. The S&P 500 hit a poetic, demonic low of 666 and then snapped back hard. By June, the market was back to where it began the year. By the end of the year, it was 15% higher.

Little did we know then, a 12-year bull market with very few interruptions would follow. Yet, even five years into the bull market, people continued to feel like they were in a recession. Unemployment was still fairly high which kept wage growth nonexistent. It may not have been classified as a five-year recession, but don’t tell that to all the folks who fell ever further behind. I get the sense that a lot of people didn’t feel like we emerged from recession until about two years ago. It doesn’t take much of a stretch of the imagination to see why the dichotomy between those who could take advantage of the bull market and those who could not played a role in creating today’s divisive political environment.

Today's market environment draws bits from all these previous recessions

Here We Go Again

It started with some people falling ill in China. Somewhat like with the Bear Stearns experience, it was known that something was wrong for several months, but it seemed like an isolated event. When it became clear it wasn’t, the market panicked. It was the fastest 10% correction from all-time highs ever. Once again, part of the reason for the extreme volatility can be blamed on computer algorithms, this time ones used by high-frequency traders who disappeared when volatility hit.

Like 9/11, we will have a period of cocooning. Unlike 9/11, it is by mandate, not choice. Once again, the travel industry got hit first and hardest. Valuations across the board were a bit stretched prior to the emergence of COVID-19, but nowhere nearly as bad as during the tech boom of the 90s. In recent months, some concept stocks took on a life of their own. I imagine some of these ideas will turn into fantastic investment ideas, but perhaps yet again not with the first to market. It would be nice if this investment era leads to companies that provide alternative energy sources that reduce our reliance on fossil fuels and healthier food choices that minimize the need for factory farming. I believe it will, but I’m not sure if the current market leaders will continue to hold that mantle and be able to benefit ten years from now.

The market disruptions are likely to be with us for awhile. It is of paramount importance to stay safe by minimizing contagion of the virus. States are ordering certain businesses to close. While some people work from home, others are not able to do so. The severity and longevity of the economic impairment are nearly impossible to ascertain. Fortunately, we went into this recession from a position of strength. Our banking system had fully healed and is in better shape than before the Great Recession. Unemployment was at historically low levels. Companies were financially strong.

One of the difficulties of the current situation is imagining what coming out on the other side might look like. How will this end? What will happen when our hospitals become overrun with the expected onslaught of severe cases? How will we feel when theoretical numbers discussed in the third person become real-life names discussed in the first person? How will the market respond to these psychological effects, not to mention to the very real economic disruptions?

Currently, the markets are being driven by fear. However, there is hope.  The Fed and Congress have responded to this crisis in record time. In 2008, the market started to convulse in September, but it wasn’t until February that Congress acted to create a stimulus package. This time, Congress took under a month to draft and approve legislation for a record amount ($2.2 T), and it will add to this package over the next several months if needed. Relief will be geared more toward helping Main Street rather than directly bailing out banks, though some of the stimulus money will help banks to assure the proper functioning of the financial system. Some money will also go to specific industries like airlines and hospitality.

Advancements in medicine may just save us.  The DNA of this virus was sequenced in record time, and scientists around the world are hard at work attempting to create a vaccine and treatments that will reduce the most severe symptoms. The market will favorably greet signs of their success, even while knowing ramping up volume of whatever they create will take time. It’s possible investors will move from fear to fear-of-missing-out. We got a taste of that last week right at the end of the quarter. Still, the effects of the virus are likely to be a part of our lives for a long time.

At White Pine, we will do the best we can to manage this process, so that when the next bull market begins (and there will be another), you will be well-positioned to reap the rewards. Paying attention to changing conditions and being flexible are vital. Bad times can feel endless when we are in the middle of enduring them. However, they always end. Until then, stay safe. We’ll take care of your investments.

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